Demand Curve for Perfect Substitutes
A good grasp of basic economics can be very helpful for small business owners. The phenomenon of substitution, and especially perfect substitution, is a good example of economics knowledge that can inform business practices. Although perfect substitution is a theoretical concept, there are concrete applications to pricing strategy.
The demand curve for a particular good is a reflection of how much consumers are willing to pay for different amounts of that good. The graph takes the form of a curve in the coordinate plane, where price is the vertical axis and quantity is the horizontal axis. Each point on the line is a potential transaction, reflecting that consumers are willing to pay price Y in exchange for quantity X of the good in question.
When two goods are similar in terms of how they benefit the consumer, they are called substitutes. The classic example is Pepsi and Coke -- the two soda brands are very similar to each other. Changes in the price of one of a pair of substitute goods affects the demand curve of the other. If the price of one good increases, the demand curve of the other will move upwards, reflecting that consumers are more willing purchase whichever of the pair is cheaper.
In the (theoretical) case of perfect substitution, the two goods are identical in every way except for price. In this case, an increase in the price of one good will cause all the consumers to shift their purchases to the other good. The demand curve of the cheaper good will shift upward by an amount equal to all the consumers who would have purchased the expensive good. It is important to note that this is a theoretical example. In the real world, forces like brand loyalty mean that some consumers will still stay with a more expensive good, even if it means they are missing out on a bargain.
If a business owner produces a good that is a strong substitute for another good on the market, they can take advantage of this principle by pricing their good below the substitute. Some consumers could be lured over by the savings. The closer substitutes the two goods are, the easier potential buyers could switch over, because they wouldn't lose anything from dropping the expensive good for the cheaper one.