Cross subsidization over products of the firm

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 noncon­ sumable 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 some­ times 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  in­ creases volume (or foot traffic) enough to result in a more than compen­ sating 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  profit­ able 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 an­ other. 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 connec­ tion between the base and profitable goods also depends on the possibil­ ity 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 an­ other supplier that is not cross  subsidizing.

Substitutes fo r 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 o f 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.    Substi­ tutes 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  perfor­ mance 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 im portant strategic implications flowing from cross subsidi­ zation 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 fabrica­ tion technologies, and  designs for consumable  supplies against imita­ tors. 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 subsidi­ zation 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 m ajor 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 compati­ ble interface are one such tactic. Another is K odak’s tactic of advertis­ ing 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 o f 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.10 Kodak  has   encouraged  entry into cameras that use its  film formats, for  example.

Avoid Unintended Cross Subsidization. A firm should cross-sub- sidize 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 effec­ tive 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.

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