Does a state of substitutability exist between two courses of action or not? It seems an arcane and obscure subtlety of economic theory to ask such a question. It might be, but the answer has radical implications for the way our economic systems form and evolve.

If you ever had the privilege of visiting the University of Queensland St Lucia Campus in the late 20th and early 21st century (I hope you did, I assure you it’s exquisitely beautiful) you may have seen a curious sight. A gentleman anxiously shuffling along oblivious to the outside world with the tell-tale thousand-yard stare fixed to the ground of the academic rushing to class, with long shoulder-length grey-blonde hair, an outrageously colourful 1970s psychedelic-print business shirt, and (usually) matching tie. This man is one of the most significant economic theorists (in my opinion the most significant) of the 20th and 21st centuries. His name is Peter Earl.

When he was a Doctoral student at Cambridge in the late 1970s he recognised the critical practicality of an otherwise subtle and obscure point of economic theory: substitutability. It is critical because, as Peter as well as Stavros Drakopoulos realised we almost always, in traditional “operational” economic theory (i.e. that we actually use) assume substitutability exists, and the behaviour the theory based on that predicts is radically different to that which would be predicted by a theory which would allow non-substitutability to exist. Since human behaviour is the basis for economic systems, our economic systems look radically different in theories which allow non-substitutability to coexist with substitutability.

The trouble is that the basic concept is so subtle and so belies its radicality that it took me the better part of three years to figure it out when I was studying as Peter’s Doctoral student at the University of Queensland. But once I did figure it out it was truly one of those moments of profundity where one’s eyes are opened to a whole new world one did not know existed right under one’s nose. It became a core technical part of the “UQ model” of economies as complex evolving networks formed by individuals acting on the basis of their psychology and social position, and for that reason I want here to try explaining to you why this otherwise obscure point of economic theory is of critical importance for our understanding of us and our world.

Substitutability: what is it?

Substitutability is a binary state between two courses of action — it either exists or does not. If it exists, then there is a state in which two courses of action can be substituted for one another “without loss”, without a significant change.

In the context of economic behaviour, this “significant change” is the preferability of outcomes expected to follow from deciding between various courses of action. Because the outcomes expected to arise from various courses of action are dependent on the knowledge we have about our world and the way we think about economic behaviour, the state of substitutability is a psychological one. A state of substitutability exists between two sets of economic behaviour if we can take the one, swap it for the other, and find no significant change in the preferability of outcomes we think we might obtain from them.

For instance, a state of substitutability might quite easily exist between a flat white (white coffee) and a latte (a slightly different white coffee) because most of us will expect roughly equivalent outcomes in terms of preferability to follow from their drinking. Of course, for those slightly crazed coffee connoisseurs (we all know and love one: “I know coffee, I used to be a barista!”) this might not be the case, for there are still differences between a flat white and a latte which might loom large in their thinking about the choice they face.

A state of substitutability might exist, but is less likely for most people, to exist between a flat white (white coffee) and a long black (black coffee). One has milk where the other does not; one can be an effective substitute for a light breakfast where the other can’t. It might still be possible to induce a state of substitutability by various alterations of the environment to be sure, but the existence of a state of substitutability is less immediate than it might otherwise have been.

A state of substitutability is less likely again to exist between a flat white and a shot of methamphetamine. Sure they’re both stimulants, but to swap a shot of coffee diluted in milk for a shot of methamphetamine is like riding a missile to the corner shop because your car is too slow — you’re probably going to overdo it and there’s a distinct possibility you’re going to die.

Take some less trivial examples. A state of substitutability is not especially likely to exist between two houses on the basis of location alone, without even accounting for differences in décor, design, utilities and the like. A state of substitutability is unlikely to exist between two cars of different brand name because they’re built in different ways and therefore “do” different things in terms of handling, fuel economy, acceleration, structural integrity and the like. A state of substitutability might exist between the shares or bonds of very similar companies, but is unlikely to exist without some changes in environment between investing in sovereign debt and venture capital, or between managed funds and equities.

