Commoditize Your Complements

I wrote about a post written by Joel Spolsky last year, and one of the many positive externalities positive spillovers of writing on this blog has been the fact that I’ve gotten to know about Joel and his writing. It is a positive treasure trove, and well worth dipping into.

But the reason I’m writing about him today is because I originally meant to write a post on a recent Ben Thompson post (AI and the Big Five). While going over that article and taking notes, I came across a reference to an old article written by Joel:

Once again: demand for a product increases when the price of its complements decreases. In general, a company’s strategic interest is going to be to get the price of their complements as low as possible. The lowest theoretically sustainable price would be the “commodity price” — the price that arises when you have a bunch of competitors offering indistinguishable goods. So, smart companies try to commoditize their products’ complements. If you can do this, demand for your product will increase and you will be able to charge more and make more.

https://www.joelonsoftware.com/2002/06/12/strategy-letter-v/

I found parts of the write-up mysterious, because I’m not familiar with both the firms and the products that have been spoken about in it. Partly a function of I not knowing enough about the tech world, and partly a function of the article itself being quite old (Transmeta, Ximian, Gnome are examples, of you are wondering).

But the core insight from the article? Both spot on, and an excellent example of a TMKK in a into class about micro.

What is the core insight? A simple, almost throwaway line in micro classes:

All other things constant, the demand for a product will go up when the price of the complement goes down

And we’ve all gone through examples of how “the demand for tea will go up when the price of sugar comes down”. But consider this instead:

When IBM designed the PC architecture, they used off-the-shelf parts instead of custom parts, and they carefully documented the interfaces between the parts in the (revolutionary) IBM-PC Technical Reference Manual. Why? So that other manufacturers could join the party. As long as you match the interface, you can be used in PCs. IBM’s goal was to commoditize the add-in market, which is a complement of the PC market, and they did this quite successfully. Within a short time scrillions of companies sprung up offering memory cards, hard drives, graphics cards, printers, etc. Cheap add-ins meant more demand for PCs.

https://www.joelonsoftware.com/2002/06/12/strategy-letter-v/

Why did this matter to Microsoft? That is, why would they want to ensure cheap add-ins (complements) for PC’s, so that the demand for PC’s (the product) go up? They didn’t actually manufacture the PC’s back then, so how were they profiting?

Microsoft’s goal was to commoditize the PC market. Very soon the PC itself was basically a commodity, with ever decreasing prices, consistently increasing power, and fierce margins that make it extremely hard to make a profit. The low prices, of course, increase demand. Increased demand for PCs meant increased demand for their complement, MS-DOS. All else being equal, the greater the demand for a product, the more money it makes for you. And that’s why Bill Gates can buy Sweden and you can’t.

https://www.joelonsoftware.com/2002/06/12/strategy-letter-v/

As always, do read the rest of Joel’s write-up, please.

Homework:

  1. What examples can you think of where this lesson has been applied in a modern context? Software or otherwise.
  2. How can those of us in the education sector think about the applicability of this lesson?
  3. Industrial organization remains an underrated subject. Discuss.

Complements, Substitutes, AI and the Way Forward

One of the most popular blogposts on this blog is one that I wrote over five years ago: a simple explainer post about complements and substitutes.

It’s part of the arsenal of an economist, an understanding of the concept of substitutes and complements, and it is useful in many surprising and unexpected ways. But never has its use been as important as it is in understanding the importance, the threat and the advantages of AI. A video that I have often linked to in the past, and will probably link to many times again helps make this point clear:

When Steve Jobs says computers are like bicycles for the mind, he is saying that our mind becomes more powerful when we work with computers, rather than instead of them (substitutes) or infinitely worse, without them (almost all examinations conducted in higher education in India today).

And if you want to think about your career in this brave new world of ours, you really should be thinking about working with computers. Not against, or without. As it turns out, this is surprisingly hard to do for most of us. I invite you to walk into a higher education institute of your choice and listen to professors talk about how many students are copying during examinations. Nobody seems to ask why it is right and appropriate to check how good students are at doing work without computers. Why is this a skill that we’re building for folks who will be working in the 21st century?

And if you are learning how to work “effectively” without a computer – and again, that is what we train you for when we make you write three hour pen-and-paper examinations in higher education – you are destroying your ability to earn more in the future.

