How Perfect Substitutes Became a Myth

In economics, one of the most basic concepts is that of perfect substitutes. Namely, this is the idea that some goods are perfectly identical and substitutable in the consumers mind, such that a price change in one will cause the consumer to simply buy the other. In studying this topic, I immediately had a myriad of problems with the concept, as consumers do not simply see products as interchangeable - they have a developed set of brand and quality preferences. Economics textbooks use the example that Coke and Pepsi are perfect substitutes, which to a soda drinker, is like saying Coke and water or Coke and Orange Juice are the same thing. (Seriously, who drinks Pepsi? I legitimately wonder.) Sure, these items are all under the "beverages" or "sodas" category, but today they are not viewed as alike. This wasn't always the case, though - the rise of American affluence gave us the luxury of choice and ability to be picky about what we like. Below you lies my economic case against perfect substitutes, so read on if you are interested in hearing how they became an economic unicorn. 

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Prior to industrialization and the explosion of communication, consumers had few, if any, options to choose between, and goods were carried in stores via relationship-based sales. This method of purchasing left little room for specific preferences or new entrants to the market, and created an environment in which the concept of perfect substitutes made sense. Globalized trade and the introduction of internet increased both affluence and the number of substitute goods available to consumers, fundamentally changing the climate in which perfect substitutes were hatched. Once marketing and advertising developed as disciplines, consumers began to have brand loyalty and see differentiation in products. The incorporation of ethical choices, brand loyalty, and product differentiation into consumer preferences is contingent upon affluence, but has meant that consumers see goods formerly classified as perfect substitutes to be merely substitutes. The rise of affluence in America allowed for marketing and advertising that has successfully dismantled the concept of perfect substitutes for nearly all goods.

Background

Early economists Francise Ysidro Edgeworth and Vilfredo Pareto were the first to define the concepts of complementary and substitute goods. Between two goods, if the price of Good X increases, and demand for Good Y decreases, Good Y is a complement. Conversely, if the price of Good X increases, and the demand for Good Y increases, Good Y is a substitute. The degree to which certain goods are substitutes or complements varies, depending on what the items are and consumer preferences. If goods are perfectly substitutable in the consumer’s mind, they are known as perfect substitutes—this category typically contains commodities and produce. Common examples of perfect substitutes by economics textbooks include Pepsi and Coke, name brand and generic product, and Budweiser and Coors. Substitutes and complements are some of the most basic economic concepts, but Edgeworth and Pareto died in 1926 and 1923, respectively, making their Edgeworth-Pareto principle around one hundred years old.

Impacts of Marketing

At around the same time, the subjects of marketing and advertising were experiencing major growth. Though topically introduced in the 19th century, it wasn’t until the beginning of the 20th century that the disciplines of marketing and advertising began to grow. Around 1900, the concept of demand evolved from including simple purchasing power to also reflecting desire to purchase, a factor that could be influenced by advertising. Robert Bartels (1967) produced a history of marketing chronicling from the advent of marketing in 1900 to the development of differentiation from 1960-1970 and the socialization of marketing in the seventies.

The Impact of Affluence

As marketing and advertising grew, consumer demand followed cyclically, a phenomenon John Kenneth Galbraith (1958) labeled the dependence effect:

As a society becomes increasingly affluent, wants are increasingly created by the process by which they are satisfied. This may operate passively. Increases in consumption, the counterpart of increases in production, act by suggestion or emulation to create wants… Or producers may proceed actively to create wants through advertising and salesmanship. Wants thus come to depend on output. (p. 129)

When an emphasis on product differentiation manifested through the dependence effect, consumers began to develop detailed preferences for consumption—regular orange juice versus pulp-free, calcium-fortified orange juice versus regular, and so on. Items consumers would have previously never dreamed of demanding slowly become distinctly different in their minds from their former perfect substitute. As absurd as it may seem, the rising affluence of American society has ensured many orange juice drinkers would not view regular orange juice to be a perfect substitute for pulp-free, implying that if the price of one were to rise, consumers would not simply buy the other.

