The threat of substitutes is the availability of other products that a customer could purchase from outside an industry. The competitive structure of an industry is threatened when there are substitutes available that offer a reasonably close benefits match. In this case, price points are limited by the prices at which substitutes are available, which limits the amount of profitability that can be generated within an industry.
When there is a strong threat of substitutes, industry players must pay more attention to operating in the most efficient manner possible; otherwise, their high cost structures will interfere with profitability and may drive some firms out of business.
When there is a reduced threat of substitutes, industry players tend to be more lax with their cost controls, resulting in higher prices charged to customers. Because there is little prospect of competition from outside the industry, there is a higher potential for profits within the industry. Thus, firms tend to generate higher profits at the expense of their customers.
The following factors cause a higher threat of substitutes for an industry:
- Customers can easily switch between products.
- Substitute products are readily available to customers.
- Substitute products have better features than comparable products within the industry.
- Substitute products have higher quality/reliability than comparable products within the industry.
- Substitute products have lower costs than comparable products within the industry.
There are a number of ways in which a company can mitigate the threat of substitutes. For example, it can inspire brand loyalty through its marketing efforts, product quality, and support services. Or, it can focus intently on specific market niches, so that the value it offers to customers within those niches exceeds the value that customers can obtain from substitutes. Another possibility is to identify those customers who are most likely to shift to substitutes, and target them for enhanced service and marketing efforts, so that they are aware of the particular value that the organization brings to them.
From the perspective of an investment analysis, an industry is a better prospect for investment when the threat of substitutes is low, since firms within the industry have a higher potential to earn an above-average profit.