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
Bargaining
Power of
Suppliers
Competitive
Rivalry
Threat of
Substitutes
From M. Porter, 1979, “How Competitive Forces Shape Strategy”
David Bryce © 1996-2002
Adapted from Baye © 2002
Bargaining
Power of
Customers
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
David Bryce © 1996-2002
Adapted from Baye © 2002
X2
Computers (X)
Complementary Goods
Software (Y)
When the price of
good X falls, the
consumption of
complementary
good Y rises.
Y1
Y2
X1
David Bryce © 1996-2002
Adapted from Baye © 2002
X2
Computers (X)
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
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
%DQx
hQx,Py =
%DPy
• Cross-price elasticity of demand defines the
strength of the relationship between X and Y
 hQx,Py > 0:
 hQx,Py < 0:
David Bryce © 1996-2002
Adapted from Baye © 2002
substitute products
complementary products
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
David Bryce © 1996-2002
Adapted from Baye © 2002
MRS Defines the Strength of
Substitutes
Good Y
• 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.
S3
S2
S1
S3 > S2 > S1
David Bryce © 1996-2002
Adapted from Baye © 2002
Good X
Strength of 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
David Bryce © 1996-2002
Adapted from Baye © 2002
Good Y
Imperfect
Substitutes
Imperfect
Substitutes
Perfect
Substitutes
Good X
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?
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