Brand Loyalty

A myriad of literature has been produced discussing the influence of brand loyalty on consumer demand. Though preference loyalty and brand loyalty are distinctly different, they may be considered as similar consumer preferences. Krishnamurthi and Raj (1991) defined the purchase decision as entailing two separate decisions—the brand choice decision and the purchase quantity decision—and empirically found that brand-loyal customers are less price sensitive than non-loyals in the choice decision, but more price sensitive in the quantity decision. That is to say, consumers would rather buy less of a certain good than deviate from their preferred brand, a clear indication that consumers do not regard the purportedly identical goods as perfect substitutes. By the economic definition, a perfect substitute is a Good Y such that if the price of Good X increases, the consumer will simply buy Good Y, as they are interchangeable. Empirical proof showing that consumers would rather buy less of the good than purchase a different brand in response to a price change thoroughly refutes the definition of perfect substitutes. 

Ethical Preferences

Affluence is also recognized as being a “pre-condition for the development of sophisticated substitute and synthetic products”, a theory explored for the food market by Polopolus (1967). This precept holds truer than ever today, as America boasts thousands of food substitutes including vegan, GMO-free, organic, locally raised, and fair-trade products. These product features all have moral and ethical undertones, reflecting, or perhaps because of, the idea that consumers should vote with their wallet. The creation of substitute products extends far beyond food, of course, as the development of chemical and petro-chemical based synthetics has extended textile and raw materials markets. It is affluence that allows for the development of these substitutes, and affluence that gives consumers the luxury of making purchases based on their political and moral causes. Duly, even the typical examples of perfect substitutes—produce and commodities—no longer remain as such.

Formerly indistinguishable foods like apples now have many different categories people are willing to pay a premium for—organic, wax-free, pesticide-free, and locally grown, to name a few. Many do not regard a regular apple to be identical to an organic apple, especially if they are the same price. Empirical findings show that consumers will choose organic over eco-labeled over regular apples, a decision influenced by household size, environmental attitudes, income, and children (Loureiro, 2001). Even in the broad categories of organic and non-organic, consumers care about the location where the item originated in order to reduce carbon emissions and support local businesses. The unique feature of produce and commodities that made them perfect substitutes was the idea that consumers didn’t care who produced the item; they saw suppliers to be interchangeable. The development of market segmentation based on moral and political preferences now precludes all produce and some commodities from being classified as perfect substitutes. The only exceptions to the rejection of perfect substitutes are physically indistinguishable commodities like gold, silver, and oil—all of the others have been marketed and differentiated upon.

The Role of Trade and Internet

The introduction of globalized trade and the internet further increased affluence and, in turn, consumer choice. The product expansion aspect of international trade as pioneered by Krugman (1980) assumes that consumers have a taste for a variety of differentiated goods that cannot all be produced by domestic firms. Trade liberalization thus benefits consumers, as it allows them to choose from a larger number of goods. The expansion of trade increases affluence and expands the variety of products available, allowing marketers to further inflate demand and differentiate products. The development of aforementioned new product qualities did not just happen organically, there had to be innovation and new market entrants with a differing product. The cost of market entrance influences whether or not innovation will be possible, and the rise of global trade coinciding with enhanced transportation and communication infrastructure allowed more actors to enter markets with unique products.

The introduction of the internet compounded the ease with which new actors could enter markets. As affirmed by Freund and Weinhold (2000), the internet stimulates trade and has created a global exchange for goods, reducing costs and acting as a virtual market. Krugman’s trade theory can be expanded to include internet trade—allowing consumers to have access to a wider variety of goods boosts welfare, whether it be through global trade, the internet, or global trade supported by the internet. The internet ensured that all the newly developed consumer preferences could be catered to, no matter where an individual lived. This was a critical market shift, as rural consumers might wish to purchase recycled or organic goods, but not have the physical retail presence to support their preferences. With the introduction of the internet and globalized trade, consumers everywhere became able to make purchases based upon their preferences and values, further cementing their views that certain goods are not perfect substitutes.  

Conclusions

Affluence may be considered the invisible hand guiding the dismantling of perfect substitutes; only those with the luxury of choice may act upon or develop complex preferences. This dismantling will only deepen as access to internet becomes a global standard and environmental concerns drive more consumers to incorporate ethics into their choices. Characterizing former perfect substitutes as merely substitutes is critical both for economists to examine consumer choice, and for businesses to target consumers more effectively. The concept of perfect substitutes made sense in a non-globalized economy with relatively low affluence, but as America has experienced tremendous growth in affluence, consumer preferences have become very complex and non-interchangeable. Resultingly, perfect substitutes should be relegated as arcane economic theory.

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