Substitution and competitive strategy of the firm

The economics of substitution carry a variety of strategic implications for firms attempting to promote substitution, as well as for firms attempting to defend against it. Defenses against substitution are, by and large, the reverse of offensive strategies that promote substitution. I will first describe some principles of promoting substitution and then turn to defense.

1. Promoting Substitution

A firm can trigger or accelerate substitution through strategic moves that enhance RVP, lower switching costs, or raise the propensity of buyers to switch. While none of these moves are without costs and risks, the following concepts for promoting substitution can be considered:

1. Target early switchers. As the section “Segmentation and Substitution” emphasized, some buyers and buyer segments in an industry will be much more likely to adopt a substitute than others because of greater RVP from the substitute, lower switching costs, or greater propensity to switch. The order of segments that are targeted for penetration is one of the most important components of a substitution strategy. A firm attempting substitution should focus its efforts on the most likely early switchers first, and use the track record it gains with these buyers and their support to trigger the self-reinforcing takeoff Early switchers may be buyers who are redesigning their products, are replacing equipment, face a pressing need for the value the substitute provides, or are adventurous purchasers. To reach these buyers, a firm may have to subsidize trial. For example, Mauna Loa macadamia nuts are sold on very favorable terms to some airlines to gain trial of target buyers.

2. Improve the firm’s offering in areas with the highest RVP impacts. The impact of improvements in the product and elsewhere in the value chain on substitution will be greater the more RVP is affected. With a sophisticated understanding of the bases of RVP, drawn from the framework presented earlier, a firm can determine its R&D and marketing priorities accordingly. In color TV, for example, picture quality was much more important to RVP initially than features or styling, given the preferences of buyers substituting from black and white sets with high picture quality. Similarly, in many industries the problem is not actual product performance but the buyer’s uncertainty about it. Here, guarantees can be an effective tool to promote substitution.

3. Reduce or subsidize switching costs. Investments to reduce switching costs can have a major role in stimulating substitution, presuming a substitute has superior RVP. A firm should direct part of its technical development to improvements that lower switching costs, and create mechanisms for information dissemination among buyers that have the same effect. This may be as simple as manuals or newsletters.

A firm may also find it advantageous to subsidize switching costs for some buyers. A firm need not subsidize the switching costs of all buyers, but only a core group of buyers whose adoption of a substitute is likely to trigger the takeoff phase. These buyers should be opinion leaders who will serve as credible signals of value to other buyers. Subsidizing switching costs can involve such things as free training, paying for product reformulation or testing, supplying or assisting in the design of ancillary equipment, providing free assistance in modifying production procedures, giving high trade-in allowances, offering money-back guarantees, and giving free in-home demonstrations.

4. Invest in signaling. A major barrier faced by a substitute may be the lack of awareness and knowledge by potential buyers. A firm must identify the most important signaling criteria used by buyers to judge the value of a substitute, and invest to influence them. Buyers often misperceive the RVP of a substitute, particularly where RVP is not obvious but has the characteristics described earlier in this Hence the importance of signaling can frequently be great to successful substitution.

5. Use tapered forward integration or induce backward integration to create pull-through. A strategy practiced successfully by the aluminum industry, among others, is to forward integrate selectively into downstream products to create pull-through demand for a substitute. A related strategy is to induce end users to backward integrate into the intermediate industry to get around intermediate producers who are unwilling to substitute. By integrating forward and creating demand with end users, a firm can sometimes force recalcitrant intermedi-ate buyers to bear the switching costs of substitution. Forward integration can also demonstrate the performance of the substitute, and be a means for developing procedures for its use or for lowering switching cost.

Tapered forward integration is most effective where the end user faces few, if any, costs of switching to a substitute, while intermediate buyers face significant switching costs. This was the case in metal cans, where beverage companies could switch to aluminum cans relatively easily but can companies faced heavy investment costs in new equipment.

6. Ensure multiple sources and/or adequate capacity. Often major buyers will not incur the costs and risk of substitution when there is only one source for a substitute or if there is insufficient capacity for it on stream to meet expected future demand. Substitution can be accelerated by remedying these concerns, through encouraging entry into the substitute industry or by building capacity ahead of demand. This is an example of how good competitors can benefit a firm (Chapter 6). 

