When a firm offers products that either are complementary in the strict sense of being used together or are purchased at the same time, pricing can potentially exploit the relatedness among them. The idea is to deliberately sell one product (which I term the base good) at a low profit or even a loss in order to sell more profitable items (which I term profitable goods).
The term “loss leadership” is commonly used to describe the application of this concept in retailing. Some products are priced at or below cost in order to attract bargain-conscious buyers to the store. The hope is that these buyers will purchase other more profitable merchandise during their visit. Loss leader pricing is also a way of establishing a low price image for the store.
The same pricing principle is at work in the so-called “razor and blade” strategy, which involves complementary products. The razor is sold at or near cost in order to promote future sales of profitable replacement blades. This same strategy is also common in amateur cameras, aircraft engines, and elevators. The complementary good is either a consumable item used with the product (e.g., film), a nonconsumable product used with the item (e.g., software cartridges with video games), replacement parts (e.g., aircraft engine parts), or service (e.g., elevator maintenance and repair).
Another variation of cross-subsidization is a trade-up strategy. Here product varieties that are typically first purchases are sold at low prices, in the hopes that the buyer will later purchase other more profitable items in the line as trade-up occurs. This strategy is sometimes employed, for example, in light aircraft, motorcycles, copiers, and computers.
1. Conditions Favoring Cross Subsidization
The motivation for cross subsidization is clear—increase total profit by selling larger quantities of profitable goods as a result of discounting the base good. The logic of this strategy depends on the existence of a number of conditions:
Sufficient Price Sensitivity in the Base Good. Demand for the base good must be sufficiently sensitive to price that discounting increases volume (or foot traffic) enough to result in a more than compensating increase in profit through the induced sales of the profitable good. If demand for the base good is not sensitive to price, however, the firm is better off making normal profits on both the base good and profitable good.
Sufficient Price Insensitivity in the Profitable Good. The profitable good must have demand that is not very sensitive to price, so that raising price does not greatly lower volume. Unless this is the case, profits lost in discounting the base good will not be recouped through profits on profitable goods. Insensitivity of demand to price in the profitable good is a function of the value it creates for the buyer and the threat of substitution for it.
Strong Connection between the Profitable and Base Good. The sale of profitable goods must also somehow be tied to the sale of the base good, so that buyers do not cherry-pick by purchasing only the low-priced base good. The connection between the products does not necessarily have to be binding, but it should be strong enough so that the proportion of buyers that purchase both from a firm is sufficient to justify discounting the base good.
The source of the connection between the base good and profitable good will vary from industry to industry. In retailing, the connection is created by shopping costs, which lead buyers to purchase other goods during the same visit to the store. In trade-up, brand loyalty and switching costs are the connection between one product and another. In a razor and blade strategy, brand loyalty and switching costs also may cause the buyer to purchase the blade from the firm that supplies the razor. In addition, perceived or actual compatibility may connect the goods (e.g., in film, spare parts), as does the belief of the buyer that the manufacturer of the product is best qualified to provide parts, maintenance, or repair (e.g., in elevators). The connection between the base and profitable goods also depends on the possibility of substituting for the profitable good. If spare parts can be refurbished, for example, then there is no longer the same relationship between equipment sales and parts sales.
Barriers to Entry into the Profitable Good. It must be difficult to enter the profitable good in order for cross subsidization to succeed, unless the base good and profitable good are strongly tied. Barriers to copying spare parts or consumables are essential, for example, to the logic of the razor and blade approach.
2. Risks of Cross Subsidization
The risks of cross subsidization tend to arise from failure to meet the third condition above. If the connection between the base good and profitable good is not sufficiently strong, a firm practicing cross subsidization may find itself selling only the low-priced base good and not the profitable good, which is purchased by the buyer from competitors. This can happen in a number of ways:
Buyer Cherry-picking. The buyer only purchases the base good, and either does without the profitable good or purchases it from another supplier that is not cross subsidizing.
Substitutes for the Profitable Good. If the need for the profitable good can be eliminated or reduced, cross subsidization is compromised because the buyer will not purchase the profitable good. For example, refurbishing spare parts instead of buying new ones or increasing the life of consumable items would have this effect.
Buyer Vertical Integration. The buyer purchases the base good but integrates to produce the profitable good internally. For example, service is performed in-house, or the buyer fabricates or refurbishes its own spare parts.
