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

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

Substitute Goods Calculators (Y) When the price of good X falls, the consumption of substitute good Y also falls. Y1 Y2 X1 X2 Computers (X) David Bryce © 1996-2002 Adapted from Baye © 2002

Complementary Goods Software (Y) When the price of good X falls, the consumption of complementary good Y rises. Y1 Y2 X1 X2 Computers (X) 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 our product and substitute products Close relative price/performance ratio Consumer tastes & preferences favor substitute’s features Low switching costs David Bryce © 1996-2002 Adapted from Baye © 2002

Cross Price Elasticity of Demand 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 hQx,Py = %DQx %DPy hQx,Py > 0: substitute products - hQx,Py < 0: complementary products David Bryce © 1996-2002 Adapted from Baye © 2002

Strength of Substitutes and Complements With strong substitutes, many customers will consume the substitute good if we raise prices Coke v. Pepsi – Suburban v. Expedition With strong complements, many customers will reduce consumption of our product if price of the complement is raised Personal computers and software Hamburger buns and E-coli tainted hamburger David Bryce © 1996-2002 Adapted from Baye © 2002

MRS Defines the Strength of Substitutes Good Y S3 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. S2 S1 Good X S3 > S2 > S1 David Bryce © 1996-2002 Adapted from Baye © 2002

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

Cross-Price Elasticity at AT&T According to an FTC Report by Michael Ward, 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? 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 David Bryce © 1996-2002 Adapted from Baye © 2002