I’m being quite serious.

The key questions will be: Are you good at working with intelligent machines or not? Are your skills a complement to the skills of the computer, or is the computer doing better without you? Worst of all, are you competing against the computer?

Cowen, Tyler. Average is over: Powering America beyond the age of the great stagnation. Penguin, 2013.

A lot of people are scared about job losses as a consequence of the rapid development of AI, and with good reason. AI can today do quite a few jobs better than humans can, and more than its current capabilities, what keeps a lot of us up at night is the rate of improvement. Not only is AI very good already, but it is noticeably better than it was last year. And for the pessimists among us, the scarier part is that not only will AI be even better next year, but the rate of improvement will also improve. That is, the improvement in AI’s abilities will not only be more in 2023 compared to 2022, but the difference between 2023 and 2022 will be higher than was the difference in 2022 compared to 2021. And that will be true(er) for 2025, and for 2026 and, well, there’s no telling where we’re headed.

But this is exactly why studying economics helps! Because both Steve Jobs and Tyler Cowen are, in effect, saying the same thing: so long as you plan your career by using computers/AI as a complement, you’re going to be just fine. If you think of your job as being substitutable – or if your job is, or will be, substitutable by a computer – well then, yes, you do have problems.

An underappreciated point is the inherent dynamism of this problem. While your job may not yet be a substitute for AI, that is no reason to assume that it will not be substitutable forever:


For example: is Coursera for Campus a complement to my teaching or a substitute for it? There are many factors that will decide the answer to this question, including quality, price and convenience among others, and complementarity today may well end up being substitutability tomorrow. If this isn’t clear, think about it this way: cars and drivers were complementary goods for decades, but today, is a self-driving car a complement or a substitute where a driver is concerned?

https://econforeverybody.com/2022/04/18/supply-and-demand-complements-and-substitutes-and-dalle-e-2/

But even so, I find myself being more optimistic about AI, and how it can make us more productive. I haven’t come across a better explainer than the one that Ethan Mollick wrote about in a lovely post called Four Paths to the Revelation:

I think the world is divided into two types of people: those obsessed with what creative AI means for their work & future and those who haven’t really tried creative AI yet. To be clear, a lot of people in the second category have technically tried AI systems and thought they were amusing, but not useful. It is easy to be decieved, because we naturally tend try out AI in a way that highlights their weaknesses, not their strengths.
My goal in this post is to give you four experiments you can do, in less than 10 minutes each, with the free ChatGPT, in order to understand why you should care about it.

https://oneusefulthing.substack.com/p/four-paths-to-the-revelation

All four examples in this post are fantastic, but the third one is particularly relevant here. Ethan Mollick walks us through how AI can:

  1. Give you ideas about what kind of business you might be able to set up given your skills
  2. Refines a particular idea that you would like to explore in greater detail
  3. Gives you next steps in terms of actualyl taking that idea forward
  4. And even writes out a letter that you might want to send out to potential business collaboarators

His earlier posts on his blog also help you understand how he himself is using ChatGPT3 in his daily workflow. He is a professor, and he helps you understand what a “mechanical” professor might be able to do

To demonstrate why I think this is the case, I wanted to see how much of my work an AI could do right now. And I think the results will surprise you. While not nearly as good as a human professor at any task (please note, school administrators), and with some clear weaknesses, it can do a shocking amount right now. But, rather than be scared of AI, we should think about how these systems provide us an opportunity to help extend our own capabilities

https://oneusefulthing.substack.com/p/the-mechanical-professor (emphasis added)

Note the same idea being used here – it really is all about compementarity and substitutability.

AI can already create a syllabus and refine it; it can create an assignment and refine it; it can create a rubric for this assignment; it can create lecture notes; and it can write a rap song about a business management concept to make the content more interesting for students. I loathe the time spent in creating documentation around education (every single teacher does) and it would take me a long time to come up with even a halfway possible rap song about substitutes and complements.

That last statement is no longer true: it took me twenty seconds.

Here are examples from outside the field of academia:

The question to ask isn’t “how long before I’m replaced?. The question to ask is “what can I do with the time that AI has saved me?”. And the answer to that question should show that you are thinking deeply about how you can use (and continue to use!) AI as a useful complement.

