We're talking about the Five Forces Analysis and this is a tool that allows us to think carefully about these five competitive forces that can have a potentially negative impact on the profitability potential in a particular industry or market segment. So right now, we are gonna to talk about the threat of substitutes. First of all, what do we mean by a substitute? What is a substitute product or service? Well, this is a product or service that is not a product or service that we are directly competing with in our exact same product category. Those actually are our rivals and we'll talk about that at another time. But substitutes, we're talking about something slightly different. These are products that are similar to our products or services, but not exactly the same. But yet, in the eyes of some consumers or buyers, they might under certain conditions, substitute in and out for one another. So strategically, this is consideration that we need to worry about if we're operating in a particular industry on market segment. So what would be an example? An example might be butter and margarine. So a dietician or a nutritionist would tell you that these are not exactly the same thing and she would be right. But for a lot of buyers and consumers, they might refer one or the other. But they may not be willing to pay a big price premium for one or the other. If one of them becomes too expensive, then they might go ahead and buy the other one instead. Another example might be if you think about laptops. Laptop computers. So again when we're talking about substitutes, we're not talking about the sort of direct competition between all the different laptop manufacturers. That's rivalry. But when we're talking about substitutes, we're thinking of what sorts of products might be not exactly the same as a laptop but similar. Have some similarities and under certain conditions might substitute in. Can you think of any products that might fit that description? If you thought of tablets or even smart phones, you'd be correct. Those are examples of products that they aren't exactly the same thing as a laptop, they can't do everything a laptop can do. But under a lot of conditions, they can substitute in for a laptop, cuz there's a lot of common functionality. And increasingly in that case, especially among young people, they're buying fewer laptops and they're just doing more and more on their tablets and their smartphones. So that would be an example of substitutes and one of the things we're worried about here is the threat of those substitutes taking away our sales. Now as with all of the five forces, we have to ask ourselves. What's desirable here? Do we want the threat of substitutes to be high or do we want the threat of substitutes to be low? Well, we want the threat of substitutes to be low. Remember, this is from the perspective of we're in the industry already and we're trying to assess how good it is to be in this industry. And if it's an industry where there's not much threat of substitution of other adjacent products, then that's good for the industry and it means the profitability potential is higher in that industry. So the question then is how do we know? How do we know if the threat of substitutes is high or low? The professor or the teacher could just assert it and say well, in a certain industry, it's high and this other industry, it's low. But I want you to be able to figure out, how can I look at data or think through the dynamics here and discern for myself, whether the threat of substitutes is high or low? And remember, we want the threat of substitutes to be low. So what would be a couple of indications that the threat of substitutes is low? Let me talk about a couple of things here. First of all, the first indication I'll talk about is, it's the idea that cross-price elasticity of demand might be low. So this is a particular metric we might look at. This cross-price elasticity of demand, that's a mouthful. So what do we mean by that? Essentially, what we're talking about is the price sensitivity and the demand sensitivity between these two products that are substitutes for one another. Take the laptops example. We wanna try to determine if the price for laptops goes up, does the demand for tablets go up, cuz everyone just switches to a tablet? That's sort of what we're talking about here. So, it might help to think about this visually. So here's three charts and these might look like sort of traditional demand or supply charts. We've got price on the vertical access and quantity on the horizontal access, but there's a subtly here when we're dealing with cross-price elasticity. And that is the vertical access is the price of one product or product class. And in the horizontal axis, the quantity demanded is the quantity demanded of the potentially substitute product. So in other words, think about this as, let's use our butter and margarine example. Maybe the price of butter is on the x-axis and the quantity demanded of margarine is on the y-axis or the vertical or horizontal. So we might think of sort of some extreme cases here. So for instance, we could think about the case of sort of perfectly or infinitely elastic demand. And it might help, if you think about that as having just a tiny bit of slope and not being perfectly flat. And the point here is that if the price of butter goes up, the quantity demanded of margarine is gonna go way up. And the reason is the consumers are highly price sensitive to butter and margarine and they maybe don't care that much about one versus the other. And that would suggest that the threat of substitution of one for the other is really high again, because of this cross-price elasticity of demand is high. So then on the other end, we might think about the inelasticity of demand and this is an example of perfectly inelastic demand. This is the vertical line. And that would suggest that in a particular product class, if a firm raises the price of a product or service that the quantity demand of this potentially substitutable product does not go up. So that might suggest actually that is not substitute and we don't have to worry about it. So that's a better situation to be in. Is to be in a industry or market segment where our product service is sort of, we can price it higher if we want and we won't lose a bunch of customers to some substitute product or service. Now, in in reality, most practical examples are somewhere in between those, like that graph in the middle. And so it's just a question of what the slope of that line is and strategically, you have to really think carefully about how we should price our product, given the potential leakage of sales to this alternative or substitute product. So that's one way to tell whether the thread of substitutes is high, you can actually look at the cross-price elasticity. And if the cross-price elasticity is high, then the threat of substitution is probably gonna be high. If it's low and it's very inelastic, then it's gonna be lower. Let me talk about one more concept here. Oh, before I do. Here's a tip on how to remember that, cuz some of these economic concepts can be confusing. Just look at the shape of those graphs. One of them looks like an E and that's for elastic and the other one looks like a capital I for inelastic. So maybe that's a tip that will help you kind of remember the sort of extreme examples as you puzzle through these things. Let me talk about the next point and this has to do with what's known as switching costs. So switching costs are essentially, these one time cost that you incur to switch to the substitute product or service. And the point here is that if switching costs are high, then the threat of buyers leaving you to go to the substitute product or service is gonna be lower, because they are just gonna be unwilling to pay those high switching costs. So what's an example, let's see. A couple of weeks ago, I had to take one of my sons to a summer camp up in New York. I live in central Virginia, so this is about 300 miles away and so I had several options. We could have traveled on a plane, we could have traveled on a train or I could have driven in the car. And of course, driving in the car would be the least pleasant option, that's the one I ended up doing. And in part, because I was a little bit sensitive to price. So what we might think, if the price of flights was low enough, we would have just flown up there. No problem. If the price of flights was a little higher, I'm more inclined to drive my car. So that's the idea we were talking about a moment ago about cross-price elasticity of demand. So lets turn that around to illustrate this idea of switching costs. Lets say, we're talking about the reverse and we're talking about a family that needs to take a child to a music camp in Virginia and they live in New York. So we might think it's the same calculation. They could fly. They could take the train. They could drive the 300 miles. But sometimes folks that have spent a lot of time in New York, especially those that were born and raised there, might in fact, not own a car. In fact, they might not even have a driver's license. I have friends that teach up in New York who don't drive. And so in that situation, it's not the simple calculation of what's the differential price of driving and putting gas in the car versus flying and buying the airline ticket. But we now have these additional switching costs. If I don't know how to drive, now I've got to buy a car, rent a car. I've got to maybe take driver's education classes and get my permit and get my license. So, all of these things represent switching costs. And so if I was in that situation, if I was the parent living in New York needing to drive to Virginia or fly the Virginia. I'd probably be less inclined to drive, if I didn't know how to drive, because I wouldn't want to incur those switching costs. So these are two ways that you can tell just by looking at the data or thinking it through, whether the threat of substitute products or services is high or low.
