The threat of a substitute often changes over time, with a corre sponding impact on the pattern of substitution. Many of the sources of change in the substitution threat are predictable and can often be influenced through a firm’s offensive or defensive substitution strategy.
Changes in the threat of substitution occur in five broadly defined areas that follow directly from the economics of substitution:
- changes in relative price
- changes in relative value
- changes in buyer perception of value
- changes in switching cost
- changes in propensity to substitute
Relative price will change if (1) the relative costs of a substitute and the product change, and the change is partially or completely passed on to buyers, or (2) their relative profit margins change. Relative value will change if valuable improvements proceed at different rates for the substitute and the product. Buyer perception of value will be a function of information dissemination. Switching cost will change if a substitute is redesigned or if early substituters bear some of the cost for later switchers. Buyer propensity to switch will be a function of evolving buyer attitudes, resources and competitive conditions.
Changes in the threat of substitution over time are determined by industry structure and competitor behavior in both the substitute industry and the threatened industry, with the substitute industry on the offensive and the threatened industry on the defensive. The two industries are engaged in a battle to influence the substitution process. Industry structure will shape the nature of competition in both indus tries and the way firms behave toward the substitution process. Because competitors’ moves will influence the course of the substitution process in one direction or another, where competitors place bets is vital. If competitors in the substitute industry are better capitalized, for exam ple, they can tip the balance in its favor because they will make greater investments to reduce costs, signal value, or set low initial prices. Similarly, other competitor strategic moves can impact the substitution process, such as R C A ’s decision to widely license its color TV patents. Determining future changes in the threat of substitution is thus an exercise in forecasting the effects of industry structure and competitor behavior on each of the components of the substitution calculation.
Some im portant determinants of changes in each of the five areas that determine substitution are as follows:
CHANGING RELATIVE PRICE
Changes in Relative Cost. A substitute and a product are in a competition to improve relative cost. A substitute often improves its relative cost as substitution proceeds through the operation of econo mies of scale or the learning curve. For example, the price of carbon fibers fell from $100 per pound in the early 1970s to $20 to $25 in 1982 for these reasons, promoting the substitution of carbon fibers for steel and aluminum in automotive and aircraft applications. A n other factor that often lowers the relative cost of a substitute over time is that technological change reduces the amount necessary to perform the required function, as illustrated in the aluminum and offshore drilling examples earlier in this chapter. Such improvements, of course, come at the expense of the volume of the substitute sold. A substitute’s cost can just as easily escalate, however, if its success forces up the cost of its key raw materials.
There may be fewer opportunities to reduce cost in the industry being threatened by a substitute because of its age and maturity. More over, penetration of the substitute may reduce the scale and capacity utilization of firms in the threatened industry, raising their costs. How ever, industries that have been sleepy have achieved remarkable cost reductions under the threat of a substitute, so one cannot generalize about how relative costs will change.
The relative cost behavior of a substitute over time is analyzed using the framework in Chapter 3. The im portant cost drivers for both the substitute and the product should be identified. Cost behavior over time will be a function of the interplay of these cost drivers coupled with the likely behavior of competitors. Sometimes the pro jection of past cost trends for the substitute and the product will clearly indicate future relative cost. It is dangerous to count on the continuation of past trends, however, because the threatened industry may respond and the early pace of cost reduction by the substitute may be unsustainable. Predicting relative cost changes thus often re quires that the impact of increasing scale, learning, and other factors on cost is estimated for a substitute and compared to the ability of the product to reduce cost through redesign, relocation, or introduction of new process technologies. The sources of cost dynamics described in Chapter 3 will suggest other im portant relative cost changes that might occur, such as differential inflation.
Changes in Profit Margins. The prices of a substitute and a product contain profit margins.6 The relative profit margins of a substi tute and a product are a key factor that can shift over time. A common reason for the change in relative margins is that the threatened industry lowers its margins to fight the substitute. Video game margins are falling rapidly to fight personal computers, for example. The extent to which a threatened industry’s margins can be reduced before firms begin to exit is a function of how high margins were initially, and whether exit barriers keep firms in the industry despite low returns. The margins of a substitute can also change as substitution pro ceeds, depending on industry structure in the substitute industry. If early entrants into the substitute industry were skimming and entry barriers are not high, the substitute’s margins can fall dramatically as new companies enter. Initial success in penetration may also lead firms selling the substitute to set low penetration prices. Rivalry in selling a substitute often increases over time as it becomes more stan dardized and explosive growth slackens, as is happening in personal computers. Increasing penetration of the substitute may also raise the threat of backward integration by buyers. All these factors can squeeze a substitute’s margins. Margins of a substitute and a product, then, will be a function of the influence of their changing industry structures over time, partly in response to. each other.
CHANGING RELATIVE VALUE
The relative value to the buyer of a substitute will often change because of changing technology, better service, and a myriad of other causes. Producers of a substitute may gain expertise in tailoring their value chains to meet buyer needs, though producers of the threatened product will look for ways to enhance value as well. While any of the factors that determine buyer value described in Chapter 4 may be changing, three important sources of change are the relative pace o f technological change in the substitute and the product, the develop ment o f infrastructure, and institutional factors.
