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Leg Zero: Pressure from Substitutes: Porter´s Industry Analysis Model. Part II.

Good morning to all.

I decided to start this blog some months ago because I really wish to help others. I decided to help people through knowledge explained in the most simple and basic terms and words. Each person gives what they have. I can´t share money or monetary aid because I don´t have it… but I can help others with my brain and advisory ideas. I am sure after you read a couple of my posts, you already know I am not a native English speaker. I speak Spanish perfectly since it is my mother tongue, and probably this blog could be better if I write it in Spanish. But, I decided to write in English because this language has a larger scope than just Latin America and Spain.  simplicity is the final Writing, with simple examples, modest and popular words, without the economic rhetoric or complicated buzzword, which makes it very confusing for entrepreneurs who do not have formal business degrees. I also apologize for not sharing personal videos, but since this world is full of them on youtube, I decided to open the space to others´ video creations who are doing excellent sharing. I love to write, anyway. education isI also wish to encourage you to continue searching and expanding your knowledge in multiple ways. If I can sow a petit seed of curiosity and the desire of continuous learning in you, I will be the happiest person on earth. Do not hesitate to continue learning. You can always read, go to the library, watch internet videos, apply to university courses, dedicate time to obtain good grades and apply for scholarships or fellowships. If you already finished your undergraduate, start thinking in your master degree or P.h.D., and continue attending seminars/conferences for free. If you already know everything about a certain subject, but you wish to learn another stuff, do it. Never stop to do it. Never stop to learn. There is always something to learn. This world is full of mediocrity and we have to change that through learning with excellence.

Simplicity-isI also know, each of us has a different learning style. And no one has a better learning style than anyone else. Some experts say there are as many as seven different learning styles, but basically, we can narrow them down to three types of learning:  (1). Listening learners, (2). Seeing learners, (3). Touch/experience learners. I understand some of us are more comfortable with reading, others watching videos, and many others are happy when listening to gurus. Of course, there are others who don´t believe in anyone and learn by their own experience or from their mistakes. As an advisor I have told my recipes of success to some people who did not believe me, and they learned their own lessons the hard way. But “À chacun son goût”. Each person has his/her own learning style.  I will keep this blog with a mix of everything, but personally, I will continue writing as a tool for sharing my ideas… My aim when sharing with you is to help you continue learning as much as you can with simplicity, returning back to basics.

Let´s continue with the topic for today: Substitutes.

The potential for profit in an industry is determined by the maximum price that customers are willing to pay. This is inherently linked with the concept of demand. Let´s remember this concept please: “Demand is a want for a specific product supported by an ability and willingness to pay for it”. Many people want a Porsche but few are able and willing to buy one. Companies, therefore, have not only to make products that people want, but they also have to make them affordable to a sufficient number of clients in order to profit.

BevMax4Dasani_Crane-682x1024Let´s talk about an example: For years, our office vending machine has only offered bottled water. Moreover, the availability of just one drink,  water in a bottle, made the charging price up to $1.50 dollars. Since there were no substitutes in the office, water was the only product we could buy. It was not possible to switch to another substitute, and people had to pay $1.50 for each bottle of water.

What will happen if suddenly our HR manager authorizes the offering of more drink choices than just water?  vending-machines-bevmax-cokeSuddenly a new vending machine is positioned next to the water one, and we are offered with Coke and Pepsi cola cans, natural fruit juices, V8, iced teas and other fancy drinks. Each product has different prices, but some of them, below $1.50 dollars each. For example, the colas and tropical fruits are set to $1.00 each. Suddenly, the majority of employees decided to don´t continue buying the water and switched to substitutes (either cola, iced teas or tropical juices).  The pressure from substitutes produced a reduction in the water price to $1.00 dollar. In consequence, the presence of new substitutes limited the water price. Before the presence of substitutes, water was sold at $1.50 per bottle, but with the arrival of substitutes, the maximum water price changed to $1.00.

In summary: If there are close substitutes for a product, then attempts by producers to raise prices cause customers to switch to substitutes – that is, demand is elastic with respect to price. Another example about elastic demand is the pricing policies of the suppliers of frozen foods, which are constrained by the prices of canned or fresh products.

Where there are few substitutes for a product, as in the case of gasoline, consumers are comparatively insensitive to price, that is, demand is inelastic with respect to price. It doesn´t matter if the gasoline price rises or reduces, if we have a gasoline car, we will always go to a Gas Station to buy it. In the case of gasoline, we are talking about a demand that is inelastic.

The extent to which the pressure of substitutes constrain industry pricing depends upon four factors:

  1. The propensity of buyers to substitute
  2. The Relative price-performance characteristics of substitutes.
  3. Buyer switching costs
  4. The perceived level of product differentiation.

As of tomorrow, we will dig deeper in these 4 factors.

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