David Bryce © 1996-2002Adapted from Baye © 2002

Power of Substitutes: Economics of Cross-Price Elasticities

MANEC 387MANEC 387Economics of StrategyEconomics of Strategy

David J. Bryce

David Bryce © 1996-2002Adapted from Baye © 2002

The Structure of Industries

Competitive Rivalry

Threat of newEntrants

BargainingPower of

Customers

Threat ofSubstitutes

BargainingPower of Suppliers

From M. Porter, 1979, “How Competitive Forces Shape Strategy”

David Bryce © 1996-2002Adapted from Baye © 2002

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 © 1996-2002Adapted 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 © 1996-2002Adapted from Baye © 2002

Substitute Goods

When the price of good X falls, the consumption of substitute good Y also falls.

Computers (X)

X1

Calculators (Y)

X2

Y1

Y2

David Bryce © 1996-2002Adapted from Baye © 2002

Complementary Goods

When the price of good X falls, the consumption of complementary good Y rises.

Computers (X)

X1

Software (Y)

X2

Y1

Y2

David Bryce © 1996-2002Adapted from Baye © 2002

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 © 1996-2002Adapted from Baye © 2002

• 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

Cross Price Elasticity of Demand

Qx,Py = %Qx

%Py

Qx,Py > 0: substitute products

Qx,Py < 0: complementary products

David Bryce © 1996-2002Adapted from Baye © 2002

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 © 1996-2002Adapted from Baye © 2002

MRS Defines the Strength of Substitutes

• 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.

Good Y

Good X

S1

S2

S3

S3 > S2 > S1

David Bryce © 1996-2002Adapted from Baye © 2002

Strength of SubstitutesGood Y

Good X

PerfectSubstitutes

ImperfectSubstitutes

ImperfectSubstitutes

• 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 © 1996-2002Adapted from Baye © 2002

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 © 1996-2002Adapted 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