If you don’t think about this, then yes, I do think that you and your job are in trouble. Get thinking!

DallE-2 and Microsoft Designer

I’ll be the first to put my hand up and admit that I’m a sucker to try out new things. But even discounting for my puppy-like enthusiasm for new shiny tech baubles, it’s hard not to get excited about Microsoft’s announcement regarding Microsoft Designer:

For the first time ever, I’m excited to announce Microsoft Designer, a graphic design app in Microsoft 365 that helps you create stunning social media posts, invitations, digital postcards, graphics, and more, all in a flash.
Microsoft Designer is powered by AI technology, including DALL∙E 2 by OpenAI, which means you’re able to instantly generate a variety of designs with minimal effort. Our cutting-edge AI supercharges your ideas.
With Designer, there’s no need to spend time building cards or social media posts from scratch. And you no longer need to search through thousands of pre-made templates. Designer invites you to start with an idea and let the AI do the heavy lifting. For example, with ‘start from scratch’ within Designer, you can simply describe an image you want to see, and the app does the work for you to create something totally unique. As you work in Designer, every surface of the app is powered by AI to help ensure consistent, aligned, properly scaled, and beautiful designs, even with or without any inherent design ability.

https://www.microsoft.com/en-us/microsoft-365/blog/2022/10/12/new-tools-from-microsoft-365-edge-and-bing-bridge-the-gap-between-productivity-and-creativity/

Students introduced me in the past couple of years to Canva, and I have been trying to develop some sort of a design aesthetic ever since. I can’t say I’ve become very good at it, alas, but I’m certainly better than before. Which is not saying much, but leave that be for the moment.

With Designer, I no longer have to try to be good, it would seem. Most excellent.


And please do read this blogpost by Tyler Cowen:

It almost goes without saying that the AI revolution currently underway is impressive. It is likely to have a huge impact in some parts of art world, such as the commercial sphere — consumers are generally not interested in who made any given ad or logo. It either works or it does not, and those conditions favor the machine. AI will also give the world quality (automated) personal assistants and autonomous vehicles, among many other advances.

https://marginalrevolution.com/marginalrevolution/2022/10/how-much-will-ai-succeed-in-the-arts.html

AI will also give students the ability to submit excellent assignments:

There will undoubtedly be many collaborations between AI and human creators, with the humans put forward as the public face of the joint effort. Periodic scandals about authorship will surface (“did he write any of that song?”), just as allegations of cheating with AI have risen to prominence in chess. AI-generated art will attract the most interest when the aesthetic of the creation and the personality of the human accompanist appear to be in sync.

https://marginalrevolution.com/marginalrevolution/2022/10/how-much-will-ai-succeed-in-the-arts.html

What a time to be alive.

The Economics of ReCAPTCHA

This has been doing the rounds on my Whatsapp groups recently, and maybe you’ve seen it too:

Mildly funny, but the story behind it is quite something.


Bots have been a problem for many many years – much before Elon Musk thought of buying Twitter. And as long as sixteen years ago, folks were trying to solve the problem of stopping bots from signing up for services. So how does a computer make sure that the entity trying to sign up for a service actually is a human?

Well, by showing images such as these, and asking the entity on the other side to make out what the word is:

We’ve all been subjected to a variant of this, haven’t we.

Now, one of the folks who came up with this system – it’s called Captcha (say it out aloud and you can figure out the reason behind the name) ran the numbers:

And at some point I did a little back of the envelope calculation about how many of these were typed by people around the world, and it turns out the number I came up with was about 200 million.
So about 200 million times a day somebody would type one of these CAPTCHAs, and that’s when I started thinking, “I wonder if we can do something with this time.” Because the thing is each time you type one of these, not only are they annoying but also they waste about ten seconds of your time, and if you multiply ten seconds by 200 million, you get that humanity as a whole is wasting like 500,000 hours every day typing these annoying CAPTCHAs.

https://tim.blog/wp-content/uploads/2018/08/135-luis-von-ahn.pdf

Work that will gladden the heart of any economist. And so the guy who did these back of the envelope calculations tried to figure out how these 500,000 hours might be put to better use. Thus was born reCAPTCHA. And the idea was a very, very good one.

