How do substitute goods affect pricing strategies?

In one line

The rule

Substitute goods are products that can replace each other to satisfy the same need. When substitutes are available, the price of one affects the demand for the other. Companies must consider substitutes when setting prices, or they risk losing customers.

There is no single formula, but demand for a product (Q) is affected by the price of its substitute (Pₛ):

If Pₛ goes up, demand for our product goes up; if Pₛ goes down, demand for our product goes down.

Let's understand it simply

Imagine you want to buy a cold drink. If Coke is ₹40 and Pepsi is ₹30, most people will buy Pepsi. Coke and Pepsi are substitute goods (products that can replace each other). If Coke raises its price, people will buy more Pepsi. If Pepsi lowers its price, Coke will lose customers. So, both companies must watch each other's prices and set their own prices carefully.

It's like two samosa stalls at your school gate. If one raises prices, students will go to the other. Both sellers know they can't charge much more than the other, or they will lose business.

How it works

1. Identify substitutes: Companies look for other products that can replace theirs (like tea and coffee).
2. Check competitor prices: They watch what price others are charging for similar products.
3. Set their own price: They decide a price that is not too high compared to substitutes, or else customers will switch.
4. Adjust if needed: If a substitute lowers its price, they may have to lower theirs too.
5. Use promotions or features: Sometimes, they add offers or new features to make their product stand out, so people choose them even if the price is similar.
6. Monitor sales and feedback: They keep checking if customers are switching to substitutes and adjust their strategy.

The story behind it

The idea of substitute goods was first explained by economists like Alfred Marshall in the late 1800s. He noticed that when the price of butter went up, people bought more margarine. This helped economists understand how products are linked in the market. The concept became important for businesses to plan their pricing and for governments to study markets.

One famous example is the cola wars between Coke and Pepsi, where each company closely watched the other's price and offers.

Where you see it in real life

• Tea and Coffee: If tea becomes expensive, more people start drinking coffee, and vice versa.
• Bus and Train tickets: If bus fares go up, more people may take the train if it is cheaper.
• Mobile networks (Airtel, Jio, Vi): If Jio reduces its data price, Airtel and Vi often follow, or they lose customers.
• Vegetables in the market: If potato prices rise, people may buy more sweet potatoes or yams.
• Streaming services (Netflix, Amazon Prime): If one lowers its price or adds new shows, people may cancel the other.
• Soap brands (Lux, Dove, Santoor): If one brand offers a discount, others may have to match it to keep customers.

Why it matters

• Prevents overpricing: Companies can't charge too much if substitutes are available, so prices stay fair for customers.
• Encourages innovation: To stand out, companies add new features or improve quality.
• Affects profit: If a company ignores substitutes, it may lose sales and profit.
• Helps in business planning: Understanding substitutes helps companies plan marketing, production, and pricing.

Worked example

Let's say two brands, A and B, sell similar washing powders.

Given: Brand A price = ₹50, Brand B price = ₹40
Step 1: Brand A sees sales dropping because B is cheaper
Step 2: Brand A lowers price to ₹38 to attract customers back
Step 3: Brand B may respond by offering a ₹2 discount coupon
Step 4: Both brands keep adjusting prices and offers to win customers

Common mistakes

• Ignoring substitutes: Some think only their product matters, but customers will switch if a better or cheaper substitute is available.
• Assuming quality is the only factor: Price is very important when substitutes are similar in quality.
• Not watching the market: Companies that don't check competitor prices often lose customers.
• Thinking substitutes only matter for luxury goods: Even basic items like rice and wheat have substitutes that affect pricing.

Remember it

When there are substitutes, price too high and customers will fly!