1. Responding to Power of Substitutes
MANEC 387
Economics of Strategy
David J. Bryce
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2. 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”
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3. Summary 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.
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4. What can be done to neutralize the power of substitutes?
Differentiate product or service so that substitutes are not close
Create demand for complementary goods
Innovate or Copy to deliver the features of substitute products
Narrow the number of substitutes of the buyer through market consolidation or exclusive alliances
Create switching costs for your customers
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5. 1. 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
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6. 2. 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
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7. 3. 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
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8. 4. 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.
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9. 5. 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, …
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10. Switching 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
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11. Sources 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)
Source: Shapiro and Varian (1998)
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12. Sources of Switching Costs
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)
Source: Shapiro and Varian (1998)
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13. Sources of Switching Costs
Loyalty programs – switching causes customers to lose out on program benefits (airline frequent flier programs, bookstore and grocery store preferred customer programs)
Source: Shapiro and Varian (1998)
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14. Limitations of Switching Costs New 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
Source: Farrell and Shapiro (1988); Besanko, Dranove, and Shanley (2000)
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15. Limitations 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
Source: Shapiro and Varian (1998)
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