Download - Power of Substitutes: Economics of Cross-Price Elasticities

David Bryce © 1996-2002Adapted from Baye © 2002

Power of Substitutes: Economics of Cross-Price Elasticities

MANEC 387MANEC 387Economics of StrategyEconomics of Strategy

David J. Bryce


The 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 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


Changing 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

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

Computers (X)

X1

Calculators (Y)

X2

Y1

Y2


Complementary Goods

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

Computers (X)

X1

Software (Y)

X2

Y1

Y2


Elasticity 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


• 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 Demand

Qx,Py = %Qx

%Py

Qx,Py > 0: substitute products

Qx,Py < 0: complementary products


Strength 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


MRS 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.

Good Y

Good X

S1

S2

S3

S3 > S2 > S1


Strength of SubstitutesGood Y

Good X

PerfectSubstitutes

ImperfectSubstitutes

ImperfectSubstitutes

• 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&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?


Impact 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

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