Intensity of Competition: Pressure from substitute products

All firms in an industry are competing, in a broad sense, with industries producing substitute products. Substitutes limit the poten-tial returns of an industry by placing a ceiling on the prices firms in the industry can profitably charge. The more attractive the price- performance alternative offered by substitutes, the firmer the lid on industry profits.

Sugar producers confronted with the large-scale commercializa-tion of high fructose corn syrup, a sugar substitute, are learning this lesson today, as have the producers of acetylene and rayon who faced extreme competition from alternative, lower-cost materials for many of their respective applications. Substitutes not only limit profits in normal times, but they also reduce the bonanza an industry can reap in boom times. In 1978 the producers of fiberglass insula-tion enjoyed unprecedented demand as a result of high energy costs and severe winter weather. But the industry’s ability to raise prices was tempered by the plethora of insulation substitutes, including cel-lulose, rock wool, and styrofoam. These substitutes are bound to be-come an ever stronger limit on profitability once the current round of plant additions has boosted capacity enough to meet demand (and then some).

Identifying substitute products is a matter of searching for other products that can perform the same function as the product of the industry. Sometimes doing so can be a subtle task, and one which leads the analyst into businesses seemingly far removed from the in-dustry. Securities brokers, for example, are being increasingly con-fronted with such substitutes as real estate, insurance, money market funds, and other ways for the individual to invest capital, accen-tuated in importance by the poor performance of the equity markets. Position vis-à-vis substitute products may well be a matter of collective industry actions. For example, although advertising by one firm may not be enough to bolster the industry’s position against a substitute, heavy and sustained advertising by all industry partici-pants may well improve the industry’s collective position. Similar arguments apply to collective response in areas like product quality improvement, marketing efforts, providing greater product avail-ability, and so on.

Substitute products that deserve the most attention are those that (1) are subject to trends improving their price-performance tradeoff with the industry’s product, or (2) are produced by indus-tries earning high profits. In the latter case, substitutes often come rapidly into play if some development increases competition in their industries and causes price reduction or performance improvement. Analysis of such trends can be important in deciding whether to try to head off a substitute strategically or to plan strategy with it as inevitably a key force. In the security guard industry, for example, electronic alarm systems represent a potent substitute. Moreover, they can only become more important since labor-intensive guard services face inevitable cost escalation, whereas electronic systems are highly likely to improve in performance and decline in costs. Here, the appropriate response of security guard firms is probably to offer packages of guards and electronic systems, based on a redefini-tion of the security guard as a skilled operator, rather than to try to outcompete electronic systems across the board.

Source: Porter Michael E. (1998), Competitive Strategy_ Techniques for Analyzing Industries and Competitors, Free Press; Illustrated edition.

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