How home loan customers can use switching costs against the banks

Economists often consider switching costs to be a problem for consumers. High switching costs can lock a consumer into buying a particular product, or lock them into buying from a particular seller. Often, the seller extracts additional profits from their locked-in customers by charging them a higher price, or selling them complementary products. However, sometimes locking in can benefit consumers, especially when they can play off one seller against another, where both sellers want to lock the customer in. Consider the example of banks, on which the New Zealand Herald reported last month:

Home loan borrowers are taking cashback incentives to stay with their current banks, as competition continues in the mortgage market.

The focus on cashback incentives intensified through the end of last year, when ANZ offered cash payments equal to 1.5% of loan amounts to new home loan borrowers.

In a competitive environment, banks really want home loan customers, and are willing to pay to attract new customers. Retaining their existing customers is important too, and banks may be willing to pay to keep their customers. However, not all customers will be able to extract the same 'retention payments' from their bank. The bank needs to weigh up how likely it is that they will lose a customer:

Helen Stuart, a mortgage adviser at Compass Mortgages, said she had seen “retention payments” offered by several banks lately, especially when someone had all their lending come off a fixed term...

It is harder to change to lenders when some of the loan is still fixed, because it usually means a break fee has to be paid.

That makes sense. When a bank customer has a fixed rate mortgage, they have to pay a 'break fee' in order to change banks. Their current bank can feel quite secure that the customer is going to stay with them, and so the bank is unlikely to offer a retention payment (or, if they do, any retention payment is likely to be quite small). On the other hand, when the fixed rate on the mortgage expires, the bank customer can change banks without paying a 'break fee', and so the bank would be more likely to offer a retention payment (or would offer a more generous retention payment). Of course, the retention payment itself is likely part of the bank’s lock-in strategy, since cashbacks often come with conditions that make future switching more costly to the customer.

Thinking further:

Jeremy Andrews, of Key Mortgages, said what people could get would depend on how long a customer had had their loan, whether they had taken a cashback previously and whether they had more than 20% equity.

“Some banks will refuse retention cash if the clients are already fixed in and they see it as of no benefit to the client to refinance to another bank. Some examples include if it’d be detrimental either in break fees – they’re already on higher than market rates, or if they would need to move to higher rates in the market, or the legal costs associated exceed any cashback benefit of moving.

So, in general, the bank is weighing up how likely it is that the customer will change banks. If changing bank would lead the customer to end up paying a higher interest rate on their mortgage, the bank infers that the customer is less likely to leave, and the bank will therefore be less likely to offer a retention payment. It is a similar story if legal costs are high - the customer is less likely to move, and the bank will be less likely to offer a retention payment.

Bank customers should be savvy about this though. Any time that they have the 'upper hand', through low switching costs, they could use their position to extract a large retention payment from their bank. This happens when their home loan comes off a fixed rate, and especially when other banks are offering enticements for the customer to switch. Of course, they need to consider not just the retention payment, but the interest rate, break fees, legal costs, the hassle of switching, as well as whether accepting the retention payment locks them in and for how long. If it makes sense overall, then playing off the banks against each other may allow the home loan customer to reverse the logic of switching costs to their advantage.

The Australian government has 'subscription traps' in its sights

As I noted in a post last week, firms are increasingly selling subscriptions rather than products because consumer inertia can make them substantially more profitable. Once a customer starts a subscription, they tend not to cancel the subscription as soon as they should, simply because it requires some thought and attention (as well as a little bit of time) to execute a cancellation of the subscription. This 'customer inertia' is a form of switching cost, which locks customers into buying the subscription. However, sellers can easily amp up the switching cost by making it more difficult (and therefore more costly) to cancel. This makes customer lock-in more effective, and can 'trap' customers into their subscription.

In this article in The Conversation last year, Jeannie Marie Paterson (University of Melbourne) provides a couple of examples of 'subscription traps', each of which represents an instance of the firm increasing the switching costs for the consumer:

One example is when consumers sign up for a service quickly and easily online, but can only cancel on the phone (sometimes needing to ring another country)...

