Switching barriers
Encyclopedia
Switching barriers or switching costs are terms used in microeconomics, strategic management
, and marketing
to describe any impediment to a customer's changing of suppliers.
In many market
s, consumer
s are forced to incur cost
s when switching from one supplier
to another. These costs are called switching costs and can come in many different shapes.
specific to his current seller must be duplicated for a new seller". As these definitions indicate, switching costs can arise for several different 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 hi-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.
Switching costs are a major reason for pursuing order-of-magnitude improvements in costs, efficiencies, and benefits to the consumer. This business strategy has been called Andy Grove
's 10x rule.
Where switching costs for a buyer are prohibitively high, the situation can be modelled as a monopoly
, for a seller, a monopsony
, and for both, a bilateral monopoly
.
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.
. 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.
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, government
s and regulators also have incentives to understand switching costs in order to be able to promote competition effectively.
Strategic management
Strategic management is a field that deals with the major intended and emergent initiatives taken by general managers on behalf of owners, involving utilization of resources, to enhance the performance of firms in their external environments...
, and marketing
Marketing
Marketing is the process used to determine what products or services may be of interest to customers, and the strategy to use in sales, communications and business development. It generates the strategy that underlies sales techniques, business communication, and business developments...
to describe any impediment to a customer's changing of suppliers.
In many market
Market
A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...
s, consumer
Consumer
Consumer is a broad label for any individuals or households that use goods generated within the economy. The concept of a consumer occurs in different contexts, so that the usage and significance of the term may vary.-Economics and marketing:...
s are forced to incur cost
Cost
In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something, and hence is not available for use anymore. In business, the cost may be one of acquisition, in which case the amount of money expended to acquire it is counted as cost. In this...
s when switching from one supplier
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...
to another. These costs are called switching costs and can come in many different shapes.
Definition
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 investmentInvestment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
specific to his current seller must be duplicated for a new seller". As these definitions indicate, switching costs can arise for several different 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
Damages
In law, damages is an award, typically of money, to be paid to a person as compensation for loss or injury; grammatically, it is a singular noun, not plural.- Compensatory damages :...
that may be awarded for breach of contract
Breach of contract
Breach of contract is a legal cause of action in which a binding agreement or bargained-for exchange is not honored by one or more of the parties to the contract by non-performance or interference with the other party's performance....
. Often, vendors combine sign-up incentives with penalties for early cancellation. Careful buyers who read the fine print
Small Print
Small Print is the debut album by English singer Sam Wedgwood, released in 2006. The album was mastered at Little Tardis Studios and clearly illustrates Sam’s varied, extensive musical tastes and influences, combining a modern acoustic vibe with some funky jazz beats, some dance numbers and real...
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
Status quo
Statu quo, a commonly used form of the original Latin "statu quo" – literally "the state in which" – is a Latin term meaning the current or existing state of affairs. To maintain the status quo is to keep the things the way they presently are...
. 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 hi-tech travelling salesman would evaluate the advantages of a mobile phone
Mobile phone
A mobile phone is a device which can make and receive telephone calls over a radio link whilst moving around a wide geographic area. It does so by connecting to a cellular network provided by a mobile network operator...
over a landline
Landline
A landline was originally an overland telegraph wire, as opposed to an undersea cable. Currently, landline refers to a telephone line which travels through a solid medium, either metal wire or optical fibre, as distinguished from a mobile cellular line, where transmission is via radio waves...
telephone from a much different perspective than a homebound, fixed-income, retiree. 3) People exhibit loss aversion
Loss aversion
In economics and decision theory, loss aversion refers to people's tendency to strongly prefer avoiding losses to acquiring gains. Some studies suggest that losses are twice as powerful, psychologically, as gains....
. The pain of giving up a benefit is much more significant than the pleasure of gaining that benefit. For example, DIVX
DIVX
DIVX was an unsuccessful attempt by Circuit City and the entertainment law firm Ziffren, Brittenham, Branca and Fischer to create an alternative to video rental in the United States.-Format:...
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.