Specialist (Focused) Competitors. A specialist competitor sells the profitable good at lower prices. For example, independent service companies are common in a number of industries which specialize in servicing a particular brand of equipment, or in copying spare parts. They target an industry leader, and perform relatively simple types of service or copy the most frequently replaced parts. The equipment manufacturer’s margins on parts and service are thus undermined, and it may increasingly be left with only exotic repairs or low- volume parts. Sulzer Brothers, for example, is the prime target of unlicensed parts suppliers in marine diesel engines. The risk of entry by a specialist competitor is a function of the tightness of the connection between the base good and profitable good, and the barriers to entry into the profitable good.
3. Cross Subsidization and Industry Evolution
The appropriateness of cross subsidization often changes as an industry matures. As in bundling, the tendency is for it to become less appropriate over time, though this not always the case. Cross subsidization can become less attractive for the following reasons:
The Strength of the Connection between the Base Good and Profit- able_ Goods Falls. As the buyer becomes knowledgeable and more price-sensitive, the perceived need to purchase the profitable good from the same firm that sells the base good often diminishes. The tie between the goods may also weaken as diffusion of technology reduces switching costs, or compatible imitations for the profitable good become available.
Barriers to Entry into the Profitable Good Fall. More available technology and falling differentiation tend to reduce barriers to entry into the profitable good. One outcome may be buyer integration into the profitable good.
Substitution Possibilities for the Profitable Good Increase. Substitutes are sometimes discovered for the profitable good as the industry matures. For example, new technology for parts refurbishing appears (e.g., aircraft engine parts), or methods of conserving consumables are discovered (e.g., reuse of dialysers in artificial kidney machines).
4. Strategic Implications of Cross Subsidization
Cross subsidization can be a way to significantly improve performance if the necessary conditions hold. Such well-known firms as Gillette, Kodak, and Xerox have practiced the strategy successfully. However, the conditions supporting cross subsidization can be fleeting, and require active efforts to sustain. Moreover, a firm must be sure that cross subsidization is intended rather than unintended.
Some important strategic implications flowing from cross subsidization are as follows:
Create Barriers to Entry into the Profitable Good. Sustaining a cross subsidization strategy requires that a firm create or enhance barriers to entry into profitable goods. This implies, for example, that a firm must protect its proprietary servicing procedures, parts fabrication technologies, and designs for consumable supplies against imitators. Doing so may require aggressive patenting, deliberately creating different consumables for use in different models, and active marketing of the need to purchase profitable goods from the supplier of the base good. Many firms have squandered the advantages of cross subsidization by not paying attention to such factors.
An example of a firm that has worked hard to protect its profitable goods is Xerox. Consumables are a major contributor to profitability in copiers, and Xerox has maintained specialized toners for different models and actively marketed the benefits of purchasing consumables from the manufacturer to ensure highest quality.
Strengthen the Connection between the Base Good and Profitable Goods. Anything that tightens the connection between the base good and profitable goods will help defend a firm’s ability to cross-subsidize. Designs that increase the competitor’s difficulty in achieving a compatible interface are one such tactic. Another is Kodak’s tactic of advertising to consumers about the desirability of finishing pictures on Kodak paper, attempting to more closely tie the sales of machines and paper to photofinishers.
Be Prepared to Modify Cross Subsidization as the Industry Evolves. A firm must be prepared to modify cross subsidization if the supporting conditions change. The relative margins on the base good and profitable goods should often be gradually equalized over time. A firm may also benefit from devising more complex pricing schemes over time that lower the price of the profitable good to those buyers most susceptible to defection. A firm must avoid the tendency to provide an umbrella that encourages entry by competitors into the profitable good.
Encourage Entry into the Base Good to Boost Sales of the Profitable Good. If the profitable good is proprietary, it may be desirable to encourage entry into the base good to boost sales of the profitable good with such tactics as licensing.98 Kodak has encouraged entry into cameras that use its film formats, for example.
Avoid Unintended Cross Subsidization. A firm should cross-subsidize only as a deliberate strategy and not because it fails to understand its true costs. Failure to understand how costs differ by segment will almost guarantee that cross subsidization is occurring. A good system for strategic cost analysis, described in Chapter 3, is essential to effective cross subsidization. Unintended cross subsidy is an invitation to cherry-picking by competitors, as well as a way of attracting new entrants.
Source: Porter Michael E. (1998), Competitive Advantage: Creating and Sustaining Superior Performance, Free Press; Illustrated edition.