7. Promote improvements in complementary products or infrastructure. A firm can often improve RVP or switching costs if it can stimulate improvements in the cost or quality of necessary complementary goods or infrastructure. This may justify investing in technology for complementary products and sharing the results freely with other It may also suggest the formation of joint ventures or other relationships with producers of complementary goods, or creating needed infrastructure such as service facilities.¹⁴ RCA originally trained many of the repair personnel who serviced all color TV sets, for example.

8. Price to balance capturing R VP against creating barriers. The price of a substitute must share some of the value created with the buyer in order to give the buyer an inducement to How close the price of a substitute approaches RVP should depend on industry structure. Where there are high entry barriers, a firm may be better off substituting slowly by penetrating high- value segments first at high prices and moving prices down gradually to capture lower-value segments. Where there are first-mover advantages (Chapter 5), the firm instead should sacrifice short-term profits to penetrate quickly and build barriers that protect long-term profits. With low barriers, a firm must attempt to reap profits quickly before entry erodes its position.

9. Conceive of new functions to widen a substitute’s market. Conceiving of new functions a substitute can perform may greatly expand the potential This not only is important in product design and selecting features, but also in pricing strategy. In fresh flowers, for example, European retailers recognized that low prices could open up a whole new function for flowers— everyday use in decorating— in addition to the traditional use of fresh flowers in weddings and for other special occasions. As a result, the European market for flowers is much bigger than the U.S. market, where pricing has tended to be higher. Many industries have accepted maturity of demand rather than looked for new substitution possibilities.
10. Harvest if competitive position in the substitute is not sustainable. Investments to build share in a substitute are indicated if a firm can sustain its competitive advantage in the substitute industry and if the industry structure is Otherwise, a firm may be better off skimming profits early in the substitution process rather than pricing to deter entry or widen the market. A successful substitute is not necessarily a good business.

2. Defense Against Substitutes

The first step in defense against substitutes is to identify all of them. This is often a difficult task, because it requires a look at the basic functions a product performs. Strategies to combat substitutes are the reverse of many of the steps described above:

• improve RVP relative to the substitute by reducing costs, improving the product, improving complementary goods,
• modify the product image
• raise switching costs
• block pull-through attempts by aggressive selling efforts directed at the buyers’ buyers

Where switching back costs are high, a firm must invest aggressively in a short-term holding action to deter switching while it seeks more fundamental long-term improvements in RVP. With high switching back costs, buyers lost to a substitute will be hard to regain.

In addition to these actions, a number of other possibilities in defending against substitutes warrant consideration:

1. Find new uses unaffected by the substitute. Sometimes a product facing substitution can be repositioned into entirely new uses. A good example is Arm & Hammer baking soda. As a result of a ten-year marketing campaign, Arm & Hammer is used in over 50 percent of American refrigerators for odor control, a use that has far surpassed the original use of baking soda.
2. Redefine competition away from the strengths of the A substitute’s RVP advantage generally stems from either low price or certain dimensions of value. A good defensive strategy may be to attempt to influence industry competition away from these advantages. Repelling a low price substitute might involve such actions as longer warranties, more engineering support, or new product features.
3. Enlist suppliers to help in defense. Suppliers of important purchased inputs often have a big stake in fighting substitution too, and can bring important resources and technological skills to the defense. Suppliers of inputs that are large cost items or that have an important influence on value are the best candidates for alliances.
4. Redirect strategy toward segments least vulnerable to Some product or buyer segments will be less vulnerable to substitution than others. A firm under attack from substitutes may be better off focusing its defensive investments on such segments. A firm may also exit from or harvest its position in the segments most vulnerable to substitution. Early withdrawal from these segments can allow the firm to generate the most cash from harvesting or from liquidating assets, while exiting later will generate little or no cash.
5. Harvest instead of defend. Depending on the likely future RVP of a substitute and the feasibility of defensive strategies, the best strategy for a firm facing substitution may be to harvest its position instead of investing in defense at all. Such strategy involves such actions as concentrating attention on the segments where substitution will be the slowest, and raising prices.