When you digitize, or scan books for the first time, there will be books with old fonts, outdated fonts. And therefore there will be a fair few words that computers will not be able to decipher. And not just books, this is also true of newspaper archives.

So if we have scanned books and newspaper archives that are non-machine-readable, and we have humans spending 500,000 hours every day… what about connecting the two, and having humans read these words, one at a time?

Scanned text is subjected to analysis by two different OCRs. Any word that is deciphered differently by the two OCR programs or that is not in an English dictionary is marked as “suspicious” and converted into a CAPTCHA. The suspicious word is displayed, out of context, sometimes along with a control word already known. If the human types the control word correctly, then the response to the questionable word is accepted as probably valid. If enough users were to correctly type the control word, but incorrectly type the second word which OCR had failed to recognize, then the digital version of documents could end up containing the incorrect word. The identification performed by each OCR program is given a value of 0.5 points, and each interpretation by a human is given a full point. Once a given identification hits 2.5 points, the word is considered valid. Those words that are consistently given a single identity by human judges are later recycled as control words. If the first three guesses match each other but do not match either of the OCRs, they are considered a correct answer, and the word becomes a control word. When six users reject a word before any correct spelling is chosen, the word is discarded as unreadable.

https://en.wikipedia.org/wiki/ReCAPTCHA

The system has evolved since then, and this version of reCAPTCHA (known as reCAPTCHA v1) is no longer around. We now have reCAPTCHA v2 and reCAPTCHA v3, and if you’re curious, you can learn more about it here.

But I really like the idea behind reCAPTCHA v1, even though it is no longer in use. It used the opportunity presented by a necessary but time-consuming activity by matching it with a necessary but money-and-effort-consuming activity, to the benefit of all concerned.

Turns out the person who came up with the idea has been thinking about computers and human brains as being complementary to each other for a fairly long time, even writing a PhD thesis about it:

Von Ahn’s Ph.D. thesis, completed in 2005, was the first publication to use the term “human computation” that he had coined, referring to methods that combine human brainpower with computers to solve problems that neither could solve alone. Von Ahn’s Ph.D. thesis is also the first work on Games With A Purpose, or GWAPs, which are games played by humans that produce useful computation as a side effect. The most famous example is the ESP Game, an online game in which two randomly paired people are simultaneously shown the same picture, with no way to communicate. Each then lists a number of words or phrases that describe the picture within a time limit, and are rewarded with points for a match. This match turns out to be an accurate description of the picture, and can be successfully used in a database for more accurate image search technology. The ESP Game was licensed by Google in the form of the Google Image Labeler, and is used to improve the accuracy of the Google Image Search. Von Ahn’s games brought him further coverage in the mainstream media. His thesis won the Best Doctoral Dissertation Award from Carnegie Mellon University’s School of Computer Science.

https://en.wikipedia.org/wiki/Luis_von_Ahn

There’s an old talk by Louis von Ahn on the topic as well, if you’re interested.

And here’s the kicker: the same idea, human computation, is at work another venture that Louis von Ahn has started. You may have heard of it, it has got this cute little green owl as its mascot:

So the way this works is whenever you’re a just a beginner, we give you very simple sentences. There’s a lot of very simple sentences on the web. We give you very simple sentences along with what each word means. And as you translate them and as you see how other people translate them, you start learning the language. And as you get more advanced, we give you more complex sentences to translate. But at all times, you’re learning by doing.

https://www.ted.com/talks/luis_von_ahn_massive_scale_online_collaboration/transcript?language=en

Both reCAPTCHA v1 and Duolingo have different business models now, of course. But as students of economics, its’s worth appreciating the idea of complementarity between humans and computers, and the idea of turning a necessary but time intensive activity into a socially useful one.

It may be a funny Whatsapp forward, sure, but as it turns out, there’s quite a story behind it. No?

