When examining how price and demand changes will affect markets, it is important to consider how various goods are related. We can separate goods into 2 basic types: substitutes and complements.
A substitute good is—you guessed it!—a substitute for something else. Broadly speaking, oranges and apples could be classified as substitutes. Obviously, oranges and apples are not that similar, which is why they are not classified as “perfect substitutes”. When the price increases for one good, the demand for the substitute will increase (assuming that price remains constant). What does this look like?
Imagine you are going grocery shopping, and have included on your list oranges and apples. You get to the grocery store and see that prices of apples have doubled, while oranges cost the same. So, you decide to just buy more oranges instead of some of both.
Obviously, this decision will also be affected by how much the price increases and the amount of money you have to spend. For a wealthy shopper, a change from $1 to $2 an apple won’t be a huge deal. A person who loves apples more than oranges may also decide not to change their purchase plan. But, consider this analogy on a larger scale—say that the cost of an SUV doubles, so you instead buy a small car. Both goods accomplish the same function, meaning they are substitutes. As long as you don’t have very strong preferences, you will change your demand for small cars due to changes in the price of SUVs.
Let’s trace back to the aforementioned concept of “perfect substitutes”, again, which is defined like it sounds—two items that are perfectly indistinguishable in the eyes of the consumer. Perfect substitutes used to be a commonly found thing, but as marketing and advertising have created brand loyalty, differentiating traits, and premium qualities (“organic”, “recycled”, etc.) consumers no longer view many goods as perfectly alike. The most relevant examples of perfect substitutes come in the form of commodities—fruit, vegetables, wheat, and more. You don’t care if you are getting a tomato from one farmer or the other, so the vendors are providing perfect substitutes. Branded items versus their generics are also often perfectly elastic—they accomplish the exact same function, so if the price skyrockets for the brand-name item, most people will just buy the generic instead (increased demand).
The idea of two tomatoes as perfect substitutes is contingent upon the idea that they have identical qualities. If one is locally raised and organic, and the other just a plain old tomato, there are people out there who will prefer the organic one. How much more are they willing to pay for these preferences? We can evaluate this through a number known as the elasticity of demand.
The elasticity of demand indicates how sensitive a consumer (or consumers) will be to the change in price of a good. When a good has elastic demand, it means that consumers are very sensitive to changes in price. Picture a rubber band to remember that elastic = sensitive. If the price changes, the consumer will bounce away to another good!
Conversely, inelastic demand means consumers will typically not be very responsive to changes in price. If there are more substitutes, a person will have more elastic demand. A good like gasoline has very few substitutes unless you own an electric car, so the demand for it will remain high even if the price skyrockets. Gasoline is thus inelastic. Of course, elasticity also depends on personal preferences—a hardcore “locavore” will strongly prefer the locally grown tomato, and likely be willing to pay extra for it.
For individual consumers, the concept of elasticity can factor in many inputs and preferences aside from just number of substitutes. When aggregated, it can be much more difficult to account for the different preferences various groups have—some might want to buy the cheapest thing regardless of origin, while others are concerned with purchasing morally-sound products, and even more people interested in buying the trendy “branded” product.
Ok, so what about complements? Complementary goods literally complement each other. Peanut butter is a complement to jelly. Gas is a complement to cars. Complementary goods are items that go together, so if the price of one increases the demand for the other will decrease. The strength of this correlation depends on how related the goods are. If peanut butter costs a lot more, some people will buy less jelly, but others will just use their jelly on toast instead of a PB&J. On the other hand, if the price of cars increases, demand for gas may decrease—you cannot use one item without the other, so the demand is tightly intertwined.
Again, this demand intertwining is called elasticity of demand. If two complementary goods cannot function without each other, they will have a perfectly inelastic demand. Examples include left and right shoes (imagine a world in which they are sold separately!) and a bike frame and bike wheels.
Complements can often have a one-sided effect because of their dependent nature. If tires become cheaper, you don't suddenly decide to buy a car. But on the other hand, if cars become cheaper, you will demand more tires. Same goes for the cost of songs on iTunes and iPods, and many other complementary relationships. Clearly these complementary pairs are not two-sided, often because one good is a sub-component of the other. In situations where the goods exist independently (such as milk and cookies), this one-sided issue doesn't really apply. Substitutes work both ways because they are supposed to be interchangeable to begin with.
With the increased amount of products available to us today, the amount of complements available has also increased. Most importantly, substitutes and complements interact to allow the consumer to adjust to price changes. Let me give a few examples:
The price of gas increases. Gas is a complement to your car. But, your car is a substitute to the city bus or subway. So, to adjust for the price in gas you simply switch to public transportation in the mean time.
The price of Oreos increases. Oreos are a complement to milk, so the demand for milk would go down, but, Chips Ahoy and Pepperidge Farm cookies are substitutes for Oreos! Unless you were dead-set on Oreos (inelastic), you will buy the other cookies, and milk will not see the demand go down much.
Now do you see how the relationship between goods is important?