That’s what substitutability is. A state of substitutability exists if we can take one course of action, substitute it for another, and obtain roughly equivalent outcomes in terms of their preferability. Now why is that of critical importance for understanding economic behaviour? How does that seemingly arcane and obscure point radically alter the behaviours predicted by economic theory?

Behaviour under substitutability: making tradeoffs

If a state of substitutability exists between two courses of action, we can always induce a behavioural change by “getting the tradeoffs right”. Once we reach a state of substitutability between A and B, I can improve the outcomes you expect of B, and you will trade off the outcomes of A for the improved outcomes of B. This is by definition really — the outcomes expected of B have become more preferable. I can change the attributes and the prices of the goods and services I’m offering to you just so that they’re substitutable; and I can then change them a little further and get you to change your behaviour from choosing the one to choosing the other.

So if I’m offering a good or service which you aren’t buying right now, but a state of substitutability exists for those you’re currently buying, not to worry. I can present you with the tradeoffs which will induce you to buy my goods and services; I just need to work out what they are.

If you’ve ever bought a car, you’ll have been part of this process of “getting the tradeoffs right”. If I were the father of a classic nuclear family (wife and two children) and choosing between a Kia Rio hatchback (a small car) and a Ford Falcon sedan (a midsize family car), my initial preference would probably be the Ford Falcon. The Rio and Ford are relatively similar, but the Ford is a little bigger, has more power and manoeuvrability, and most importantly has four passenger doors as standard. The standard Kia Rio comes with two passenger doors. If you’ve ever tried to get two kids to climb in the back of a car over the front seats you’ll know it’s not a deal breaker, but it’s a bit of a nuisance.

However, the Rio is substantially cheaper than the Ford, and can go cheaper. Even though the government is trying very hard to make it otherwise by printing ever more money, an extra $7000 in the pocket is as yet a substantial amount. It’s substantial enough that simply by lowering the price of the Rio the Kia dealer might be able to induce me to trade off convenience for a substantially cheaper price and get me to a state where the outcomes I expect from the two cars are roughly equivalent in terms of preference. If the dealer offers a yet lower price, or even better, offers me an upgrade to the version of the Kia Rio with four passenger doors, he might just get the “tradeoffs” right, and I’ll forego the power and manoeuvring manliness of a Ford for a cheaper and perfectly adequate Kia Rio.

Peter Earl realised that economists have traditionally been fairly good at explaining this sort of behaviour, because our theories of behaviour are built around the assumption of substitutability. Marshall explained this behaviour very well in his Principles of Economics using marginal analysis, in which it is theorised that behaviour is changed at the point where marginal cost (the price) comes to exceed marginal utility (one variant of a state of substitutability). You raise the price far enough, or lower it far enough, we reach the point of substitutability and behaviour changes. Kelvin Lancaster extended the theory into the world of non-price attributes where the utility itself (as well as price) might be changed by changing the attributes of the course of action which give rise to utility. If we make the attributes progressively “better” we reach the point of substitutability, and behaviour changes. This is a more restricted way of saying that if we change prices and attributes when substitutability exists, our thinking about the expected outcomes of our behaviour changes until we reach the point of substitutability and our behaviour changes.

What we haven’t traditionally been so good at is explaining behaviour which is not the outcome of substitutability and making tradeoffs.

Behaviour under non-substitutability: applying cutoffs

If a state of substitutability exists, I can induce you to change your behaviour, I just need to find the right mix of tradeoffs. This is not the case if a point of substitutability does not exist.

If a point of substitutability does not exist, then there isn’t a state in which two courses of action can be substituted for one another without a significant change in the preferability of outcomes we think we might obtain from them. Simple, right? Sure.

But here’s why that matters — if a point of substitutability doesn’t exist, I can’t guarantee I can change your behaviour by manipulating the tradeoffs you face. I can’t just change prices and attributes a little and have you trade the one course of action against another. I can’t get to the point at which the outcomes you think will arise from them will be roughly equivalent in terms of preferability. Something more fundamental has to change.