A substitute and the threatened product are engaged in a techno logical race to see which can improve value faster. The likely pace and extent of technological change can be analyzed using the concepts in Chapter 5. A substitute may have the edge in technological change if it is a new industry, but several examples in Chapter 5 have shown how a threatened product or process can often achieve significant technological improvements. The relative pace of technological change is also strongly influenced by the resources and skills of competitors. In the substitution of plastics and aluminum for steel, for example, the greater technological orientation of plastics and aluminum firms was one of the factors leading to a faster pace of change in those industries.
RVP often changes in favor of the substitute over time as better infrastructure develops to support it. As a substitute becomes estab lished, for example, it frequently spawns independent repair shops and is added to the product lines of established wholesalers. Availability improves and the perceived risk of shortages falls.
RVP of a substitute can also change as a result of a wide variety of other exogenous influences and institutional factors. The rapid sub stitution of polyvinyl chloride (PVC) for materials such as aluminum in residential siding was set back by the revelation that vinyl chloride was a possible carcinogen. Similarly, the penetration of solar heating has been buffeted by shifts in government policy and a fluctuating energy price outlook, while the relative value of food products has been altered by rising concerns about cholesterol and sodium. Such exogenous influences are often as hard to predict as they are powerful.
CHANGING BUYER PERCEPTION OF VALUE
The perception of value by buyers frequently changes over time in substitution because time and m arketing activity are working to alter the way buyers view a substitute compared to a product. A substitute may gain in perceived value position over time as buyers become more and more familiar with how to use it. One of the inhibit ing factors in the use of carbon fibers in aircraft wings and other applications (as a substitute for steel, titanium, or aluminum), for example, has been that most engineers had no idea how to design with fibers. Yet the properties of carbon fibers are sufficiently unique that their benefits can be fully reaped only if the designer understands the material. As this has begun to happen, the perceived value of fibers is increasing. While time often benefits a substitute, it can also hurt it. Many substitutes emerge amid overinflated buyer perceptions of their value, and time and trial are moderating influences.
The perception of a substitute and a product can also be affected by the relative intensity and creativity of signaling activities. Campaigns to increase the awareness of a substitute are pitted against efforts by the threatened industry to improve its perceived value. The U.S. record industry, for example, has responded to flattening sales at the expense of video entertainment products with its “ Gift of M usic” campaign. Record manufacturers contribute one-half cent per record for advertis ing, stressing the value of records as a gift. The appropriate signaling activities will depend on signaling criteria for the product.
CHANGING SWITCHING COSTS
The costs of switching to a substitute often change over time, frequently in a downward direction. One reason is that early switchers can bear some of the costs for later switchers, by developing procedures, designs, or standards. An early switcher from steel to aluminum bever age cans, for example, might develop product standards and methods of lithographing labels on the cans that can easily be copied. Switching costs can also fall over time because the substitute is redesigned to be more compatible with ancillary equipment, or suppliers develop procedures to minimize the buyer’s switching costs. In addition, third parties may spring up to lower the cost of switching, such as consul tants, installers and training firms. In office equipment, for example, consultants and training firms are proliferating to ease the changeover to office automation.
Switching costs are partly determined by a buyer’s technological choices, and thus change over time as buyers alter their products and processes. In the substitution of aluminum for steel and cast iron, for example, new buyer technology has reduced switching costs. Auto makers have built more flexible plants that can machine either alumi num or cast iron, while can makers’ new lines can accept both aluminum and tinplate can stock.
CHANGING PROPENSITY TO SWITCH
The propensity to switch to a successful substitute ftv.juently grows over time. Early success with a substitute allays buyer risk aversion, at the same time as competitive considerations lead buyers to switch so as not to have a disadvantage relative to early switchers.
1. Substitution and Overall Industry Demand
In addition to taking share from existing products, a substitute can raise or lower overall industry demand. A substitute with a longer useful life than the product it is replacing will lower overall demand after the initial period when the substitute stimulates faster replace ment. This pattern seems to have occurred in the substitution of longer- lasting radial tires for bias ply tires.
The penetration of a substitute can also increase overall industry demand if the substitute expands the industry or increases the usage or replacement rate. Portable cassette players such as Sony’s Walkman, for example, have surely expanded the total market for cassette players at the same time as they have taken share from conventional cassette players. Similarly, the introduction of disposable ballpoint pens, cham pioned by BIC Corporation, led to substitution for conventional pens but also stimulated the purchase of more ballpoint pens per buyer. Any impact of a substitute on overall demand for a product must be combined with a forecast of the path of substitution in order to predict the absolute volume of sales of a substitute over time.
2. Substitution and Industry Structure
Penetration of a substitute may have second order effects on the resulting industry structure. A substitute may shift the buyer’s cost structure, for example, in ways that increase or decrease price sensitiv ity. A substitute may also require new suppliers, and entry barriers may differ from those of the product it replaces. Thus the substitute must be analyzed as a new industry, not merely as a change in product. The substitute industry can be more or less attractive structurally than the industry it replaces, a fact that has im portant implications for strategy towards a substitute.
Source: Porter Michael E. (1998), Competitive Advantage: Creating and Sustaining Superior Performance, Free Press; Illustrated edition.