David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

12.8 E-products
If Britain had to start from scratch, it might decide to
drive not on the left but on the right. British cars would
no longer be different from those in continental
Europe. Car makers would find it much harder to
charge British people premium prices for cars if similar
cars were easily imported across the Channel. However,
the UK has made many investments in driving on the
left. Any switch would entail changing street signs and
motorway slip roads, scrapping most of the existing
stock of left-hand-drive cars, and teaching drivers to
do things the other way round. During the transition
there would be accidents and expense. Even though
Britons would benefit from cheaper right-hand-drive
cars, switching costs may be so high that it is better to
leave things unaltered.
Table 12.8
Switching costs
Supplier A
User benefit £500 £700
Switching cost = £300
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Net benefit
If began with A £500 £400
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-- -
If began with B £200 £700
Supplier B
Similarly, the cost of switching out of nicotine dependence is large. Someone who has never smoked and
someone smoking 20 cigarettes a day make different decisions. The past matters. So does the future. Switching
costs force users and suppliers to take a long-run view in the first place. Do not start smoking on the
assumption it is easy to quit. You get locked in.
Table 12.8 illustrates this. A service can be bought from supplier A or supplier B. The latter is now a better
supplier. Its service yields a benefit (net of any charges to consumers) of £700. The former yields a benefit
of only £500. Without any switching costs, everyone would use supplier B.
However, if switching costs are £300, people who began using supplier A will not switch. The gain is £200
but the cost is £300. So they stay with supplier A and get benefits of £400. People who began with supplier
B are delighted to stay with that supplier and get benefits of £700.
Why did anyone start out with supplier A? Perhaps, previously, this supplier had offered a great deal that
tempted some customers who believed that the good deal would last, or were too short-sighted to realize
that a long-run decision was needed. In Table 12.8 it is best to interpret the benefits as present values of the
benefits over all the future time that the user needs the service. It is the difference in these present values
that must be compared with the one-off switching cost.
In Chapter 9 we distinguished innocent and strategic entry barriers, one made by nature, the other planned
in boardrooms. Switching costs have both aspects. Smart suppliers devise strategies to lock in users. Air
miles and reward points are obvious examples made possible by the information economy. Previously, it
was too costly to keep track of individual retail customers.
Modern computing changed all that. Once individuals can be distinguished, they can be 'incentivized'.
Reward points offer customers a small reward for staying with a particular supplier. The customer
may care little whether he flies with BA or Virgin, or shops at Tesco or Sainsbury's, but to the airline or
supermarket it makes a big difference. Yahoo! and Freeserve were initially free. Once you are familiar with
their systems they can charge you for the same services in the future, just as leading football clubs used
satellite TV to reach wide audiences but then set up their own pay-TV stations.
The information economy did not invent these practices but is pushing to the limit things done more
crudely for years. For decades, high street banks have known that today's students are tomorrow's profitable
customers. Banks compete for space on campus and offer students subsidized banking, relying on the later
cost of switching banks to lock in the customer, offering a future opportunity to get back their original
investment with interest. Banks could always distinguish between students and non-students. The
information economy takes this principle to the limit, distinguishing between individual customers and
working out when early subsidies earn later returns.
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