Why might this be the case? A great deal of our behaviour isn’t about making tradeoffs. Herbert Simon and his followers (James March, Richard Cyert, later Gerd Gigerenzer and, yes Peter Earl) taught that we follow behavioural rules: “choose A if B”, “C is satisfactory only if x, y and z”. And rules are all about cutoffs.

If we think that some course of action isn’t going to meet the requirements our behavioural rules impose, satisfy the cutoffs, it’s discarded and given no further consideration. No ifs, buts or maybes.

To continue our automobile example from above, the Japanese car industry in its nascence learned the hard way that certain goods and services are not even considered before they meet particular requirements. When Japanese cars first appeared on the American market, they did not meet requirements of speed, power, and manoeuvrability imposed by American consumers needing to drive them on fast-paced highways. This couldn’t be compensated for by lower prices, the cars simply didn’t “make the cut”. The Japanese engineers had to go back into the fundamentals and change the technology to meet the requirements of American consumers before they could begin to have their cars considered as potential purchases.

The difficulty need not actually be physical either. For instance, when Chinese cars first appeared on the Australian market in large quantities they did not achieve much market penetration because of the concerns Australian consumers had about their safety (“if the Chinese put lead in children’s toys…”) and basic reliability (“made in China=broken within a year”). Not until the well-respected Australian automobile associations verified their safety and road-worthiness did the Chinese cars meet the requirements imposed by Australian consumers and come to be considered a satisfactory option. Again, this wasn’t something that could be compensated for by lower prices, the cars simply didn’t “make the cut”.

Until the requirements of behavioural rules are met, we cannot even have goods and services considered, tradeoffs are moot because the cutoffs have not been met. I can’t change your behaviour by “getting the tradeoffs right”, I have to meet requirements before I can even have you consider changing your behaviour. I can’t even begin to think about finding the “right” tradeoffs before I’ve found out what cutoffs I am required to meet.

Behaviour under “deep” non-substitutability: no-go zones

An even deeper form of non-substitutability exists because of the distinction between need and want. Economists typically haven’t been very comfortable with this distinction but it is vitally important. Needs are distinct because they have no obsolescence, they are by their nature necessary. They have to be satisfied if it’s at all possible.

The satisfaction of needs creates deep non-substitutability. If some course of action doesn’t satisfy a need, it simply cannot have expected outcomes as preferable as those associated with some course of action which does, and there is therefore no point of substitutability between the two. I cannot induce you to choose a course of action which fails to satisfy some need until either I change it so that it doesn’t so fail, or I literally leave you with no other option but to leave that need unsatisfied. Needs cannot be traded off against, and if they are in competition (some course of action satisfies one need but not another and vice versa), they aren’t decided between by weighing the one against the other; they are decided between by the imposition of a dictatorial hierarchy which establishes an order of necessity. The existence of this form of non-substitutability creates what Peter Earl and I have called “no-go zones”.

The original (though published later) New Consumer Theory of Duncan Ironmonger in New Commodities and Consumer Behaviour was built around this form of non-substitutability. Economic behaviour subject to this form of non-substitutability looks quite different to the kind which results from making tradeoffs. Each bundle of goods and services must meet the same successive needs in the hierarchy as others before they can be even considered. A change of buying and selling, producing and exchanging behaviour cannot be induced until the object of that behaviour itself (the goods and services) changes to satisfy needs.

John Maynard Keynes, the most famous economist of them all, in The General Theory realised this is critical for understanding how financial markets work, especially in crises. To expand lending activities and borrow in a recession rather than hold money and pay back debts is to seriously risk bankruptcy, and to risk bankruptcy is to contradict the basic need for employment and income born of the basic needs for food, shelter and clothing. There is a breakdown of substitutability between lending and money holdings because of the risk of disaster associated with lending being elevated from possibility to distinct probability. Extending loans becomes a “no-go zone”.

