1. Nile Hatch © 1996-2002 Responding to Power of Substitutes MANEC 387 Economics of Strategy MANEC 387 Economics of Strategy David J. Bryce

2. Nile Hatch © 1996-2002 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. Nile Hatch © 1996-2002 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. 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.

4. Nile Hatch © 1996-2002 What can be done to neutralize the power of substitutes? 1. 1.Differentiate product or service so that substitutes are not close 2. 2.Create demand for complementary goods 3. 3.Innovate or Copy to deliver the features of substitute products 4. 4.Narrow the number of substitutes of the buyer through market consolidation or exclusive alliances 5. 5.Create switching costs for your customers 1. 1.Differentiate product or service so that substitutes are not close 2. 2.Create demand for complementary goods 3. 3.Innovate or Copy to deliver the features of substitute products 4. 4.Narrow the number of substitutes of the buyer through market consolidation or exclusive alliances 5. 5.Create switching costs for your customers

5. Nile Hatch © 1996-2002 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 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

6. Nile Hatch © 1996-2002 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 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

7. Nile Hatch © 1996-2002 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 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

8. Nile Hatch © 1996-2002 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. 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.

9. Nile Hatch © 1996-2002 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, … 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, …

10. Nile Hatch © 1996-2002 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 B i be the benefit of good i –Perfect substitutes: P Y + S < P X –Imperfect substitutes:P Y + (B X -B Y ) + S < P X 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 B i be the benefit of good i –Perfect substitutes: P Y + S < P X –Imperfect substitutes:P Y + (B X -B Y ) + S < P X Price of the substitute must be proportionally lower to compensate for the switching cost before the substitute attracts customers

11. Nile Hatch © 1996-2002 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) 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)

12. Nile Hatch © 1996-2002 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) 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)

13. Nile Hatch © 1996-2002 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)

14. Nile Hatch © 1996-2002 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 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)

15. Nile Hatch © 1996-2002 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 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)