Mobile phone providers and the repeated switching costs game

This week, my ECONS101 class covered pricing and business strategy, and one aspect of that is switching costs and customer lock-in. Switching costs are the costs of switching from one good or service to another (or from one provider to another). Customer lock-in occurs when customers find it difficult (costly) to change once they have started purchasing a particular good or service. The main cause of customer lock-in is, unsurprisingly, high switching costs.

As one example, consider this article from the New Zealand Herald last month:

A new Commerce Commission study has found the switching process between telecommunications providers is not working as well as it should for consumers...

The study found 50% of mobile switchers and 45% of broadband switchers ran into at least one issue when switching.

The experience was so bad that 29% of mobile switchers and 27% of broadband switchers said they wouldn’t want to switch again in future...

The commission’s latest consumer satisfaction report found that 31% of mobile consumers and 29% of broadband consumers have not switched because it requires ‘too much effort to change providers’...

Gilbertson said a lack of comprehensive protocols between the “gaining” service provider and the “losing” service provider was a central issue with the current switching process.

This led to a number of problems, including double billing, unexpected charges, and delays.

The difficulty of changing from one mobile phone provider to another is a form of switching cost. It's not a monetary cost, but the time, effort, and frustration experienced by consumers wanting to switch makes the process of switching costly. And because the process is costly, mobile phone consumers are locked into their current provider.

It is clear why a mobile phone provider would want to make it difficult (costly) for its consumers to switch away from it and use some other provider. However, why don't mobile phone providers try to make it easier to switch to using their service instead? Maybe they could have staff whose role is to help consumers to navigate the process of switching to their service. That would allow the mobile phone provider to attract consumers and capture a greater market share. The answer is provided by considering a little bit of game theory.

Consider the game below, with two mobile phone providers (A and B), each with two strategies ('Easy' to switch to, and 'Hard' to switch to). The payoffs are made-up numbers that might represent profits to the two providers.

To find the Nash equilibrium in this game, we use the 'best response method'. To do this, we track: for each player, for each strategy, what is the best response of the other player. Where both players are selecting a best response, they are doing the best they can, given the choice of the other player (this is the definition of Nash equilibrium). In this game, the best responses are:

1. If Provider B chooses to make switching easy, Provider A's best response is to make switching easy (since 3 is a better payoff than 2) [we track the best responses with ticks, and not-best-responses with crosses; Note: I'm also tracking which payoffs I am comparing with numbers corresponding to the numbers in this list];
2. If Provider B chooses to make switching hard, Provider A's best response is to make switching easy (since 8 is a better payoff than 6);
3. If Provider A chooses to make switching easy, Provider B's best response is to make switching easy (since 3 is a better payoff than 2); and
4. If Provider A chooses to make switching hard, Provider B's best response is to make switching easy (since 8 is a better payoff than 6).

Note that Provider A's best response is always to choose to make switching easy. This is their dominant strategy. Likewise, Provider B's best response is always to make switching easy, which makes it their dominant strategy as well. The single Nash equilibrium occurs where both players are playing a best response (where there are two ticks), which is where both providers make switching easy.

So, that seems to suggest that the mobile phone providers should be making switching to them easier. However, notice that both providers would be unambiguously better off if they chose to make switching hard (they would both receive a payoff of 6, instead of both receiving a payoff of 3). By both choosing to make switching easy, it makes both providers worse off. This is a prisoners' dilemma game (it's a dilemma because, when both players act in their own best interests, both are made worse off).

That's not the end of this story though, because the simple example above assumes that this is a non-repeated game. A non-repeated game is played once only, after which the two players go their separate ways, never to interact again. Most games in the real world are not like that - they are repeated games. In a repeated game, the outcome may differ from the equilibrium of the non-repeated game, because the players can learn to work together to obtain the best outcome.

So, given that this is a repeated game (because the providers are constantly deciding whether to make switching easier or not), both providers will realise that they are better off making switching harder, and receiving a higher payoff as a result. And unsurprisingly, that is what happens, and it doesn't require an explicit agreement between the players - the agreement is 'tacit' (it is understood by the providers without needing to be explicit). Each provider just needs to trust that the other providers will make switching hard (because there is an incentive for each provider to 'cheat' on this outcome). Any instance of cheating (by making switching easier) would be immediately known by the other providers, and the agreement would break down, making them all worse off. So, there is an incentive for all providers to keep switching hard for the consumers. Even a new entrant firm into the market, which might initially make it easy for consumers to switch to them in order to capture market share, would soon realise that they are then better off making switching more difficult (it is not so long ago (2009) that 2degrees was a new entrant in this market).

The Commerce Commission is correct that the difficulty of switching mobile phone providers (the switching cost) keeps consumers with their current provider (customer lock-in). The result is that the mobile phone providers can profit from increasing prices for their lock-in consumers. The only solution to this situation would be to find some way to force a breakdown of the tacit arrangement. Then the market would settle at the equilibrium of all providers making it easy to switch to them. This may be an instance where some regulation is necessary.