Power of Substitutes: Economics of Cross-Price Elasticities
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Transcript of Power of Substitutes: Economics of Cross-Price Elasticities
David Bryce © 1996-2002Adapted from Baye © 2002
Power of Substitutes: Economics of Cross-Price Elasticities
MANEC 387MANEC 387Economics of StrategyEconomics of Strategy
David J. Bryce
David Bryce © 1996-2002Adapted from Baye © 2002
The Structure of Industries
Competitive Rivalry
Threat of newEntrants
BargainingPower of
Customers
Threat ofSubstitutes
BargainingPower of Suppliers
From M. Porter, 1979, “How Competitive Forces Shape Strategy”
David Bryce © 1996-2002Adapted from Baye © 2002
Demand and the Prices of Other Products
• In addition to its own price, consumption of a good depends on other factors– Prices of other goods– Product quality– Income– Preferences– Advertising
• Changes in these factors results in a “change in demand” – shift of the demand curve
David Bryce © 1996-2002Adapted from Baye © 2002
Changing Prices of Rival Products• Substitute goods – an increase (decrease)
in the price of good X leads to an increase (decrease) in the consumption of good Y.
• Complementary goods – an increase (decrease) in the price of good X leads to a decrease (increase) in the consumption of good Y.
David Bryce © 1996-2002Adapted from Baye © 2002
Substitute Goods
When the price of good X falls, the consumption of substitute good Y also falls.
Computers (X)
X1
Calculators (Y)
X2
Y1
Y2
David Bryce © 1996-2002Adapted from Baye © 2002
Complementary Goods
When the price of good X falls, the consumption of complementary good Y rises.
Computers (X)
X1
Software (Y)
X2
Y1
Y2
David Bryce © 1996-2002Adapted from Baye © 2002
Elasticity and the Power of Substitutes
• Substitutes are defined by product function, not by product form
• Substitutes have power to reduce prices when buyers have high cross-price elasticity between a firm’s product and substitute products– Close relative price/performance ratio– Consumer tastes & preferences favor
substitute’s features– Low switching costs
David Bryce © 1996-2002Adapted from Baye © 2002
• Cross-price elasticity gives the sensitivity of demand of good X to changes in the price of good Y
• Cross-price elasticity of demand defines the strength of the relationship between X and Y
Cross Price Elasticity of Demand
Qx,Py = %Qx
%Py
Qx,Py > 0: substitute products
Qx,Py < 0: complementary products
David Bryce © 1996-2002Adapted from Baye © 2002
Strength of Substitutes and Complements
• With strong substitutes, many customers will consume the substitute good if a firm raises its prices– Coke v. Pepsi – Suburban v. Expedition
• With strong complements, many customers will reduce consumption of a firm’s product if price of the complement is raised– Personal computers and software– Hamburger buns and E-coli tainted hamburger
David Bryce © 1996-2002Adapted from Baye © 2002
MRS Defines the Strength of Substitutes
• Marginal Rate of Substitution – the rate at which a consumer is willing to substitute one good for another and stay at the same satisfaction level.
Good Y
Good X
S1
S2
S3
S3 > S2 > S1
David Bryce © 1996-2002Adapted from Baye © 2002
Strength of SubstitutesGood Y
Good X
PerfectSubstitutes
ImperfectSubstitutes
ImperfectSubstitutes
• Willing to exchange perfect substitutes one-for-one, i.e., indifference curve has a slope of –1
• Imperfect substitutes exchange at different rates
• Diminishing marginal satisfaction creates imperfect substitutes
David Bryce © 1996-2002Adapted from Baye © 2002
Cross-Price Elasticity at AT&T
• According to an FTC Report, AT&T’s cross price elasticity of demand for long distance services is 9.06
• If competitors reduced their prices by 4 percent, what would happen to the demand for AT&T services?
David Bryce © 1996-2002Adapted from Baye © 2002
Impact of AT&T Rivals’ Price Cuts
• 9.0 is a high cross-price elasticity – customers are sensitive to rival prices so we would expect to see a loss of market share– 1% reduction in rival prices generates a 9.06%
reduction in demand for AT&T services, so– 4% reduction in rivals prices generates a 36.24%
reduction in demand for AT&T services• Stealing market share so easily tempts all
firms to cut prices substitutes have power over AT&T prices