Perfect Complements and Perfect Substitutes are 2 common jargons of MBA life. Apart from being at the heart of Micro Economics, its relevance to an individual and businesses are many folds.
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A perfect competition is a good that has to be consumed with other good.
As the consumption of one good goes up, the consumption of the other good also increases. This phenomenon is observed in many goods in the market. Take the example of shoes, as the sale of left shoe increases, the right one also increases by the same level; ergo they are perfect complements. But complements are also found in other object and may not necessarily grow at 1:1 ratio. Take paint and brush, as the sales of paint grow, so does the brush.
Supply Demand Curve
The demand for the complementary good decreases as the price of the original good increases. The idea here is because people would buy less of the good due to increased prices and as the consumption of the complement is directly proportional to the consumption of the good; the consumption of complement decreases given everything else is kept constant (ceteris paribus 😜)
The utility function of the complement increases if and only if you have both the goods in the specified proportion.
Take the classic example of shoes. You can have 100s of left shoes and 1 right shoe. The utility from such a collection is only 1 pair of shoes, no more no less.
A substitute good is the one that can be used in the place of other
Take the example of water and cold drink. If I have to quench my thirst, I would either drink water or cold drink. In a way the usage of one thing satisfies the utility of the individual as would the usage of other.
Supply Demand Curve
As we observe from the above example, the price increase of the product leads to a subsequent demand drop in the product. As the demand for the product falls, the demand for its substitute eventually increases.
The utility function of complements is visible in the above graph. The overall utility that can be gained by both the goods is inversely proportional to each other. Also it is important to note that the utility functions are parallel to each other.
Implication to Businesses
Complements and Substitutes lie at the heart of any business. As a matter of fact, based on the iconic Porter’s 6 forces, the profitability of the industry is based on the forces from Substitutes and Complements. The substitutes can affect a specified industry based on the following factors:
- Relative Price performance of substitutes
- Switching costs
- Buying propensity towards substitutes
Complements also affect the industry profitability accordingly, thus affecting the profitability of all the individual businesses.
Perception: The plot twist
Till this point through the narrative, we would have established and cemented the fact that complements and substitutes are basically antonyms, the exact opposite of each other. A product can either be a complement or substitute, but not both at the same time. I grew through my MBA life believing in this fact. But then, off recently while reading a book (The Content Trap – Bharat Anand), I came across this very unique example that completely changed my attitude towards both these jargons.
Take the example of 2 white t shirt. Imagine them to be of the same size and color with little, if any differentiation.
Both are clearly perfect substitutes of each other. You can simple replace the usage of one with another. But then just take a moment and see how these products completely transform their behavior with a slight modification. We just add incomplete hearts on 2 white t-shirts, as shown below
And voila, they are now perfect complements of each other.