nile hatch © 1996-2002 responding to power of substitutes manec 387 economics of strategy manec 387...

Nile Hatch © 1996-2002Nile Hatch © 1996-2002

Responding to Power of SubstitutesResponding to Power of Substitutes

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”


Summary of Last SessionSummary of Last Session

• Substitutes give buyers choices and lower their price elasticity of demand for our product.

• The closeness of a substitute is measured by the cross-price elasticity of demand. When substitutes are close, our customers are able and willing to switch – they are more price sensitive.

• Complements are the opposite of substitutes; when demand for a complement falls, demand for our product also falls.

• Substitutes give buyers choices and lower their price elasticity of demand for our product.

• The closeness of a substitute is measured by the cross-price elasticity of demand. When substitutes are close, our customers are able and willing to switch – they are more price sensitive.

• Complements are the opposite of substitutes; when demand for a complement falls, demand for our product also falls.


What can be done to neutralize the power of substitutes?

What can be done to neutralize the power of substitutes?1. Differentiate product or service so that

substitutes are not close2. Create demand for complementary goods3. Innovate or Copy to deliver the features of

substitute products 4. Narrow the number of substitutes of the

buyer through market consolidation or exclusive alliances

5. Create switching costs for your customers

1. Differentiate product or service so that substitutes are not close

2. Create demand for complementary goods3. Innovate or Copy to deliver the features of

substitute products 4. Narrow the number of substitutes of the

buyer through market consolidation or exclusive alliances

5. Create switching costs for your customers


1. Differentiate Product1. Differentiate Product

• Substitutes have power when the price/performance ratio is close.

• Differentiation on features or image can reduce cross-price elasticity and widen the perceived price/performance ratio.

• By differentiating, the firm may, in effect, create a monopoly within some particular consumer segment

• Example – Kobe Beef

• Substitutes have power when the price/performance ratio is close.

• Differentiation on features or image can reduce cross-price elasticity and widen the perceived price/performance ratio.

• By differentiating, the firm may, in effect, create a monopoly within some particular consumer segment

• Example – Kobe Beef


2. Create Demand for Complementary Goods2. Create Demand for Complementary Goods

• Complementary goods work with other products or services to create joint value for customers

• Cooperate with complementary companies or create new goods outright and stimulate demand for that good; or

• Make your good or service an exclusive input into the production of another good or service and create demand for that good

• Example – Microsoft office and computers

• Complementary goods work with other products or services to create joint value for customers

• Cooperate with complementary companies or create new goods outright and stimulate demand for that good; or

• Make your good or service an exclusive input into the production of another good or service and create demand for that good

• Example – Microsoft office and computers


3. Narrow the Options of the Buyer3. Narrow the Options of the Buyer

• Since many substitutes available to buyers diminishes a seller’s flexibility, one strategy is to limit buyer’s options

• How?– Buy, merge, or align with your

competitor(s), supplier(s), or customer(s)– Lobby the government to impose

preferential treatments for your products

• Example – Microsoft’s attempt to acquire Intuit, maker of Quicken

• Since many substitutes available to buyers diminishes a seller’s flexibility, one strategy is to limit buyer’s options

• How?– Buy, merge, or align with your

competitor(s), supplier(s), or customer(s)– Lobby the government to impose

preferential treatments for your products

• Example – Microsoft’s attempt to acquire Intuit, maker of Quicken


4. Innovate or Copy4. Innovate or Copy• If another firm’s substitute product is rapidly stealing

customers, the best alternative may be to rapidly copy the other product’s attractive features

• This may reduce the relative appeal of the substitute

• Stands in contrast to differentiation, in which you create a “monopoly;” here you instead share the market in a duopoly

• The decision about whether to copy or differentiate turns on the relative size and profitability of the markets served– If a competitor’s differentiated substitute appeals to a very large

market (e.g. double your current market), then copy

– If you can appeal to a large market with unique features, then differentiate

• Example – Coke and Pepsi innovating to match the substitutes that threaten cola, these include sports drinks, water, energy drinks.

• If another firm’s substitute product is rapidly stealing customers, the best alternative may be to rapidly copy the other product’s attractive features

• This may reduce the relative appeal of the substitute

• Stands in contrast to differentiation, in which you create a “monopoly;” here you instead share the market in a duopoly

• The decision about whether to copy or differentiate turns on the relative size and profitability of the markets served– If a competitor’s differentiated substitute appeals to a very large

market (e.g. double your current market), then copy

– If you can appeal to a large market with unique features, then differentiate

• Example – Coke and Pepsi innovating to match the substitutes that threaten cola, these include sports drinks, water, energy drinks.


