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The cost of switching providers

Stanford Graduate School of Business examines how lower switching costs are making different industries more competitive.

Can you picture the obstacles to changing a home, business or cell phone number: having to notify everyone in your phone book, changing your stationery, and putting a forwarding message on your old number. Such considerations are known as "switching costs," and they are aggressively exploited by companies in areas such as computers, banks, telephones and others. The game is to lure you in with attractive introductory offers and then zap you with higher rates, new fees, and fewer perks once you are so "locked in" that switching to a new firm would be a real pain in the neck--or the wallet.

While it's clear that companies that can distinguish between new and old customers will always price their products and services higher for the "locked in" crowd, it hasn't been as clear whether a firm that can't tell who's who in its customer base--or one that has been prohibited by regulation from engaging in price discrimination--will price higher or lower across the board. Brian Viard, assistant professor of strategic management at the Stanford Graduate School of Business, studied the issue theoretically and empirically and found evidence to support the idea that lower switching costs actually do translate into lower prices for consumers.

Viard's theoretical analysis reveals that pricing by discrimination-prohibited firms whose customers incur switching costs can go either way, higher or lower, depending on the nature of the market. "If there are enough new customers coming into the market, firms will compete to grab them and will therefore price their products or services lower overall," Viard explains. "If, however, there aren't enough new customers in the market, then firms focus on exploiting the customers they already have who are 'locked in' and price higher."

Earlier research in the field concluded that switching costs always lead to higher prices. Viard disagrees, arguing that earlier work assumed that firms did not put value on long-term relationships with customers. "Such models would only be appropriate for companies that were, say, going bankrupt shortly and didn't really care about the ongoing value of new customers. My model considers a longer time horizon and is applicable for companies that are going to be around for a while," he says.

Previous research also did not explore whether prices are higher or lower in markets in which firms cannot price discriminate. Viard's study begins to fill in that gap by looking at 800-number pricing before and after such numbers became portable.

"In May 1993, regulations permitted customers to take their numbers with them even if they switched telephone service providers," Viard explains. "That significantly reduced switching costs for these customers, which were considerable in the case of companies that relied heavily on 800 numbers, such as American Airlines."

Earlier research in the field concluded that switching costs always lead to higher prices.
By studying several hundred AT&T telephone contracts for big 800-number users, Viard found that after portability, the cost of 800 numbers fell. "This means that when switching costs were high, prices were higher.

Lower switching costs led to lower prices," Viard says. "This is the intuitive answer, but theoretically it could have gone the other way. Again, if switching costs ever led to lower prices, it would be in a high-growth market where there were lots of new customers. The fact that the 800-number market was growing quickly during this period means that this finding is very conservative and that we can pretty much expect lower switching costs to lead to more competitive markets across the board."

The significance of such research, Viard says, lies in its public policy implications.

"If switching costs do lead to higher prices, regulators will want to institute rules to reduce such costs for the consumer."

In fact, he notes, such a decision has recently come up in the cell phone industry. "The FCC has ruled that cellular companies must institute cell number portability by November," he says. "Number portability will lower consumers' switching costs, which my work suggests will lead to lower prices. If the costs of portability implementation are not too great and you care about consumers, you should be in favor of it."

Click here for the Stanford Graduate School of Business information portal.

© Copyright 2003 Stanford University--Graduate School of Business