1. David Bryce © 1996-2002 Adapted from Baye © 2002 Power of Substitutes: Economics of Cross-Price Elasticities MANEC 387 Economics of Strategy MANEC 387 Economics of Strategy David J. Bryce

2. David Bryce © 1996-2002 Adapted from Baye © 2002 The Structure of Industries Competitive Rivalry Threat of new Entrants Bargaining Power of Customers Threat of Substitutes Bargaining Power of Suppliers From M. Porter, 1979, “How Competitive Forces Shape Strategy”

3. David Bryce © 1996-2002 Adapted from Baye © 2002 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 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

4. David Bryce © 1996-2002 Adapted from Baye © 2002 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 – 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.

5. David Bryce © 1996-2002 Adapted from Baye © 2002 Substitute Goods When the price of good X falls, the consumption of substitute good Y also falls. Computers (X) X1X1 X1X1 Calculators (Y) X2X2 X2X2 Y1Y1 Y1Y1 Y2Y2 Y2Y2

6. David Bryce © 1996-2002 Adapted from Baye © 2002 Complementary Goods When the price of good X falls, the consumption of complementary good Y rises. Computers (X) X1X1 X1X1 Software (Y) X2X2 X2X2 Y1Y1 Y1Y1 Y2Y2 Y2Y2

7. David Bryce © 1996-2002 Adapted from Baye © 2002 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 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

8. David Bryce © 1996-2002 Adapted from Baye © 2002 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 Demand  Q x,P y = %Qx%Qx %Qx%Qx %Py%Py %Py%Py  Q x,P y > 0: substitute products  Q x,P y < 0: complementary products  Q x,P y > 0: substitute products  Q x,P y < 0: complementary products

9. David Bryce © 1996-2002 Adapted from Baye © 2002 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 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

10. David Bryce © 1996-2002 Adapted from Baye © 2002 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 S1S1 S1S1 S2S2 S2S2 S3S3 S3S3 S 3 > S 2 > S 1

11. David Bryce © 1996-2002 Adapted from Baye © 2002 Strength of Substitutes Good Y Good X Perfect Substitutes Perfect Substitutes Imperfect Substitutes Imperfect Substitutes Imperfect Substitutes 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 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

12. David Bryce © 1996-2002 Adapted from Baye © 2002 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? 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?

13. David Bryce © 1996-2002 Adapted from Baye © 2002 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 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