5. Switching Costs5. Switching Costs

• Switching costs impose additional costs on customers who shift to a substitute product relative to staying with the familiar brand – Buyers develop brand specific knowledge –

e.g., software– Seller develops buyer-specific knowledge or

after-sales service – e.g., consulting firms– Repeated use discounts – e.g., frequent

fliers, frequent clients (law services), frequent video rentals, …

• Switching costs impose additional costs on customers who shift to a substitute product relative to staying with the familiar brand – Buyers develop brand specific knowledge –

e.g., software– Seller develops buyer-specific knowledge or

after-sales service – e.g., consulting firms– Repeated use discounts – e.g., frequent

fliers, frequent clients (law services), frequent video rentals, …


Switching Costs Reduce Substitute PowerSwitching Costs Reduce Substitute Power

• With switching costs, price:performance must be even closer for the customer to switch – e.g., let S be switching cost and Bi be the benefit of good i

– Perfect substitutes: PY + S < PX

– Imperfect substitutes: PY + (BX-BY) + S < PX

• Price of the substitute must be proportionally lower to compensate for the switching cost before the substitute attracts customers

• With switching costs, price:performance must be even closer for the customer to switch – e.g., let S be switching cost and Bi be the benefit of good i

– Perfect substitutes: PY + S < PX

– Imperfect substitutes: PY + (BX-BY) + S < PX

• Price of the substitute must be proportionally lower to compensate for the switching cost before the substitute attracts customers


Sources of Switching CostsSources of Switching Costs

• Contractual commitments – breaking contracts to switch may lead to compensatory damages (breaking a lease)

• Durable purchases – replacing existing equipment to switch is incrementally more expensive (razors and blades, digital broadband vs. DSL)

• Brand specific training – switching means learning a new interface (software)

• Contractual commitments – breaking contracts to switch may lead to compensatory damages (breaking a lease)

• Durable purchases – replacing existing equipment to switch is incrementally more expensive (razors and blades, digital broadband vs. DSL)

• Brand specific training – switching means learning a new interface (software)

Source: Shapiro and Varian (1998)Source: Shapiro and Varian (1998)



• Information and databases – switching to new systems requires transferring data to new storage media and/or data formats

• Search costs – finding and evaluating an acceptable new supplier costs time and money

• Specialized suppliers – sometimes critical components are supplied by a single supplier (Dell and operating systems)

• Information and databases – switching to new systems requires transferring data to new storage media and/or data formats

• Search costs – finding and evaluating an acceptable new supplier costs time and money

• Specialized suppliers – sometimes critical components are supplied by a single supplier (Dell and operating systems)




• Loyalty programs – switching causes customers to lose out on program benefits (airline frequent flier programs, bookstore and grocery store preferred customer programs)

• Loyalty programs – switching causes customers to lose out on program benefits (airline frequent flier programs, bookstore and grocery store preferred customer programs)



Limitations of Switching CostsNew entrants may be less affectedLimitations of Switching CostsNew entrants may be less affected

• Switching cost applies only to repeat purchases of customers who have already purchased– New customers have no switching costs– Entrants can capture new customers with less

discounting– Incumbents may hesitate to match discounts

because they lose margins on established customers

• Early market share leaders set high price and let market share erode (stabilizing inertia) – e.g., STATA vs. SAS and SPSS

• Switching cost applies only to repeat purchases of customers who have already purchased– New customers have no switching costs– Entrants can capture new customers with less

discounting– Incumbents may hesitate to match discounts

because they lose margins on established customers

• Early market share leaders set high price and let market share erode (stabilizing inertia) – e.g., STATA vs. SAS and SPSS

Source: Farrell and Shapiro (1988); Besanko, Dranove, and Shanley (2000)Source: Farrell and Shapiro (1988); Besanko, Dranove, and Shanley (2000)


Limitations of Switching CostsLimitations of Switching Costs

• Compatibility interfaces to reduce knowledge specific lock-in– Quattro Pro and Lotus 1-2-3– Word and WordPerfect– Mac OS and Windows

• Installed base does not necessarily imply switching costs – you must be careful to identify the lock-in mechanisms to verify switching costs

• Compatibility interfaces to reduce knowledge specific lock-in– Quattro Pro and Lotus 1-2-3– Word and WordPerfect– Mac OS and Windows

• Installed base does not necessarily imply switching costs – you must be careful to identify the lock-in mechanisms to verify switching costs


nile hatch © 1996-2002 responding to power of substitutes manec 387 economics of strategy manec 387...

Documents

closecreate demand

substitute product relative

number of substitutes

opposite of substitutes

large market

market consolidation

current market

sales service