How to tell if two goods are substitutes or complements from demand function

In this micro video on the theory of demand, we look at substitute and complementary goods. You will come across these when you cover cross price elasticity of demand in introductory microeconomics.

Substitutes and Complements

Substitute goods

• Substitute goods are two alternative goods that could be used for the same purpose.
• They are goods that are in competitive demand
• A rise in the prices of Good S will lead to a contraction in demand for Good S
• This might then cause some consumers to switch to a rival product Good T
• This is because the relative price of Good T has fallen
• The cross-price elasticity of demand for two substitutes is positive

Examples of substitute goods:

• Tea and coffee
• Smartphone Brands
• Rival ride sharing apps
• Competing supermarket chains
• Online streaming platforms
• Cereal brands

Evaluation points on substitutes:

1. Always consider the cost of substitution – there might be switching costs for consumers if they opt for a new brand
2. Some products are close substitutes with a high (positive) cross price elasticity of demand
3. Others are weaker substitutes especially when consumer/brand loyalty is high

Complement goods

• Complementary goods are products which are bought and used together
• A fall in the price of Good X will lead to an expansion in quantity demand for X
• And this might then lead to higher demand for the complement Good Y
• Complements are said to be in joint demand
• The cross-price elasticity of demand for two complements is negative

Examples of complement goods:

• Fish and chips
• Smartphones and apps
• Solar panels & batteries
• Flights and taxi services
• Shoes and polish
• Pasta and pasta sauces

Complement goods and product bundling

• Businesses understand that complements are bought together
• Product bundling is to offer bundles of products sold together at an attractive discount

On the other hand, substitute goods are those goods that compete with each other. Meaning that these goods can be used as a replacement for another good. The relationship depicted by complements and substitutes are covered under ‘Cross Demand‘.

What is Cross Demand?

Cross Demand or cross elasticity of demand, determines the responsiveness of the consumers in the quantity demanded of one commodity, in case the price of another inter-related commodity increases or decreases, while other things remain constant. The sign, i.e. plus or minus, plays a significant role in the cross-price elasticity of demand, as it determines whether the commodities are complements or substitutes.

In this write-up, you will get to know about the difference between complementary goods and substitute goods.

Content: Substitute Goods Vs Complementary Goods

1. Comparison Chart
2. Definition
3. Key Differences
4. Examples
5. Conclusion

Comparison Chart

Basis for ComparisonSubstitute GoodsComplementary GoodsMeaningSubstitute Goods refers to the goods which can be used in place of one another to satisfy a particular want.Complementary Goods refers to those goods which are consumed together to satisfy a particular want.Demand CurveNature of DemandCompetitive DemandJoint DemandPrice-Demand RelationshipDirectInverseCross Price Elasticity of DemandPositiveNegativeSlopeUpward SlopingDownward SlopingDependencyIndependentInterdependentExamplesTube light and LED BulbPetrol and MotorbikeSoap and Body washSolar Panel and BatteryGel Pen and Ball PenElectricity and Electronic DevicesPlane tickets and Train ticketsPencil and EraserLPG and Induction stoveTennis racket and Tennis ball

Definition of Substitute Goods

Substitute Goods, as the name suggests, are the goods that are perceived as an alternative to one another by the consumer, i.e. they can be used in place of each other in consumption. Such goods have the capability of satisfying human wants with the same ease.

When the two goods are developed with similar technology or contain the same ingredient, serve the same purpose and their price is approximately equal, they are called Substitutes. In such a case, an increase in the price of the product leads to an increase in the quantity demanded of its substitutes.

For example, there will be a rise in the total number of train ticket bookings, if there is a rise in the fare of aeroplane tickets.

The cross demand curve is positive in the case of substitute products, which means it moves in the upward direction, indicating that more and more quantities of the commodity will be demanded when there is a hike in the prices of the substitute product. The price of the substitute product is assumed as constant. Hence, if there is an increase in the price of a particular commodity, the demand for its substitute will rise.

