Changes in the substitution threat for firm’s product-service

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:


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.


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.


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.


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.


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.

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