The definition of switching costs is quite broad. Thompson and Cats-Baril (2002) defines switching costs as "the costs associated with switching supplier", while Farrell and Klemperer (2007) write that "a consumer faces a switching cost between sellers when an investment specific to his current seller must be duplicated for a new seller". As these definitions indicate, switching costs can arise for several reasons.
Examples of switching costs include the effort needed to inform friends and relatives about a new telephone number after an operator switch; costs related to learning how to use the interface of a new mobile phone from a different brand; and costs in terms of time lost due to the paperwork necessary when switching to a new electricity provider.
Types of switching costs include exit fees, search costs, learning costs, cognitive effort, emotional costs, equipment costs, installation and start-up costs, financial risk, psychological risk, and social risk.
Some of these costs are easy to estimate. Exit fees include contractual obligations that must be paid to the current supplier and compensatory damages that may be awarded for breach of contract. Often, vendors combine sign-up incentives with penalties for early cancellation. Careful buyers who read the fine print should not be surprised by exit fees. Search costs and learning costs, the effort and expense required to find an alternative supplier and learn how to use the new product, are also usually expected.
On the other hand, the psychological, emotional, and social costs of switching are often overlooked or underestimated by both buyers and sellers. Gourville (2003) lists several rules of thumb to help understand why many consumers do not immediately switch from a product they currently use to the latest innovative improved product, even if the cost difference is minimal. 1) People are sensitive to the relative advantages and disadvantages of any change from the status quo. Therefore, a new, improved product, no matter how great it is on its own merit, must be significantly better than what the consumer is currently using before he will switch. 2) Different people have different reference points. For example, a high-tech travelling salesman would evaluate the advantages of a mobile phone over a landline telephone from a much different perspective than a homebound, fixed-income retiree. 3) People exhibit loss aversion. The pain of giving up a benefit is much more significant than the pleasure of gaining that benefit. For example, DIVX technology may have failed, in part, because it offered the typical consumer no clear benefit to offset the perceived sacrifice of unlimited viewing time and the cost of having to hook into a phone line.
However, Shalev and Asbjornsen found that Switching Costs is not a relevant consideration for the public sector procurement. In the public sector, buyers are almost always obliged to engage in an auction process as contracts expire. Given that periodic auctions cannot be avoided in the public sector, switching costs are always incurred, and so switching costs would not be a relevant consideration.
Competition, collective switching costs, and market performance
Switching costs affect competition. When a consumer faces switching costs, the rational consumer will not switch to the supplier offering the lowest price if the switching costs in terms of monetary cost, effort, time, uncertainty, and other reasons, outweigh the price differential between the two suppliers. If this happens, the consumer is said to be locked-in to the supplier. If a supplier manages to lock-in consumers, the supplier can raise prices to a certain point without fear of losing customers because the additional effects of lock-in (time, effort, etc.) prevent the consumer from switching.
Competition is also influenced by collective switching costs, especially in markets with strong network effects. Collective switching costs are the combined switching costs of all users in a particular market. For example, the QWERTY keyboard layout illustrates the difficulty of collective switching costs and the problems associated with co-ordinating an escape from a collective lock-in. Since its adoption, alternate keyboard layouts have been developed and used (e.g. the Dvorak layout). Individuals and firms who perceive an alternate keyboard layout as more efficient may still be dissuaded from choosing it on the basis of switching costs.
New users who have to choose between QWERTY and another layout may favor QWERTY because it dominates the keyboard layout market. Individual lock-in leads to collective lock-in as network effects drive more and more new users to adopt QWERTY and prevent current QWERTY users from switching to another layout.
Collective switching costs affect competition by strengthening incumbents and hindering new entrants, who must overcome both the collective and individual switching costs to be able to succeed in the market. Recognition of these switching costs has recently led to several attempts to design alternative keyboard layouts which lower the barrier to entry by retaining many of the features of QWERTY. However, none of them is in widespread use.
Switching costs are likely to be present in a large class of markets. The importance of understanding switching costs has been emphasised with the rise of information technologies, since switching costs seems to be a phenomenon that is especially strong in the information economy. Shapiro and Varian (1999) write: "[y]ou just cannot compete effectively in the information economy unless you know how to identify, measure, and understand switching costs and map strategy accordingly." Businesses are not the only ones who need to be aware of and understand switching costs. Since switching costs affect market performance, governments and regulators also have incentives to understand switching costs in order to be able to promote competition effectively.
- Barriers to entry
- Barriers to exit
- Job lock
- Porter 5 forces analysis
- Transaction cost
- Vendor lock-in
- Carl Shapiro and Hal R. Varian (1999). Information Rules, Boston: Harvard Business School Press.
- John T. Gourville (2003). "Why Consumers Don't Buy: The Psychology of New Product Adoption," Harvard Business School Case No. 504-056. (Revised April 5, 2004).
- Andy Grove, (July 21, 2003). "Churning Things Up," Fortune. Retrieved 13 December 2012.