Points to Remember

If the cross-price elasticity of demand is positive, its size determines how closely the goods are capable of being substituted. Therefore,

• Cross elasticity between two items will be infinite when they are perfect substitutes.
• Cross elasticity between two items will be positive and large when they are close substitutes.
• Cross elasticity between two items will be positive and small when they are not close substitutes.
• Cross elasticity between two items will be zero when they are completely unrelated.

Also Read: Difference Between Demand and Quantity Demanded

Definition of Complementary Goods

Complementary Goods are defined as the goods which are used or consumed concurrently, so as to satisfy a particular want. This means that these goods are needed jointly, to serve the purpose.

For Example, A increase in the price of computer will lead to a decrease in the demand for the software package.

When there is a change in the price of a particular commodity, it will react oppositely to the demand for the other commodity, which is associated with the primary commodity.

Therefore, there is an inverse relationship between the price of a particular commodity and demand for its complementary item, while other things remain constant. And because the cross elasticity of demand between them is negative, the demand curve is downward sloping.

Points to Remember

The size of the cross-price elasticity of demand is an indicator of how strongly the two goods complement each other. Therefore,

• The goods are said to be weak complements when the cross elasticity between them is only slightly below zero.
• The goods are said to be strong complements when the cross elasticity between them is negative and very high.

Note: One must take a note of the fact that it is not always necessary that goods whose cross elasticity is negative are complimentary because when there is very strong income effect of the price change, then also the cross elasticity is negative.

Also Read: Difference Between Demand and Supply

Key Differences Between Substitute Goods and Complementary Goods

The points given below are important so far as the difference between substitute goods and complementary goods is concerned:

1. Goods that are perceived by the consumer as the same, such that they can be used instead of one another and provide the same level of satisfaction, are called Substitute Goods. On the other hand, goods that are used by the consumer together and are of no use when consumed alone, are called Complementary Goods.
2. While goods that are substituted have competitive demand, goods that are complements experience joint demand.
3. When there is an increase (decrease) in the price of a related product leads to a rise (fall) in the quantity demanded of the main product, then the goods are said to be substitutes. So we can say that substitute goods have a direct relationship between them. On the other hand, when the reduction (hike) in the price of a related good, results in an increase (decrease) in the quantity demanded of the main product, then the goods are said to be complements. Hence, complementary goods have an inverse price and demand relationship.
4. The cross-price elasticity of demand in case of substitutes is positive, because the rise in the price of a commodity increases the demand for another commodity, and causes the curve to shift right. But, the cross-price elasticity of demand in case of complements is negative. This is due to the fact that the rise in the price of a commodity decreases the demand for another, which leads to a leftward shift.
5. In the case of substitute products, the demand curve is upward sloping, whereas, in the case of complementary goods, the demand curve is downward sloping.
6. Substitute goods, for instance, tea and coffee are independent of each other, i.e. they can individually capable of satisfying a particular want. As against, complementary goods, for example, bread and butter, are interdependent on each other, which means that they are used along to satisfy a particular want.

Example

Substitute Goods

Suppose there are two goods Air Conditioner and Cooler, which are commonly used as substitutes by the consumer. The change in their prices and quantity demanded are given in the table below:

As you can see, the price of AC has increased, whereas the price of cooler is constant, leading to an increase in demand for coolers.

Complementary Goods

Suppose there are two goods Laptop and Battery, which are complements to one another. The change in their prices and quantity demanded are depicted hereunder:

In the given schedule, you can observe that as the price of laptops increases, the demand for laptop batteries decreases.

Conclusion

So, with the above discussion, it is quite clear that the change in the price of related goods has a great impact on the quantity demanded of the main product. While the price and demand relationship in the case of substitutes is directly proportional, it is inversely proportional in the case of complements.

How can we say that a goods is a substitute or a complement?

When determining whether two goods are complements you would look for a cross elasticity of demand?

What are substitutes and complements in relation to demand?