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In microeconomics, two goods are substitutes if the products could be used for the same purpose by the consumers. That is, a consumer perceives both goods as similar or comparable, so that having more of one good causes the consumer to desire less of the other good. Contrary to complementary goods and independent goods, substitute goods may replace each other in use due to changing economic conditions. An example of substitute goods is Coca-Cola and Pepsi, the interchangeable aspect of these goods due to the similarity of the purpose they serve,i.e fulfilling customers desire for a soft drink. These types of substitutes can be referred to as close substitutes.

Perfect substitutes refer to a pair of goods with uses identical to one another. In that case, the utility of a combination of the two goods is an increasing function of the sum of the quantity of each good. That is, the more the consumer can consume (in total quantity), the higher level of utility will be achieved, see figure 3.

The threat of substitution refers to the likelihood of customers finding alternative products to purchase. When close substitutes are available, customers can easily and quickly forgo buying a company's product by finding other alternatives. This can weaken a company's power which threatens long-term profitability.

The risk of substitution can be considered high when :

Customers have slight switching costs between the two substitutes available.

The quality and performance offered by a close substitute are of a higher standard.

Customers of a product have low loyalty towards the brand or product, hence being more sensitive to price changes.

Goods $$x_i$$ and $$x_j$$ are said to be net substitutes if



\left.\frac{\partial x_j}{\partial p_i}\right|_{u=const}>0 $$

That is, goods are net substitutes if they are substitutes for each other under a constant utility function. Net substitutability has the desirable property that, unlike gross substitutability, it is symmetric:



\left.\frac{\partial x_j}{\partial p_i}\right|_{u=const} = \left.\frac{\partial x_i}{\partial p_j}\right|_{u=const} $$

That is, if good $$x_j$$ is a net substitute for good $$x_i$$, then good $$x_i$$ is also a net substitute for good $$x_j$$. The symmetry of net substitution is both intuitively appealing and theoretically useful.

The common misconception says that competitive equilibrium is non-existent when it comes to products that are net substitutes. Like most times when products are gross substitutes, they will also likely be net substitutes, hence most gross substitute preferences supporting a competitive equilibrium also serve as examples of net substitutes doing the same. This misconception can be further clarified by looking at the nature of net substitutes which exists in a purely hypothetical situation where a fictitious entity interferes to shut down the income effect and maintain a constant utility function. This defeats the point of a competitive equilibrium, where no such intervention takes place. The equilibrium is decentralized and left to the producers and consumers to determine and arrive at an equilibrium price.

Cross price elasiticity helps us understand the degree of substitutability of the two products