Switching and switching costs

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Switching and switching costs

Michael Waterson Presentation prepared for
Encore conference, the Hague, April 2006
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Plan

• Theoretical issues and basic mechanisms
• Types of switching and empirical implications-
  links to other literatures
• Analysis of cases- when will welfare increase
  through switching? Extended examples of Petrin
  and GWW.
• Competition in energy supply- impact on consumers
• Broader implications and conclusions

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Types of switching costs

• Transaction costs
• Learning costs- different facilities etc
• Artificial switching costs- compatibility etc.
• Switching costs of all types have the effect of
  relaxing competition

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Klemperer- mechanism
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Reflecting on the theory

• Klemperer consumers face a cost in switching
  between one firm and another. They are reluctant
  to switch, and therefore firms can get away with
  high prices
• Shaffer and Zhang ( others) firms are able to
  identify which consumers are their own old ones
  and which are customers of rivals. They can then
  decide whether to discriminate in price between
  these groups.
• not clear whether it is better to set a lower
  price for new customers (pay to switch) or a
  lower price for loyal customers
• in some circumstances, prices fall to both groups
  of consumers, a prisoners dilemma for the firms
  but better for consumers, so that
• Price discrimination has some desirable features.

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Categories of switching
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Links

• Examining the impact of new products is similar
  in principle to examining the impact of
  competition in new areas.
• Note the link to cost-benefit analysis techniques.

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Brown and Goolsbee The role of the internet in
improving information

• Examine real price of term life assurance,
  controlling for age, State, etc.
• 10 increase in numbers using the internet
  reduces average prices by 5, after accounting
  for controls
• Variance in prices is non-monotonic.

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Petrin- JPE 2002

• Valuing the introduction of a new good- the
  minivan
• Introduced by Chrysler 1984 imitated rather
  imperfectly by GM and Ford in 1985 and 1986.
• Chryslers product an immediate success
• Markups are high initially on minivans but fall
  somewhat, markups on station wagons fall - the
  other firms lost significant profits as a result.

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Petrin (contd)- conceptually
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Petrin- (contd)

• Utility specification

where X is observed characteristics, x is
unobserved characteristics, n is idiosyncratic
tastes for characteristics, g measures
heterogeneity in tastes for the observed
characteristic in the population. Demand and
costs are estimated.
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Petrin- results welfare increases a good deal,
most to consumers, 43 to non-minivan consumers
Petrin Vehicle sales and welfare changes (M) Vehicle sales and welfare changes (M) Vehicle sales and welfare changes (M) Vehicle sales and welfare changes (M)
Year Minivans Station wagons Sum CV DP D Welfare
1983 0.00 10.32 10.32
1984 1.58 8.90 10.48 367.29 -36.68 330.61
1985 2.32 7.33 9.65 625.04 -25.07 599.97
1986 3.63 6.70 10.33 439.93 27.30 467.23
1987 4.86 6.47 11.33 596.59 29.75 626.34
1988 5.97 5.14 11.11 775.70 110.24 885.94
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Giulietti, Waddams, Waterson- EJ October 2005

• Switching in UK domestic gas market
• involves both search and switching activity
• Useful example of the development of competition
• How competitive has the market become?

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Who switches gas supplier?- results of bivariate
probit model

• Middle high income
• high expected potential savings
• Savings important
• ease of switching unimportant
• supplier reputation unimportant
• Know bill
• Changed house, car insurance, phone
• Expect less than an hour to switch

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Market beliefs and switching behaviour

• Importance of beliefs regarding how your current
  supplier will react
• Strategic position
• of incumbent?

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Implications

• Switching has affected a significant proportion
  of consumers- now around 47 in gas
• However, many are remaining with their incumbent,
  and incumbents (gas and electricity) recognise
  they can maintain high prices to this group
• Corroborative evidence on company purchase of
  incumbent consumers
• Beliefs of consumers about competition matter

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Why the big welfare differences between Petrin
(large) and GWW (small)?

• No explicit switching cost in Petrin- since
  people will be switching from an older vehicle
• In Petrin, the new product reduces the price of
  the old product to consumers, but also adds
  significantly to consumer welfare because it
  satisfies many needs better.
• The new product has a big positive impact on
  consumers and a smaller and largely negative
  impact overall on producers.
• In GWW, the benefits to consumers are largely
  gains at the expense of producers. Demand
  overall very inelastic, so little net social
  welfare gain.
• Introduction costs and reorganisation costs
  (essentially ignored in Petrin).
• No consideration of cost reductions in GWW.

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Implications of the comparison

• There will be significant distributional impacts,
  between producers and consumers and within
  consumer groups
• But in many cases, the net benefits of a new
  product that largely replaces an old one for
  consumers will be small, particularly if demand
  rather inelastic.
• How do we know whether new products that satisfy
  needs better will not be forthcoming? They may
  indeed be. The point is that we have not
  conceived of them yet.
• Inevitably, introducing choice where there has
  been none before is somewhat of a leap in the
  dark, because certain of the benefits only arise
  if firms find new ways of doing old things.

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Benefits of supply competition

• Is it the fact of competition/ allowing
  switching, the impact on users, or the ability to
  bargain on tariffs that matters in determining
  price?
• What is the impact?

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Table Market arrangements- domestic and non-domestic energy supply in the UK Table Market arrangements- domestic and non-domestic energy supply in the UK Table Market arrangements- domestic and non-domestic energy supply in the UK Table Market arrangements- domestic and non-domestic energy supply in the UK Table Market arrangements- domestic and non-domestic energy supply in the UK Table Market arrangements- domestic and non-domestic energy supply in the UK Table Market arrangements- domestic and non-domestic energy supply in the UK

2002 data Market Fully Open HHI Ave incumbent share Ave incumbent share Price type Ave price of energy component Ave price of energy component
Electricy Domestic 1999 app 5000 66 Tariff 50/MWh
Non-domestic 1998 1547 Tariff 41/MWh
Medium 1998 1802 Bespoke 27/MWh
Gas Domestic 1998 app 4300 64 Tariff 31p per therm
Non-domestic 1998 2010 Tariff 36p per therm
Medium 1998 1413 Bespoke 24p per therm
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• There does seem to be a measurable impact of
  supply competition on prices paid by consumers of
  electricity and, perhaps, gas.
• Electricity-

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Benefits from competition

• Lower prices
• Innovation?
• Choice
• BUT
• Distributional changes
• Mistakes by consumers and others
• Costs on the system
• Limited new suppliers

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What is the optimal degree of switching?

• No switching consistent with
• No search or
• Everyone happy.
• There can be too much switching- it imposes costs
  on the system
• Is it better to allow special deals or uniform
  category pricing?
• Role of contract length.

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If I were a psychologist

• Are people more easily fooled in new choice
  situations?
• Do they look to the longer term?
• Is it sensible to move from 100 paternalism to
  0 paternalism?
• What about guided or framed choice?
• Should there be a backstop?