Let’s pretend that you want to buy a Ford vehicle, but General Motors wants your business instead. So they may imitate Ford, by copying or augmenting certain features of their vehicles to be comparable. This is called an imitation product. Then there is the company that wants to sell you a road bike as a form of transportation and get rid of automobiles all together. This would be called a substitute product.
Substitute products and services come from different industries that replace products and services in other industries. Like imitators, they essentially create the same thing as your product or service but unlike imitators, they do it in a different way. For example, Reebok shoes can imitate a pair of Nike’s, but bare feet could be a substitute for a pair of Nike’s.
Truck transportation became popular in the 1960’s and 70’s, the demand for rail transportation dropped. At the same time, railroad had an excellent reputation in the rail business (an isolating mechanism within the industry). For example, this did little to hinder the reductions in demand caused by the increasing use of highway-borne freight. What can be done to protect demand from reduction due to substitutes?
In order to protect an entrepreneur’s company from substitutes, build “positioning” in strategic relationships. Where strategic positioning boundaries can become useless due to a competitors change in strategy, an alliance with potential competitors can forestall reduction in sales due to substitutes. That’s where you can participate in the profits of the demand-reducing substitute and you can efficiently position your venture to prevent demand reduction.
This approach was successfully demonstrated by the railroads in our example above. When faced with demand reduction from the highway transportation substitute, the truck transportation industry intervened by offering “piggy-back” service transportation of semi-trailers on flat cars. The railroad industry efficiently prevented the erosion of demand for their service by co-opting a portion of the business in the trucking industry. The boundary between industries was permeable due to marginal long-haul charges for railroads are lower compared to trucks.
If you are evaluating an ongoing business and substitutability is high, look for the possibility for a strategic alliance. Begin by looking at the cost and efficiency structure, to ascertain where value can be added to products and services in the substitute industry. Using the “value chain analysis” (Porter, 1985) is particularly helpful, since it highlights the possibilities for strategic alliances in substitute industries.