Responding to Power of
Substitutes
MANEC 387
Economics of Strategy
David J. Bryce
Nile Hatch © 1996-2002
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”
Nile Hatch © 1996-2002
Bargaining
Power of
Customers
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.
Nile Hatch © 1996-2002
What can be done to neutralize
the power of substitutes?
1. Differentiate product or service so that
substitutes are not close
2. Create demand for complementary goods
3. Innovate or Copy to deliver the features of
substitute products
4. Narrow the number of substitutes of the buyer
through market consolidation or exclusive
alliances
5. Create switching costs for your customers
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
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
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
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.
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 aftersales service – e.g., consulting firms
– Repeated use discounts – e.g., frequent fliers,
frequent clients (law services), frequent video
rentals, …
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 Bi be the
benefit of good i
– Perfect substitutes:
– Imperfect substitutes:
PY + S < PX
PY + (BX-BY) + S < PX
• Price of the substitute must be proportionally
lower to compensate for the switching cost
before the substitute attracts customers
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)
Source: Shapiro and Varian (1998)
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)
Source: Shapiro and Varian (1998)
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)
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
Source: Farrell and Shapiro (1988); Besanko, Dranove, and Shanley (2000)
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
Source: Shapiro and Varian (1998)
Nile Hatch © 1996-2002