Sunday, April 12, 2009

Switching Costs

Switching costs are the costs associated with changing from one value provider to another and can be costs relating to learning, finding alternatives, compatibility costs, uncertainty costs, psychological costs, transaction costs, or contractual costs. It is a control mechanism that exists in most markets and can be real or perceived costs such as frequent flyer programs, in which passengers don't want to lose credits earned in one program by switching to another.

Switching costs give the value provider market and pricing power, thus current adoption or market shares become important determinants of future success. Social networks such as Facebook and Twitter base their business models on future revenues generated from a large base of user and developers that won't switch to another social network due to real or perceived switching costs.

Understanding switching costs is a key component to create sustainable business models for both incumbent firms and start-ups trying to break into an existing market or build a new one. I will follow-up this post with identified strategies on how to use switching costs as a value provider and how to manage own switching costs in relation to external partners and suppliers.

Not limited to customers
The traditional way of looking at switching costs is between the value provider and paying customer but I believe the concept is valuable also in relation to other stakeholders. When companies develop strategies in relation to suppliers, government/regions, own employees, developer communities, companies providing complementary products and service etc. switching costs are an important factor to include. The economic downturn makes this kind of reasoning evident for many suppliers and governments.

Switching costs and network effects
In most cases switching costs go hand in hand with network externalities or network effects. If adoption by different value recipients is complementary so that each value recipient's adoption payoff, the incentive to adopt increases as more others adopt. Thus, the more users of a communication service such as Skype, the more valuable the service is to each user and the higher the switching cost to switch to another communication service bringing all users or friends.

Switching costs and standards
Almost everything is affected by standards, in relation to different forms of compatibility, interoperability, safety or quality. Standards can be both a solution to avoid high switching costs and a source of the same. Standards are most often developed to reduce switching costs in having several products or systems based on the same principles, technologies or formats.

When a company manage to get a dominant position for its technology, products or services, by tradition, enforcement, or market dominance, it is said to have a de facto standard. A classical example is Microsoft Office that is believed to have a perceived switching cost of over $1000 thus buyers are paying hundreds of dollars for Microsoft Office even when free alternatives exists. In the case of Microsoft Office almost all different forms of switching costs occur. What would be the alternative? Would this be compatible with everyone else that are using Microsoft Office? Can I transfer my templates? Would I learn fast enough to work in the same pace? Would I miss any functions or features? etc.

Switching costs and competitive pricing
Switching costs shift competition away from a single value recipient's needs in a single period to needs over time, thus the outlook of higher profits later provides a strong incentive to buy adoption today. Each value provider faces a trade-off between investing in adoption by charging a low price or give away something for free to attract new value recipients or on the other hand charging a higher price reflecting the value of what is being offered. When network effects exist the share of adopters makes a valuable asset, reflected in strategies such as penetration pricing. Examples of aggressive competition for market share before the customers have developed switching costs are banks providing free banking services to students, online poker sites offering cash bonuses when opening accounts or free access to proprietary databases with training material to schools to make students used to tools and available data.

Smaller actors often have a stronger incentive for price competition than larger ones as they can enlarge their customer base without hurting their revenues from their current customer base that is small. Larger actors on the other hand, have little incentives to cut prices because this hurts more with their current (larger) customer base.

Switching costs varies over time depending on the business model
The switching costs vary over time and depending on the business model it can either increase or decrease over time. If you sell a computer storage device the value of the device depreciates over time and the customer might chose another brand when it is time to replace it. If you sell online storage, the service will become increasingly valuable to the customer over time as it gets dependent on the increased amount of stored data and relating services such as back-up, mobile access or file sharing possibilities. With the increasingly popular concept of cloud software and platforms, that in some cases uses nonstandard APIs and proprietary technologies, some companies will probably find themselves facing high switching costs in the near future.

Switching costs and lock-in
When the value recipient is dependent on a single value provider or cannot move to another value provider without substantial costs or inconvenience, the value recipient is said to be locked in to the value provider. Lock-in is seldom absolute but when lock-ins is created by dominant companies and there are too high barriers to market entry, it may result in antitrust action.

Further reading

Further External Reading

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