About Presentations

A student wrote in asking about my ideas about presentation design for a project that she I and are working on together. Here is advice I have found useful, based on what I’ve read/seen online, and for having delivered and sat through presentations:

  1. Be clear about how the presentation is going to be used. Is it meant to be read by participants as a hand-out or on their screens, without you or somebody else being around to deliver a talk? That means lots more details, more notes, and a much lengthier and text heavy presentation. My sincere advice would be to not design a presentation, but to use a document (Google Docs/MS Word/whatever you prefer) instead.
  2. But if the presentation is a complement to what you – the speaker – are going to say, use the 10-20-30 rule.
    “It’s quite simple: a PowerPoint presentation should have ten slides, last no more than twenty minutes, and contain no font smaller than thirty points.”
  3. You’re taking up the audience’s time: value it. If you have thirty people listening to you for thirty minutes, that’s fifteen hours that could have been spent doing something else. Your presentation should be worth that time, you have a huge responsibility on your shoulders. Not enough people appreciate this, unless they happen to be in the audience.
  4. Ruthlessly edit the number of words on your slide. The “30” part of the 10-20-30 rule is a heuristic, and the idea behind it is to force you to use lesser words.
  5. The words that do remain on your slide should be “keywords”, and should be words that you want your audience to remember after the talk is over. If this is not true, then why do you have that word on your slide in the first place?
  6. If you’re presenting a chart, or a table or an infographic, make sure the corresponding title answers the question “So What?”. If your chart shows that sales have gone up in the last four quarters, don’t title the chart “Sales Have Gone Up In The Last Four Quarters.”
    Does that mean you need to hire more workers? Increase inventory? Increase shift timings? Each of these (and so many more) are the “so what’s”. Make the most important of these the title of the chart.
  7. Don’t use the default color template that PowerPoint (or any other software) gives you. Take the time and trouble to figure out how to change the color template, and use one that is appropriate for your presentation. It helps make your presentation more memorable. But also note that simplicity is underrated!
  8. Check, double check and triple check for spelling mistakes. (I’m being a hypocrite right now, because I discover typos in my older blogposts all the time, and it kills me). For presentations, I usually add a thick black diagonal line to each slide, and only remove it after I know that I have double checked each word and element on that slide.
  9. For truly important presentations, have somebody else do the same thing after you’ve done it yourself. A fresh pair of eyes really helps!
  10. Always be prepared to deliver a presentation without the corresponding PPT. Yes, you may have back-ups, but there will be the occasional time when nothing has worked and everything has failed… but the show must go on. Be prepared!

Complements, Substitutes and Examinations

Writing all of what I wrote in February 2020 was a lot of fun, and gave rise to a series of interesting, and interlinked ideas.

In today’s essay, I want to explore one of these interlinked ideas: I want to riff on the concept made famous by Steve Jobs: the computer as a bicycle for the mind. But with an Econ 101 twist to the topic!

I’ve already linked to the video where Steve Jobs speaks about this, but just in case you haven’t seen it, here’s the video:

As I mentioned in the post “Apple Through Five Articles“, Steve Jobs was essentially saying that the computer is a complementary good for the mind: that the mind becomes far more powerful, far more useful as a tool when used in conjunction with a computer.

A complement refers to a complementary good or service used in conjunction with another good or service. Usually, the complementary good has little to no value when consumed alone, but when combined with another good or service, it adds to the overall value of the offering. A product can be considered a compliment (sic) when it shares a beneficial relationship with another product offering, for example, an iPhone complements an app.

One way to understand Apple is to understand that Jobs effectively ensured that Apple built better and better computers. Apple has continued to do that even after Jobs has passed on, but they’ve been building computers all along. You can call them Macs and iPhones and iPads and Apple Watches, but they’re really computers.

But that’s not the focus of this piece. The focus of this piece is to think about this as an economist. If the mind is made more useful when it is able to complement the processing power of the computer, then the world is obviously more productive now that many more minds are being complemented with many more computers. I writing this piece on my laptop, and you reading it on your device is the most appropriate example – or so we shall assume.

But viewed this way, I would argue that we get the design of most of our examinations wrong. Rote memorization, or “mugging up” is still the default method for evaluating whether a student has learnt a particular subject. Mugging up is just another way of saying that we need to substitute for the computer, not complement it!

When we reject open book examinations, when we reject the ability to write a paper using laptops/tablets that are connected to the internet, when we force students to substitute for computers, rather than use them to write better, richer, more informed answers, we’re actively rejecting the analogy of the bicycle for the mind.

To say nothing, of course, of the irrelevance of forcing people to write examinations for three hours using pen and paper. But that’s a topic for another day.

