Stephanos Avgeropoulos and John McGee. Cross-subsidization refers to using .... Porter, M.E. (1985) Competitive Advantage: Creating and Sustaining Superior ...
cross-subsidization1 Stephanos Avgeropoulos and John McGee
Cross-subsidization refers to using profits earned in one product market to support activities in another. It may be carried out on government instructions, such as for social reasons (e.g., the cost of postage may be set to be uniform nationwide, with city postal traffic subsidizing that of rural areas), or it may be for commercial motives, using the strategy to enable a firm to compete in a market in which it would otherwise find it difficult to survive, or to otherwise enhance the combined revenue earning potential of the two product markets, particularly if these involve complementary products.
TYPES There are three main cross-subsidization strategy variants, all of which require two conditions: (i) price one of the goods (the base good) low to stimulate its sales volume which thereby ensures greater purchases of the other, and then (ii) price the other (more profitable) tied good high to more than recoup lost revenue. The three strategies are: loss leadership (predominantly used in retailing, whereby the base good is priced low to attract the price-sensitive customer to the outlet, while other goods that the customer would like to buy once he is in the outlet are priced at more profitable levels); the razor and blade strategy (whereby the base product is priced low in order to lock the buyer into making subsequent purchases of the more profitably priced complementary products); and the trade-up strategy (whereby the base product is priced very competitively, and the buyer is expected to subsequently move up the range and buy items which are more profitable).
price and its supply must be restricted so that the firm does not end up supplying only the unprofitable good. Finally, a strong link on the demand-side must exist between the two, so that purchase of the base good leads to (repeated) purchase of the profitable good as well. For the razor and blade strategy this link typically deteriorates with time, and as products mature, cross-subsidization becomes less relevant. This is because the profitable good may become more widely available, or because substitute products are developed. With loss leadership the base goods may change over time as consumer price elasticities increase because of increases in competition for the base goods. Trade-up strategies will typically weaken over time as the product matures but will recover with the introduction of a new generation of products.
IMPLICATIONS FOR STRATEGY As a result of the necessity for the above conditions to hold, for a company to be able to exploit the cross-subsidization potential between two products, an effort must be made to create barriers to entry (see BARRIERS TO ENTRY AND EXIT) into the market for the profitable good and to strengthen the connection between the base and the profitable good (e.g., by raising the switching costs involved). It is not important, however, to erect barriers in the market for the base good, and as long as the above conditions hold, that market may even be left to other suppliers. Turning to pricing, the increasing difficulty that the firm will face over time in continuing to profit from the sale of goods in this way implies that prices may well need to be adjusted so that, over the long term, the profit margins for the two goods become comparable.
ENDNOTES PRECONDITIONS For a cross-subsidization strategy to work even with buyers who are able to see through the mechanisms, a number of conditions must hold. First, the demand for the base good must be sufficiently price-sensitive to attract the customer in the first place. Then, demand for the profitable good must not be as pricesensitive, so that this is purchased at the high
1 Original
article by Stephanos Avgeropoulos. Updated by John McGee.
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