Switching costs are a major reason for pursuing order-of-magnitude improvements in costs, efficiencies, and benefits to the consumer. This business strategy has been called Andy Grove
Andrew Grove
Andrew Stephen Grove , is a Hungarian-born Jewish-American Businessman/ Engineer, Author & a science pioneer in the semiconductor industry. He escaped from Communist-controlled Hungary at the age of 20 and moved to the U.S., where he finished his education...
's 10x rule.
Where switching costs for a buyer are prohibitively high, the situation can be modelled as a monopoly
Monopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...
, for a seller, a monopsony
Monopsony
In economics, a monopsony is a market form in which only one buyer faces many sellers. It is an example of imperfect competition, similar to a monopoly, in which only one seller faces many buyers...
, and for both, a bilateral monopoly
Bilateral monopoly
In a bilateral monopoly there is both a monopoly and monopsony in the same market.In such, market price and output will be determined by forces like bargaining power of both buyer and seller...
.
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 competitionCompetition
Competition is a contest between individuals, groups, animals, etc. for territory, a niche, or a location of resources. It arises whenever two and only two strive for a goal which cannot be shared. Competition occurs naturally between living organisms which co-exist in the same environment. For...
. When a consumer faces switching costs, the rational consumer
Consumer
Consumer is a broad label for any individuals or households that use goods generated within the economy. The concept of a consumer occurs in different contexts, so that the usage and significance of the term may vary.-Economics and marketing:...
will not switch to the supplier
Supply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...
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
Vendor lock-in
In economics, vendor lock-in, also known as proprietary lock-in or customer lock-in, makes a customer dependent on a vendor for products and services, unable to use another vendor without substantial switching costs...
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.
QWERTY example
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 QWERTYQWERTY
QWERTY is the most common modern-day keyboard layout. The name comes from the first six letters appearing in the topleft letter row of the keyboard, read left to right: Q-W-E-R-T-Y. The QWERTY design is based on a layout created for the Sholes and Glidden typewriter and sold to Remington in the...
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
Dvorak Simplified Keyboard
The Dvorak Simplified Keyboard is a keyboard layout patented in 1936 by Dr. August Dvorak and his brother-in-law, Dr. William Dealey. Over the years several slight variations were designed by the team led by Dvorak or by ANSI...
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
Information technology
Information technology is the acquisition, processing, storage and dissemination of vocal, pictorial, textual and numerical information by a microelectronics-based combination of computing and telecommunications...
, since switching costs seems to be a phenomenon that is especially strong in the information economy
Information economy
Information economy is a term that characterizes an economy with an increased emphasis on informational activities and information industry.The vagueness of the term has three major sources...
. 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, government
Government
Government refers to the legislators, administrators, and arbitrators in the administrative bureaucracy who control a state at a given time, and to the system of government by which they are organized...
s and regulators also have incentives to understand switching costs in order to be able to promote competition effectively.
See also
- Porter 5 forces analysisPorter 5 forces analysisPorter's five forces analysis is a framework for industry analysis and business strategy development formed by Michael E. Porter of Harvard Business School in 1979. It draws upon industrial organization economics to derive five forces that determine the competitive intensity and therefore...
- Barriers to entryBarriers to entryIn theories of competition in economics, barriers to entry are obstacles that make it difficult to enter a given market. The term can refer to hindrances a firm faces in trying to enter a market or industry - such as government regulation, or a large, established firm taking advantage of economies...
- Barriers to exitBarriers to exitIn economics, barriers to exit are obstacles in the path of a firm which wants to leave a given market or industrial sector. These obstacles often cost the firm financially to leave the market and may prohibit it doing so....
- Transaction costTransaction costIn economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange . For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal...
- Vendor lock-inVendor lock-inIn economics, vendor lock-in, also known as proprietary lock-in or customer lock-in, makes a customer dependent on a vendor for products and services, unable to use another vendor without substantial switching costs...
Further reading
- 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 7 October 2005.
- http://www.scribd.com/doc/39032383/Electronic-Reverse-Auction-and-the-Public-Sector-Factors-of-Success-Moshe-E-Shalev-Stee-Asbjorensen
- http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1727409