Threat of substitutes

Substitutes to the products and services offered by the focal industry can be a serious threat to profitability or, in some cases, even the survival of the focal industry. Customers buy products to fulfil their needs. A product can satisfy a need, but so can the substitutes to the product. It is important to understand the needs a product fulfils before the full range of substitutes can be identified. This was first noted by Ted Levitt in a classic article:

The railroads did not stop growing because the need for passenger and freight transportation declined. That grew. The railroads are in trouble today not because that need was filled by others (cars, trucks, airplanes, and even telephones) but because it was not filled by the railroads themselves. They let others take customers away from them because they assumed themselves to be in the railroad business rather than in the transportation business. The reason they defined their industry incorrectly was that they were railroad oriented instead of transportation oriented; they were product oriented instead of customer oriented. (Harvard Business Review, 1960)

This is post five in a series on industry analysis.



Economic definition of substitution. The economists define substitutes as products with a positive cross-elasticity. In other words, two products are substitutes if an increase in the price of product A increases the demand for product B. For instance if there is an increase in the price of private cars, there will be an increase in the demand for public transport. Cars and pubic transport are substitutes. This is a useful heuristic if you are familiar with economics, but it is not going to be useful in identifying substitutes. Rarely in practice do we have any information about cross-elasticities between products.

Types of substitutes. A substitute can either have lower price, more unique benefits, or (rarely) both features. It is not possible to state that one advantage is more common than the other in a general sense.

Stages in the industry supply chain. Substitution can occur on all the intermediary steps in the industry supply chain making substitution analysis quite difficult. Consider the the following industry supply chain. The substitutes listed under each stage are from the buyer's perspective.

The soft drink producer can use PET polyester or rolled aluminium to produce bottles or cans. In the past, other substitutes would have been glass bottles and rolled steel. If you produce rolled aluminium, you have to consider all the possible substitutes downstream in the industry supply chain. If the end-customer is switching to tap water that will effect the demand for rolled aluminium. The situation can get very complex, because rolled aluminium is sold to many other industries in addition to the soft drink industry.  The raw material producers will sell to so many industries that it is often infeasible to study substitution in all downstream branches of the supply chain. Practically, the important downstream branches of your important direct customer-industries should be the focus of attention.

The supermarket can fill its shelves with other drinks; like bottled water and fruit juice. Since the supermarket stage represents a large portion of the sales of the soft drink industry it is also necessary to study the indirect customer, the end-customer. Studying the needs of the end-customer can thus provide an early warning sign to the soft drink producer.

The end-customer has several choices when satisfying his need for drinks. However, from the supermarket's perspective some of these alternative products are not substitutes. If the end-customer decides to drink fruit juice instead of a soft drink, that is not a substitute from the perspective of the the supermarket. All supermarkets will carry both soft drinks and fruit juices. However, if the end-customer decides to buy a home carbonation machine he has to go to a home appliances shop. The end-customer can also decide to buy from another retail format like the internet or convenience stores. Those are also substitutes from the perspective of the supermarket industry.

Another example. A paper mill selling paper to the newspaper industry must analyse the substitutes both at the newspaper stage as well as the end-customer stage. Long before end-customers started to read their news on-line, the traditional newspaper business lost subscribers and thus reduced the demand for newsprint. Here substitution happened at the end-customer stage (watching television instead of reading newspaper). More recently, the substitution is occurring at the direct customer level (publishing on-line instead of in paper).

Used goods. If the goods are durable, there is also the option of buying a second hand product. Airlines always have the choice of buying a new aircraft from the manufacturer (i.e. Airbus or Boeing) or a used aircraft. An aircraft lasts around 40 years, so the overwhelming majority of aircraft produced during this time period are still available for purchase. When the aircraft manufacturers consider substitutes, the direct customers can buy used aircraft and the indirect customer can decide to buy a train ticket instead. Substitution on both levels are important.

Cash. Sometimes the substitute could be cash. This is short-hand for saying that in some cases almost anything can be a substitute. If a company is selling retirement savings products, any kind of long term savings product could constitute a substitute. However, the customer might consider the whole idea of saving for the long-term as too complicated and decide to keep the cash instead. Another example is a couple getting married and deciding not to buy an expensive diamond ring.

Differences within an industry. The threat of substitutes to an industry can vary between the different industry segments. This is often determined by the product serving different needs in different segments of the market. Maslow described a hierarchy of human needs, starting with the most basic needs we get the following list of increasingly sophisticated needs; physiological, safety, love/belonging, esteem, and self-actualisation. If a particular product only satisfies the more basic needs, the number of potential substitutes is fairly limited. If on the other hand a more advanced need like the esteem of other is included, the number of possible substitutes increase.

Example: In the low-end of the clothing industry there are few substitutes as people buy clothing for protection from the weather or physical comfort. In the high-end of the clothing industry there are more substitutes because the items also fulfil other needs like conveying a certain self-image or status. Instead of buying an expensive Giorgio Armani dress, a customer can buy a Gucci handbag. The handbag is not a substitute for the more basic needs, but it is a substitute for the higher-order needs.

Rate of substitution. Like for the other forces, it is most important to understand whether the future trend of substitution is likely to be different to the historical trend. More on that in a future post.