Saturday, July 1, 2006

Lowering Switching Costs Have Made Cellular Services More Competitive

STANFORD GRADUATE SCHOOL OF BUSINESS—Since November 2003, mobile phone customers have been able to change carriers and keep their phone number. Wireless local number portability (LNP) eliminated a barrier to full competition in mobile telephone services and leveled the field between landline and wireless services.

In the first year alone more than 8.5 million consumers took their local number with them, porting more than twice as many numbers among wireless carriers as they did among landline carriers. In response, wireless prices have decreased as the market became more competitive.

Brian Viard, assistant professor of strategic management at the Stanford Graduate School of Business, forecast three years ago that lower switching costs would actually translate into lower prices for consumers. Recently, research by Minjung Park, a Business School doctoral student, found that since the Federal Communications Commission allowed number portability, average prices for wireless plans with intermediate and large numbers of minutes decreased by about $3 and $8 a month, respectively.

In his earlier paper, Viard explored the issue of "switching costs" exploited by companies in areas such as computers, banking, telephony, and more. The game is to lure you in with attractive introductory offers and then zap you with higher rates, new fees, and fewer perks once you are so "locked in" that switching to a new firm would be a real pain in the neck—or the wallet.

It was clear to Viard that companies that can distinguish between new and old customers will always price their products and services higher for the "locked-in" crowd. However, it was not as clear whether a firm that can't tell who's who in its customer base—or one that has been prohibited by regulation from engaging in price discrimination—would price higher or lower across the board.

Viard argued that firms whose customers incur switching costs could charge either higher or lower rates, depending on the nature of the market. "If there are enough new customers coming into the market, firms will compete to grab them and will therefore price their products or services lower overall," Viard explains. "If, however, there aren't enough new customers in the market, then firms focus on exploiting the customers they already have who are ‘locked in' and price higher."

Previous research concluded that switching costs always lead to higher prices. Viard disagreed, arguing that earlier work assumed that firms did not put value on long-term relationships with customers. "Such models would only be appropriate for companies that were, say, going bankrupt shortly and didn't really care about the ongoing value of new customers. My model considers a longer time horizon and is applicable for companies that are going to be around for a while," he says.

Early research also did not explore whether prices are higher or lower in markets in which firms cannot price discriminate. Viard's study helped fill in that gap by looking at 800-number pricing before and after such numbers became portable. "In May 1993, regulations permitted customers to take their numbers with them even if they switched telephone service providers," Viard explains. "That significantly reduced switching costs for these customers, which were considerable in the case of companies that relied heavily on 800 numbers, such as American Airlines."

By studying several hundred AT&T telephone contracts for big 800-number users, Viard found that after portability became the rule, the cost of 800 numbers fell. "This means that when switching costs were high, prices were higher. Lower switching costs led to lower prices," Viard says. "This is the intuitive answer, but theoretically it could have gone the other way. Again, if switching costs ever led to lower prices, it would be in a high-growth market where there were lots of new customers. The fact that the 800-number market was growing quickly during this period means that this finding is very conservative and that we can pretty much expect lower switching costs to lead to more competitive markets across the board."

The same trend in wireless telephony since the advent of number portability strengthens the case that lowering consumers' switching costs leads to lower price. Says Viard, "The evidence thus far indicates that building lock-in is a good strategy for firms and reducing it is a reasonable goal for regulators hoping to help consumers, regardless of market growth."

Related Information

"Do Switching Costs Make Markets More or Less Competitive? The Case of 800-Number Portability," V. Brian Viard, forthcoming in The RAND Journal of Economics, 2006

"The Economic Impact of Wireless Number Portability," Minjung Park, SIEPR Discussion Paper No. 04-17, 2005

Information Rules: A Strategic Guide to the Network Economy, Carl Shapiro and Hal R. Varian, Chapters 5 ("Recognizing Lock-In") and 6 ("Managing Lock-In"), Harvard Business School Press, 1998

"Competition When Consumers Have Switching Costs: An Overview with Applications to Industrial Organization, Macroeconomics, and International Trade," Paul Klemperer, Review of Economic Studies, 1995