Right now, suffice it to say that when it comes to examinations in India, Steve Jobs would almost certainly have not approved.

Bottom line: If computers are a complement, our examinations are incorrectly designed, and we end up testing skills that are no longer relevant.

And the meta-skill you might take away from this essay is the fact that a lot of ideas in economics are applicable in entirely surprising and unexpected areas!

I hope some of you disagree, and we can argue a bit about this. I look forward to it! 🙂

EC101: Links for 3rd October, 2019

  1. Everything is correlated.
    ..
    ..
  2. For students at Gokhale Institute for sure, but elsewhere too: the Stiglitz essay prize.
    ..
    ..
  3. Capitalim vs Socialism.
    ..
    ..
  4. On reforming the PhD.
    ..
    ..
  5. On complements, substitutes, YouTube and reading.

Own Price, Cross Price and Income Elasticity

We studied elasticity in a previous post:

The percentage change in quantity demanded, given a percentage change in price.

In today’s post, we expand the definition of elasticity a little. That naturally makes it a little complicated, but it also enriches our understanding of it – a good bargain.

What if the price of a substitute changes? What if, that is, the price of Coke changes a little. By what percentage will the quantity demanded of Pepsi change? The measurement of such a thing is called cross price elasticity (substitute).

The percentage change in quantity demanded, given a percentage change in the price of a substitute.

The first definition above is therefore the definition of own price elasticity, while the second one is of cross price elasticity. Cross price elasticity, naturally, will be of twp types – that of complements, and that of substitutes.

There is yet a fourth type of elasticity, called income elasticity of demand. As you might imagine, it is

The percentage change in quantity demanded, given a percentage change in income.

Say your income in a particular month goes down by 10 percent. Is it reasonable to imagine that you will therefore cut back on your consumption of movies in a theatre, or dinners in restaurants? Unless you are a hardcore movie buff, or love eating out a lot, the answer would probably be yes. The income elasticity of demand for these goods is therefore high.

On the other hand, will you cut back your consumption of pills prescribed by your doctor? Almost definitely not, right? The income elasticity of demand for these goods is therefore low.

And that concludes our series on the basics of supply and demand!

Here’s a quick recap:

The demand (and supply) of a good depends upon:

  1.  it’s own price
  2. the price of complements and substitutes
  3. it’s own price elasticity
  4. the cross price elasticities
  5. the income elasticity
  6. changing tastes and preferences
  7. changing incomes

As you can no doubt see, thinking about demand is fairly complex – but it is, nonetheless, rewarding. In the next post, we’ll give you a list of resources for learning more about demand and supply (as we did for the Solow model), and then begin a new topic.

Tastes, Preferences and Income

Remember CD’s? They used to be the last word in convenient storage, and if you are of a particular age or higher “AVSEQ01.dat” will be a very evocative term indeed.

CD’s these days are available for around 15 rupees each, down from about 50 rupees a while ago, and maybe even higher. The law of demand that we have been learning about all this while suggests that the demand for CD’s should go up, since the price has come down.

Ah, but who uses CD’s these days? All the music you’d ever want to listen to and more is available on multiple streaming services. YouTube ensures that you have more video content to watch than is humanly possible, while services such as Netflix and Amazon Prime have made CD and DVD players ancient relics.

In other words, tastes and preferences of people have changed, and they will not want to buy CD’s, no matter the cost. So it’s not just the price of a good, nor that of complements and substitutes that matters – it also is whether or not you want to buy the good at all or not.

And to complicate matters even further, it’s not just tastes and preferences – it’s also income!

Remember dalda? Every Indian household used to use it in the 1980’s, but families today won’t go within sniffing distance of the stuff. That’s because, generally speaking, incomes have been rising, and households now have the money to make health-conscious choices – which means dalda is out, not matter the price.

And you could say the same thing for landlines, cassette recorders, cathode ray televisions, desktops, dumbphones – and that’s just from the world of electronics. As societies progress, they experience a rise in incomes and a change in tastes and preferences – and these things impact both the demand and supply of goods.

So, in a nutshell:

The price of a good, its elasticity, the price of its complements and substitutes, changes in incomes, tastes and preferences all impact the demand (and supply) of a particular good.

Next, we’ll take a look at cross price elasticity and income elasticity.

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.