This is a concept that I have found particularly useful in understanding actions and strategies by companies.
The following is the definition of switching costs by Investopedia:
Switching costs are the costs that a consumer incurs as a result of changing brands, suppliers or products. Although most prevalent switching costs are monetary in nature, there are also psychological, effort- and time-based switching costs. A switching cost can manifest itself in the form of significant time and effort necessary to change suppliers, the risk of disrupting normal operations of a business during a transition period, high cancellation fees, and a failure to obtain similar replacement of products or services.
In other words, switching costs represent how much consumers care about your services or products.
In economics, the relationship between a firm’s profit, competition and switching costs is illustrated in the following formula below. To learn more how the formula is formed, you may want to read this.
Φ = t/n2– f
Φ`- the firm’s profit
t – the switching cost
n – the number of firms in the market
f – fixed cost
There are a few lessons to learn from the formula. First of all, the bigger n is, the smaller the profit. In other words, the more competitive a market, the smaller the profit. As a result, companies try to have monopoly or monopolistic competition in the market in which they operate. The goal is to have n as small as possible. That’s why companies such as EVN, Mobifone, Viettel or Petrolimex in Vietnam generate so much profit every year because they practically have a monopolistic competition. On the other hand, industries in which prices determine purchase decisions (hospitality for example) are very competitive and can yield a small margin.
If a firm cannot make n smaller, another way to increase profit is to increase t. In other words, make consumers care more about you. In business language, create differentiation from your competition. Here are a few examples:
- Amazon raised the subscription fees of Prime from $79 to $119 a year over the years. They have successfully made consumers love the service with fast delivery, discounts or so they claimed, convenience, more digital content, especially original content by Amazon Studio. Consumers find it very difficult to find a replacement or to leave because for some consumers, Prime plays quite a role in their life. It is not easy to find a proper replacement for Prime services. It would take a lot of time. In addition, it is not possible to access Prime original content without a subscription.
- Netflix increased subscription fees late 2017. Not only do consumers get hooked with their streaming quality, sleek interface and a wide collection of content, but consumers care more about Netflix because of its original content (movies, documentaries, etc…) that they could not get anywhere else
- After a short period of market penetration with high incentives for drivers and discounts for riders, Grab steadily cuts incentives and increases the prices, even before the acquisition of Uber (lowering n). When consumers find it hard to find a replacement for Grab or live without it, Grab has all the conditions needed to raise the price and increase profits
- In freemium models, consumers are allowed to use the service for a period of time before opting to pay for the premium. After the trial period, consumers care more about the services and are willing to pay more for continued access to them. If you are a hardcore music fan who uses Spotify all the time, would you pay for continued access now that the company decides to charge a fee every month? We would be more willing to pay to enjoy the established convenience and avoid the hurdle of building playlists again on another platform
At its peak as the King of social media, Facebook was where we interacted with our friends and family. Would you have paid a few dollars a year to use it if Facebook had added the fee? We would be more willing to pay to remain in contact with our friends and family and to avoid losing data, videos, statuses and pictures.
- Companies create customer loyalty programs to make consumers stick around longer and care more about the companies’ offerings. We tend to favor a particular brand over its competitors if we have some loyalty points in account, don’t we? We care more about gaining points and are willing to pay a bit extra to get closer to the next level. Examples can be airlines, hotels/resorts, clothing lines…
- Brands, especially luxury & high-end brands, spend a massive amount of money on advertising to tell engaging stories and make consumers “relate” more to the brands and care more about them. How much would you pay for Starbucks coffee without the brand compared to an equally good coffee from a mom-and-pop store? How much would you be willing to pay more for luxury sports shoes such as Jordan or Nike without the branding compared to an equally functional non-branded pair of shoes from a factory?
- Another example is when you are at public places such as airports, zoos or cinemas, just to name a few examples. Goods at those places are charged more and consumers are willing to pay because it would be a hassle to bring alternatives or impossible to do so (airports). Though shops have to pay the management of those places to be present there, image if the prices go up by $0.5 or $1 (about 22,000 VND), would you still buy the goods?
In summary, I think switching costs are a useful simple economics concept to look at business strategies and actions. Whether you enjoy analyzing business or investing, I think it is a good starting question to ask whether a business activity makes it harder for consumers to switch to alternatives. Of course, there may be a lot of other factors involved and it’s always good to have things in hindsight. Nonetheless, this is still a helpful tool to have in mind.