This is why central banks (which seek to control the economy by manipulating tradeoffs to induce other banks to expand and contract their lending) have struggled badly to control their economies in the ongoing European sovereign debt crisis, the Global Financial Crisis, the dotcom bubble, the Japanese depression, the Asian crisis, all the way back to the Great Depression and further. In every case, there has been a breakdown in substitutability, and the central bank tinkering with the tradeoffs of loans versus money holdings becomes moot, for making loans is in a “no-go zone”.

Behaviour under complimentarity: together or not at all

The final type of non-substitutability is its contrary; complimentarity, when things “go together”. When two courses of action are not substitutable but complimentary, we are quite contrary to a situation in which we are considering tradeoffs. When two courses of action compliment each other the outcomes we think are associated with the taking of one are more preferable if the other is taken also.

It isn’t too hard to see that the presence of compliments might be decisive for behaviour. The preferability of the outcomes of some course of action over others may depend on its compliments being present. Therefore, whether we engage in some course of action may depend if it can be taken together with some other; we might choose courses of action “together, or not at all”.

For instance, when I’m deciding whether to go to the shops on the weekend or not to get this or that necessity (groceries or such like), one of the reasons I might go to one of the four mega-shopping centres dotted around Brisbane will be the other shops clustered in and around the centre which have other stuff (like a nice lunch or film I can take my family to). I can kill the proverbial two birds with one stone. I often won’t find it more preferable to make the effort to leave the house, be around other people (I’m a bit of an introvert if you hadn’t guessed), and satisfy that original necessity than simply make do unless I can bundle it with doing something else.

Complimentarity can be important for strategic product design — consider the iPhones 6 and 7. Apple is famous for linking products together so your phone can “talk” to your computer, your iPad, your TV and your fridge. But the iPhone 6 and 7 design missed an important complimentarity which nearly sank the design, at least in the media. As people upgrade their iPhones they and their family tend to accumulate a set of chargers and headphones which becomes really rather convenient (a set for home, a set for the car, a set for work). The iPhone 6 altered the port of the charger, and then the iPhone 7 eliminated the headphone port and merged it with that of the charger. Suddenly to upgrade one’s iPhone wasn’t complimented by one’s accumulated set of necessary accessories.

Apple did this for good reason of course, seeking exploiting the “Diderot effect” of which Peter Earl has spoken whereby the upgrading of one part of a person’s belongings requires the upgrading of the whole. But they forgot was that existing belongings might themselves provide useful, even necessary compliments for new products rather than exist as substitutes for them.

Why this matters a lot: policy, business strategy, technology

If a state of substitutability exists between two courses of action, the one may be swapped for the other with no significant change to the preferability of outcomes we think will arise from them. This all may have seemed an arcane and obscure point of economic theory, but hopefully now we can see why that belies its critical practical importance. It very much matters if a state of substitutability exists or not, because we can avoid making big, painful mistakes when trying to get people to change their behaviour in policymaking, business strategy and designing technology.

Either behaviour is mutable to changes of prices or attributes or it is not. If a state of substitutability exists then it is, and we merely need to get the prices and attributes “right”, if we can, to make those goods and services we want selected associated with the most preferable expected outcomes in people’s thinking. But if a state of substitutability does not exist then behaviour is not mutable to changes of prices or attributes and we can waste inordinate amounts of resources trying to make those changes possible when they would be better devoted to finding the reason for the non-substitutability and addressing it.

If a state of non-substitutability exists, and we still want to induce a change of behaviour in policymaking, business strategy and designing technology, then we need to be thinking much more radically than merely altering the price and attribute tradeoffs people face. We need to either be making fundamental technological changes or changes to the way that people think about the courses of action available to them. We need to either change the world, or change the way people think about it. Then we’re looking beyond traditional economic theories of behaviour, even piecemeal “behavioral” economic theory and entering a brave new world of wholesale psychological economics.