6. Enter the substitute industry. Rather than viewing a substitute as a threat, it may be better to view it as an opportunity. Entering the substitute industry may allow a firm to reap competitive advantages from interrelationships between a substitute and the product, such as common channels and  buyers.

3. Industry Versus Firm Substitution Strategy

A substitution process is partly under the control of a firm and partly a function of the industry as a whole. No matter what it does, the individual firm is affected by such things as the industry’s image and the consistency of industrywide product offerings, which influence buyer attitude and confusion about the benefits of a substitute. This implies that industrywide actions can usefully supplement individual firm efforts to promote or defend against substitution. For example, New Zealand producers of kiwi fruit have greatly stimulated its substitution for other fruits through an industry-sponsored R&D program to breed one uniform variety of fruit (down from twenty) and adoption of this single variety by all the growers.¹⁷ This campaign has been reinforced by advertising of the fruit.

Some industrywide activities that can promote (or prevent) substitution include:

• Image advertising of the Total industry advertising can affect overall industry demand.
• Collective R&D expenditures to develop uses for the product, or techniques for integrating the product into buyers’ value chains
• Establishment and enforcement of product standards to allay buyers’ fears of poor quality or inadequate performance.
• Gaining the necessary regulatory approvals for the product to lower buyers’ switching costs and perceived risks.
• Joint actions to improve the quality, availability, and cost of complementary products, thereby improving RVP.

Expenditures made by a firm to promote or discourage substitution also may benefit competitors, who get a free ride. In order to deal with this problem, collective industry action through trade associa-tions or other industry groups is a common approach to promoting or defending against substitution. For example, the coal industry has recently embarked on a television and print advertising campaign in the United States to improve the image of coal as an abundant, easy- to-obtain, and “American” fuel. Without some collective action, fragmented industries often have difficulty promoting or fighting substitution because of the free-rider problem.

4. Pitfalls in Strategy Against Substitutes

Substitution is a positive or negative force, to some degree, in every industry. Yet firms often make some common errors in dealing with substitutes. A discussion of these will provide a summary of some of the important concepts in this chapter:

Failing to Perceive a Substitute. Firms often fail to recognize substitutes at all until the substitution process is well under way, because they view their product’s function too narrowly, do not recognize the different substitutes faced by different segments, or overlook downstream substitution.

Not Understanding R VP. The determinants of RVP are complex, and firms often have a simplistic view of why a substitute is succeeding or failing. For example, they may believe that superior product performance is the cause of substitution when the real reason is lower cost of use for the buyer because of easier installation. Not knowing why a substitute is succeeding or failing can be a ticket to the wrong offensive or defensive strategy, or to an unpleasant surprise when a substitute takes off.

Misreading of Slow Early Penetration. The slow early penetration of a substitute can be misread as a sign that it is not a serious threat, rather than as a manifestation of the S-shaped nature of the substitution process. While many substitutes do indeed fail, slow early penetration is not a reliable sign that this will happen. What is necessary is a careful analysis of RVP, and early buyer experience with the substitute.

A Static View of RVP. Both offensive and defensive strategy towards substitution should be driven by the future as well as present RVP of a substitute. A firm can mistakenly direct its product and marketing improvements toward the wrong areas, or fail to plan for improvements in RVP or reduction in margins by the substitute over time.

Fighting Versus Joining. Many firms invest heavily to defend against substitutes when long-term RVP is compellingly against them. Similarly, their defense against a substitute is across the board, instead of reflecting differences in vulnerability to the substitute in different segments. Early moves to focus on certain segments, harvest, or enter the substitute industry are sometimes called for.

Accepting Maturity. Perhaps the most unfortunate pitfall of all is accepting the maturity of one’s product, and not considering substitution as a possibility. Firms often look inward, and become preoccupied with battling rivals. It may be better to expand the size of the pie through substitution. The age of an industry is not a reliable indicator of the substitution possibilities. Industry maturity may be just an illusion.

Source: Porter Michael E. (1998), Competitive Advantage: Creating and Sustaining Superior Performance, Free Press; Illustrated edition.