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 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.
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.
Read more about this topic: Switching Barriers
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