david bryce © 1996-2002 adapted from baye © 2002 power of substitutes: economics of cross-price...

David Bryce © 1996-2002Adapted from Baye © 2002


Power of Substitutes: Economics of Cross-Price Elasticities

Power of Substitutes: Economics of Cross-Price Elasticities

MANEC 387MANEC 387

Economics of StrategyEconomics of Strategy

MANEC 387MANEC 387

Economics of StrategyEconomics of Strategy

David J. BryceDavid J. Bryce



The Structure of IndustriesThe Structure of Industries

Competitive Rivalry

Threat of newEntrants

BargainingPower of

Customers

Threat ofSubstitutes

BargainingPower of Suppliers

From M. Porter, 1979, “How Competitive Forces Shape Strategy”



Demand and the Prices of Other ProductsDemand and the Prices of Other Products

• In addition to its own price, consumption of a good depends on other factors– Prices of other goods– Product quality– Income– Preferences– Advertising

• Changes in these factors results in a “change in demand” – shift of the demand curve

• In addition to its own price, consumption of a good depends on other factors– Prices of other goods– Product quality– Income– Preferences– Advertising

• Changes in these factors results in a “change in demand” – shift of the demand curve



Changing Prices of Rival ProductsChanging Prices of Rival Products

• Substitute goods – an increase (decrease) in the price of good X leads to an increase (decrease) in the consumption of good Y.

• Complementary goods – an increase (decrease) in the price of good X leads to a decrease (increase) in the consumption of good Y.

• Substitute goods – an increase (decrease) in the price of good X leads to an increase (decrease) in the consumption of good Y.

• Complementary goods – an increase (decrease) in the price of good X leads to a decrease (increase) in the consumption of good Y.



Substitute GoodsSubstitute Goods

When the price of good X falls, the consumption of substitute good Y also falls.

When the price of good X falls, the consumption of substitute good Y also falls.

Computers (X)Computers (X)

X1X1

Calculators (Y)Calculators (Y)

X2X2

Y1Y1

Y2Y2



Complementary GoodsComplementary Goods

When the price of good X falls, the consumption of complementary good Y rises.

When the price of good X falls, the consumption of complementary good Y rises.

Computers (X)Computers (X)

X1X1

Software (Y)Software (Y)

X2X2

Y1Y1

Y2Y2



Elasticity and the Power of SubstitutesElasticity and the Power of Substitutes

• Substitutes are defined by product function, not by product form

• Substitutes have power to reduce prices when buyers have high cross-price elasticity between a firm’s product and substitute products– Close relative price/performance ratio– Consumer tastes & preferences favor

substitute’s features– Low switching costs

• Substitutes are defined by product function, not by product form

• Substitutes have power to reduce prices when buyers have high cross-price elasticity between a firm’s product and substitute products– Close relative price/performance ratio– Consumer tastes & preferences favor

substitute’s features– Low switching costs



• Cross-price elasticity gives the sensitivity of demand of good X to changes in the price of good Y

• Cross-price elasticity of demand defines the strength of the relationship between X and Y

• Cross-price elasticity gives the sensitivity of demand of good X to changes in the price of good Y

• Cross-price elasticity of demand defines the strength of the relationship between X and Y

Cross Price Elasticity of DemandCross Price Elasticity of Demand

Qx,Py =Qx,Py = %Qx%Qx

%Py%Py

Qx,Py > 0: substitute products

Qx,Py < 0: complementary products

Qx,Py > 0: substitute products

Qx,Py < 0: complementary products



Strength of Substitutes and ComplementsStrength of Substitutes and Complements

• With strong substitutes, many customers will consume the substitute good if a firm raises its prices– Coke v. Pepsi – Suburban v. Expedition

• With strong complements, many customers will reduce consumption of a firm’s product if price of the complement is raised– Personal computers and software– Hamburger buns and E-coli tainted hamburger

• With strong substitutes, many customers will consume the substitute good if a firm raises its prices– Coke v. Pepsi – Suburban v. Expedition

• With strong complements, many customers will reduce consumption of a firm’s product if price of the complement is raised– Personal computers and software– Hamburger buns and E-coli tainted hamburger



MRS Defines the Strength of SubstitutesMRS Defines the Strength of Substitutes

• Marginal Rate of Substitution – the rate at which a consumer is willing to substitute one good for another and stay at the same satisfaction level.

• Marginal Rate of Substitution – the rate at which a consumer is willing to substitute one good for another and stay at the same satisfaction level.

Good YGood Y

Good XGood X

S1S1

S2S2

S3S3

S3 > S2 > S1S3 > S2 > S1



Strength of SubstitutesStrength of Substitutes

Good YGood Y

Good XGood X

PerfectSubstitutesPerfectSubstitutes

ImperfectSubstitutesImperfectSubstitutes

ImperfectSubstitutesImperfectSubstitutes

• Willing to exchange perfect substitutes one-for-one, i.e., indifference curve has a slope of –1

• Imperfect substitutes exchange at different rates

• Diminishing marginal satisfaction creates imperfect substitutes

• Willing to exchange perfect substitutes one-for-one, i.e., indifference curve has a slope of –1

• Imperfect substitutes exchange at different rates

• Diminishing marginal satisfaction creates imperfect substitutes



Cross-Price Elasticity at AT&TCross-Price Elasticity at AT&T

• According to an FTC Report, AT&T’s cross price elasticity of demand for long distance services is 9.06

• If competitors reduced their prices by 4 percent, what would happen to the demand for AT&T services?

• According to an FTC Report, AT&T’s cross price elasticity of demand for long distance services is 9.06

• If competitors reduced their prices by 4 percent, what would happen to the demand for AT&T services?



Impact of AT&T Rivals’ Price CutsImpact of AT&T Rivals’ Price Cuts

• 9.0 is a high cross-price elasticity – customers are sensitive to rival prices so we would expect to see a loss of market share– 1% reduction in rival prices generates a 9.06%

reduction in demand for AT&T services, so– 4% reduction in rivals prices generates a 36.24%

reduction in demand for AT&T services

• Stealing market share so easily tempts all firms to cut prices substitutes have power over AT&T prices

• 9.0 is a high cross-price elasticity – customers are sensitive to rival prices so we would expect to see a loss of market share– 1% reduction in rival prices generates a 9.06%

reduction in demand for AT&T services, so– 4% reduction in rivals prices generates a 36.24%

reduction in demand for AT&T services

• Stealing market share so easily tempts all firms to cut prices substitutes have power over AT&T prices

david bryce © 1996-2002 adapted from baye © 2002 power of substitutes: economics of cross-price...

Documents

price of good x

consumption of good

high crossprice elasticity

david bryce

bryce slide

increase decrease

price elasticities manec

demand curve slide