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

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”
David Bryce ©
Adapted from Baye © 2002

3. 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 ©
Adapted from Baye © 2002

4. 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 ©
Adapted from Baye © 2002

5. 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 ©
Adapted from Baye © 2002

6. 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 ©
Adapted from Baye © 2002

7. 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 ©
Adapted from Baye © 2002

8. 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 ©
Adapted from Baye © 2002

9. 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 ©
Adapted from Baye © 2002

10. 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 ©
Adapted from Baye © 2002

11. 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 ©
Adapted from Baye © 2002

12. 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 ©
Adapted from Baye © 2002

13. 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 ©
Adapted from Baye © 2002