Market Share Selling: The Substitution Effect

November 16th, 2009 by

By Pat Hinds,

I read an article in the Calgary Herald this week entitled, “It’s a new world for Greenspan”; the article is a summary of the speech former U.S. Federal Reserve chairman Alan Greenspan gave while he was in Calgary. The entire article was interesting as Alan Greenspan is a very knowledgeable person who has incredible insight into global economics. At the end of the article, Mr. Greenspan used a term called the “economic law of substitution” when he referred to what impact unconventional gas may have on the North American energy market.

¬_“Greenspan also touched on the revolution that has taken place in North American natural gas markets as a result of the increased production from shale gas plays.”

“And while he characteristically shied away from making any suggestions as to how best to deal with the current largesse, Greenspan did suggest that the surplus could push the economic law of substitution to take place, as industry and consumers substitute oil for natural gas.”_

While at university I studied economic laws including “The Law of Substitution Effect” referred to as the “economic law of substitution” by Mr Greenspan. Listed below is one interoperation of the law I found on the internet:

The law of demand can be explained by the substitution effect. If the price of a good is lower than expected then that good appears to the consumer as a bargain opportunity in comparison to the goods which remain at full price. The consumer will temporarily switch his/her pattern of consumption by substituting bargain items for full price items._

If you look at natural gas as a case study, as a general rule of thumb crude oil has traditionally traded at a 7-8 multiple to natural gas, or put another way, natural gas trades at a 7-8 times discount to crude. In today’s economic environment “New Normal” natural gas trades at 16 times discount to crude. Natural gas can be converted to barrels of oil equivalent using a ratio of 5,487 cubic feet of natural gas per one barrel of crude oil. This ratio is based on the actual average equivalent energy content of natural gas reserves. As a result of the “New Normal” economic environment you have push for North America to substitute oil from the Middle East with North American natural gas. The push for natural gas to be North America’s primary energy source is most evident in the Pickens Plan that is being promoted by American oilman, T.Boone Pickens.

The point I want to make with this blog post is when you are targeting a market and the goal is to capture market share you need to know if you are building a product category or if you are substituting a product. If the goal to capture market share is based on product substitution you need to respect the “Law of Substitution Effect” and make your product appear as a bargain to your target market. That does not mean that it has to be the lowest price, it just has to appear to be a “bargain”. The economic condition I refer to as the “new normal” has created a unique environment for change as seen in the push for the adoption of natural gas to replace oil. If you target your market and do a good job to position your product as “bargain” you will have the opportunity to capture market share.

Topics: Sales Consulting