Economic Concepts #3 - Substitutes vs. Complements

Everything in the world is somehow connected in one way or another. Sometimes it is obvious, sometimes it is not, and sometimes things are connected in strange ways we could not have imagined. Today, I want to talk about complements and substitutes. In economics when we discuss complements and substitutes, we are generally referring to goods and services that are complementary or substitutional to each other.

Complements

A complement is something that generally supports, operates with, or enhances something else. Bread and jam are complementary to each other. Bread tastes better with jam spread on top. Jam tastes better on bread than just on its own. Bread and jam enhance each other.

A television set and a DVD player are complementary to each other and a DVD player and DVDs are complementary to each other. The television enables a person to watch the DVD using the DVD player. The television is not complementary to DVDs in the absence of the DVD player.

Demand and price of complementary goods are linked. If the demand for DVDs increases, the demand for DVD players also increases. The demand for televisions will also increase but not substantially. In order to watch a DVD, a DVD player is required. If DVD players (this includes all devices with DVD capability) did not exist, nobody would want DVDs as they could not be watched. A DVD player is a perfect complement to a DVD.

A DVD player is a complement to a Television but not a perfect complement. A television can be used to watch free to air broadcasts, watch satellite or cable programs, or play video games. A DVD player improves the experience of having a television but a television provides utility to the viewer in its own right.

An increase in demand in DVDs will put pressure on the price of DVDs to increase as well as the price of DVD players to increase. It is however, unlikely that an increase in demand will actually result in an increase in price. What will happen instead is that the market will respond to the increase in demand by increasing supply. The increase in production of DVDs and DVD players will result in economies of scale. Economies of scale will bring down the cost of DVDs and DVD players. Through competition, the lower costs of production will bring down the price of both DVDs and DVD players. Economies of scale for DVD and DVD player production are most likely to be quite significant as both can be mass produced very easily.

Substitutes

A substitute is something that acts as an alternative or replacement for something else. Margarine acts as a substitute to butter. Someone would use margarine instead of butter. It is unlikely that someone would use margarine and butter together. Both margarine and butter are complements to bread. Margarine and butter are substitutes because they perform very similar functions. In the context of bread, they both add flavour and taste to the bread. As the flavour they add is very similar, they would not be spread together. Butter and margarine could be considered by some as close substitutes but they are not perfect substitutes as they are not identical. Many argue butter has a nicer flavour but margarine is easier to spread.

Peanut butter and jam also add flavour to bread but for most people they are complements to each other as peanut butter and jam add different flavour to the bread and the flavours of jam and peanut butter are very complementary to each other. Having peanut butter and jam on bread together is an improvement over just having one of them.

PlayStation and Xbox are substitutes to each other. They are both gaming consoles and they mostly have the same games and offer very similar gaming experiences. Even though they offer similar experiences they may not necessarily be close substitutes. Brand loyalty has been established by both brands of consoles. Both consoles also offer online communities and networking that helps maintain loyalty to one brand over the other. The controls and interface of the consoles are also different. Switching from one console to another would require the user to adapt to the controllers and interface, which could be inconvenient.

For substitutes, if the price of a good goes up, the demand for the substitute also goes up. The higher price of the good will push customers to buy the substitute instead. If the price of butter went up, people would switch to buying margarine. In economics, this is what we call positive cross elasticity of demand (elasticity of demand measures the sensitivity of price to quantity, it is not in the scope of today’s post). When the price of the good increases the quantity of demand of the substitute increases.

In reality, it is a bit more complex. If the price of butter increased because of higher costs, then people would switch to margarine. If the price of butter increased because of the increase in demand for bread, the demand for margarine would also increase but because of new customers rather than from people switching from butter. If the price of butter increased because of an improvement in the taste of butter or if butter became easier to spread, the demand for margarine may actually even fall as people would prefer the new improved butter.

Further application

The concepts of substitutes and complements can be applied beyond just goods and services. They can be applied to activities. Some activities complement each other such as bird watching and hiking. Other activities are substitutes to each other such as surfing and water skiing.

These concepts can be applied to people. Some people complement each other with different skill sets and personalities. While other people with similar abilities can substitute each other and fill in for each other when necessary. A good example is football. There are players that can substitute for each other. For example when a player gets injured another similar player is available to fill that player’s role. There are also players that complement each other. Speedy cornerbacks complement big strong defensive lineman. A defence with both fast players and strong players operates better than a defence that has only fast players or only strong players.

Conclusion

The concepts of substitutes and complements are useful to explain the relationships between goods, services, activities, and people. It also important to know that there are many different factors at play that can influence relationships between goods, services, activities, and people.

General equilibrium modelling has been developed to try and capture a whole picture of all relationships. In reality, this is an impossible task and beyond the scope of modelling. There are just simply too many things happening. The best we can do, is identify causality on a case by case basis. Less can be accomplished from trying to analyse too much.

Thank you for reading this post. I hope you found it informative and that you now have a better appreciation by what is meant by substitutes and complements. I have several more posts to come in my economic concepts series.