Strategy Dynamics Briefing 57: Switching costs, delays and limited rationality in customer choices

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Recent briefings have made some simplifying assumptions – that customers switch between rivals for any gain, no matter how small, that they do so instantly, and that they always work out what’s economically optimal – none of which are very realistic!

  1. Switching can require time and effort. Some costs are real, financial expenses. A Windows-PC user switching to a Mac would have to spend a lot on new software. There would also be non-financial costs, such as learning how the new software works. Firms may try to create switching costs for customers, to reduce their inclination to switch. Cellphone operators subsidize the cost of handsets, but cannot afford these costs if subscribers soon switch again. They therefore require users to take contracts for periods long enough to recover those subsidies from the monthly service charge.
  2. Limitations to rational choices. Economic models often assume that human behavior is rational; people are assumed to have perfect knowledge of functionality and prices, and to make choices on what is rationally best. A car is bought, for example, because it offers exactly the right amount of space, performance, fuel economy and other known factors that the customer wants for the price being charged. It is not purchased, on the rational view, because it’s a nice shade of blue, nor because it has cup holders. Apart from the limited cognitive capacity to evaluate and compare so many details about a product or service, customers first need to be both aware of and understand the better value on offer from alternative suppliers if they are to switch. Interest charges on credit cards vary widely, for example, and most consumers at most times could find cheaper alternatives, but will not invest the necessary effort to find that out.
  3. Delays in customer response. Even in Figure 1, there is a short delay for the practical process of switching—customers must be offered the new price, receive a bill that shows they could save money, apply to switch, and have their account transferred. But there can also be behavioral delays — some customers act immediately on noticing they could save money, whereas others may not act until they have received several communications from our competitor and several bills from us. People can be just lazy – not ‘getting round to’ doing something, even though they know it makes sense! Adding delays to Figure 1 would extend the migration process, possibly over many quarters.

In Figure 1, electricity consumers would save money on their quarterly bills by switching to a new supplier who offers a lower price. If rational, all consumers would switch immediately because the saving is far greater than their switching cost. However, as the fraction who are not entirely rational in their decision increases, the number that actually switch reduces. Note that zero rationality does not imply that no-one switches, but that a few do so for no rational reason.

Figure 1: How customer switching between electricity suppliers reflects rationality. (Click image to view larger)

How customer switching between electricity suppliers reflects rationality.

Until next time…

 

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Cyclicality in project-based industries

Many project-based industries are notoriously cyclical – going through periods of rapidly escalating demand, followed by near-total collapse. This happens for two reasons. First, relatively small changes in demand for final products – packaged consumer goods, for example – produce big swings in the supply-demand balance for intermediate and up-stream suppliers (producers of packaging and plastic raw materials). A switch from plentiful supply to shortage therefore means that more capacity is needed, so projects get started. This pressure is made worse because everyone in the supply chain sees rising prices and the chance of rising sales at the same time, so all may rush to build new capacity at the same time. In 2008, for example, charter rates for large ships hit an all-time high of $300,000 per day, compared with just $15,000 in 2003, resulting in a 4-fold increase in ship-building. Similar issues arise in industries as diverse as commercial real-estate, petrochemicals, memory chips and insurance.

This briefing summarises material from chapter 7 of Strategic Management Dynamics, pages 453-462.

Read more about the book on our website

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