Complements and Substitutes

Two simple concepts, but really important ones.

When we speak about the demand of, and the supply of any particular thing, it is impacted by a variety of factors. One of these factors is the existence of substitutes and complements.

What are substitutes, and what are complements?

Say you walk into a store at the height of summer, thirsting for a nice, ice-cold cola. If you ask for a can of Coke, and upon being told that Coke isn’t available but Pepsi is, drink that can of Pepsi – well, then, you have “substituted” Pepsi for Coke. Goods that can act as a replacement for each other are substitutes.

These substitutes can be near/far substitutes. If no cola drink is available, and you drink nimbu sharbat instead, that is also a substitute. If you just have a glass of water instead of  a cola, well, that is also a substitute. Pepsi would be a close substitute, while water, arguably would be a not so close substitute.

Complements, on the other hand, are things that go well with, or must be used with, the good in question. Who ever heard of a flat screen TV without a set-top box? Of what use is a plate of pakoras in the monsoons without a hot cup of adrak wali chai? These become complements.

Now the reason these concepts are important is because they help us predict demand better. Say Coke sells its cans for 30 rupees, but Pepsi lowers prices to 20. Will the demand for Coke go up or down? Down, naturally, because a close substitute is available at a lower price.

When the price of a close substitute goes up, the demand for the good in question rises, and vice versa.

Generally speaking the closer the substitute, the more worried you should be about the price. Maruti Suzuki won’t lose sleep over its pricing of the Alto if Rolls Royce ups the prices on its models. Strictly speaking, these are substitutes – but not really. On the other hand, if Hyundai lowers the price on Eon (a very close substitute to the Alto), Maruti Suzuki will pay very, very close attention.

Also, the higher the number of susbtitutes, the lesser your ability to raise prices. Who ever heard of a chaiwalla selling tea at 20? It simply doesn’t make sense, because you can typically walk less than 100 meters to find a another chaiwalla selling an equally good cup of tea for the going rate.

And what about complements? Well, it’s easy to think through this. If the price of set-top boxes rises, the demand for flat-screen TV’s will go down. Think about it – you have to factor in not just the cost of the TV, but also the thing that makes the TV useful in the first place. So as a whole package, if the cost is going to go up, well, demand will go down.

When the price of a complement goes up, the demand for the good in question falls, and vice versa.

Complements and substitutes affect the demand for goods, and are also important concepts in the field of marketing.

Next up, we’ll take a look at changing tastes and preferences.

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