Substitution and competitive strategy of the firm

The economics of substitution carry a variety of strategic implica­ tions 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 Sub­ stitution” 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 The order of segments that are targeted  for penetration is one of the most im portant 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 take­ off phase. 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, M auna Loa macadamia nuts are sold on very favorable terms  to some airlines to gain trial of target buyers.
  1. Improve the firm ‘s offering in areas with the highest RVP im- pacts.­ 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 im portant 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 uncer­ tainty about it. Here, guarantees can be an effective tool to promote substitution.
  1. Reduce or subsidize switching costs. Investments to reduce switching costs can have a m ajor role in stimulating substitution, pre­ suming 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 news­ letters.

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 substi­ tute 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  demon­ strations.

  1. Invest in signaling. A m ajor barrier faced by a substitute may be the lack of awareness and knowledge  by potential  buyers. A firm must  identify   the   most  im portant  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 chap­ ter. Hence the importance of signaling can frequently be great to suc­ cessful substitution.
  1. Use tapered forward integration or induce backward integration to create pull-through. A strategy practiced  successfully by the alumi­ num industry, among others, is to forward integrate selectively into downstream  products to create pull-through  demand  for a 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 de­ mand 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 rela­ tively easily but can companies faced heavy investment costs in new equipment.

  1. 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    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). 
  1. Promote improvements in complementary products or infrastruc- ture.­ A firm can often improve RVP or switching costs if it can stimu­ late 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 firms. It may also suggest the formation of joint ventures or other relation­ ships 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.
  1. 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 switch. 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 seg­ ments. 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. W ith low barriers, a firm must attempt to reap profits quickly before entry  erodes its position.
  1. Conceive o f new functions to widen a substitute’s market. Con­ ceiving of new functions a substitute can perform may greatly expand the potential market.  This not  only is im portant  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  m aturity  of demand rather than looked for new substitution possibilities.
  1. Harvest i f competitive position in the substitute is not sustain- able.­ 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 attractive.  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, im­ proving the product, improving complementary goods, etc.
  • modify the product image
  • raise switching costs
  • block pull-through attempts by aggressive selling efforts di­ rected at the buyers’ buyers

Where switching back costs are high, a firm must  invest aggres­ sively in a short-term holding action to deter switching while it seeks more fundamental long-term improvements in RVP. W ith high switch­ ing 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 A good example is Arm & Ham mer baking soda. As a result of a ten-year marketing campaign, Arm & Ham m er is used in over 50 percent of American refrigerators for odor control,  a use that  has far surpassed the original use of baking soda.
  1. Redefine competition away from   the strengths o f the substitute. 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.
  1. Enlist suppliers to help in defense. Suppliers of im portant pur­ chased inputs often have a big stake in fighting substitution too,   and can bring im portant 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.
  1. Redirect strategy toward segments least vulnerable to substitu-tion.­ Some product or buyer segments will be less vulnerable to substi­ tution 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.
  1. Harvest instead o f defend. Depending on the likely future RVP of a substitute and the feasibility of defensive strategies, the best strat­ egy for a firm facing substitution  may be to harvest its position instead of investing in defense at Such strategy involves such actions as concentrating   attention  on   the   segments   where  substitution  will be the slowest, and raising prices.
  1. 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  m atter  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 substi­ tution 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) substi­ tution 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 substitu­ tion 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 “ Am erican” fuel. W ithout some collective action, frag­ mented industries often have difficulty promoting or fighting substitu­ tion 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 im portant concepts in this chapter:

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

Not Understanding R VP. The  determinants  of RVP  are com­ plex, 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 o f Slow Early Penetration.     The  slow early penetra­ tion 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.  W hat is necessary is a careful analysis of RVP, and  early buyer  experience with the substitute.

A Static View o f 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. M any 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 m aturity of one’s product, and not considering substitu­ tion 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 m aturity may be just an illu­ sion.

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

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