Another example, known as “confirm shaming”, involves requiring consumers to click through multiple screens before they can cancel.

Typically, each of those screens has a message asking consumers to reconsider, often reiterating the service’s purported benefits and even offering new discounts on the price not previously available.

When the switching costs are higher for the consumer, the customer lock-in is more effective (it is harder for the consumer to cancel, or switch). The firm can then profit through selling at a higher price, or by selling complementary goods and services to the locked-in consumer.

It is deceptively easy for a consumer to get locked in as well. I'm sure that you will have been offered the first month free on a subscription. That is how the firms get you. Firms often offer subscriptions at a low price initially (or free), then once the consumer is locked in, the firm can raise the price (this is referred to as multi-period pricing).

However, governments are wising up to the 'subscription traps' that Paterson highlights. She notes that:

Making it hard to cancel – commonly called a “subscription trap” – isn’t currently illegal. But now the federal government has announced a plan to ban subscription traps and other hidden fees.

Since then, the policy process in Australia has advanced, with draft legislation released in early 2026 that would impose disclosure, notification, and easy-cancellation requirements on subscription contracts from 1 July 2027, if the legislation is passed.

It is worth noting that banning subscription traps is not the only policy solution here. Anything that reduces the switching costs will likely be effective at reducing customer lock-in. One example that Paterson notes is:

California’s “click to cancel” rules also mean consumers must be able to cancel using the same method of communication they used to subscribe. And businesses must offer consumers information on how to cancel.

So, if signing up for a subscription requires a single click, then cancelling a subscription must also require a single click. That minimises the switching costs, and minimises customer lock-in. Making subscriptions easy to cancel would allow consumers to retain the genuine benefits of subscriptions (including lower transaction costs and fewer service interruptions) while reducing the unnecessary costs from subscriptions they no longer use. Firms may still be able to offer discounts or reminders to retain customers, but the cancellation process should inform consumers rather than obstruct them. Reducing these artificial switching costs is therefore likely to improve consumer welfare overall.

Read more:

• The subscription economy as price discrimination
• The switching costs of online subscriptions
• More on the switching costs of online subscriptions
• Cancelling subscriptions and customer lock-in
• Why do firms increasingly prefer to sell subscriptions, rather than products?

Why do firms increasingly prefer to sell subscriptions, rather than products?

An increasing number of goods and services that were once sold as one-off purchases are now offered as subscriptions. Newspaper subscriptions and gym memberships have existed for a long time, and 'software as a service' is now commonplace. But the model has spread much more widely: consumers can now subscribe to meal kits (such as HelloFresh), razors (such as Dollar Shave Club), and a growing range of other products. Why are firms that once sold products outright increasingly choosing to sell subscriptions instead?

That is the question addressed in this 2025 article by Liran Einav (Stanford University), Ben Klopack (Texas A&M University), and Neale Mahoney (Stanford University), published in the prestigious American Economic Review (ungated earlier version here). They start by noting that the rapid growth in subscriptions is often attributed to the rise of digital products, and the convenience of a subscription for consumers. However, Einav et al. focus their attention on a third factor:

Because subscriptions are automatically renewed, consumers who are inertial may continue to pay for subscriptions they no longer value... If consumers do not fully anticipate their inertia at sign-up, this may create supply-side incentives to offer subscriptions to exploit inertial consumers, amplifying the growth of subscription offerings.

My ECONS101 students will be familiar with this explanation for subscriptions, because we literally covered this in the lecture today. Einav et al. test for the extent to which inertia matters using transaction data from "a large payment card network in the United States between August 2017 and December 2021". Their final dataset includes over 800,000 accounts, and about 870,000 account-service pairs (each account-service pair is a set of observations of a payment card account that subscribes from one of the ten largest subscription services).

Einav et al. exploit the fact that when a card expires and is replaced, consumers typically have to update the billing information for their subscriptions, prompting them to either update or cancel each subscription. To the extent that card replacement decreases the retention rate of subscriptions, this provides evidence of customer inertia. If consumers cancelled subscriptions whenever they stopped making use of them, then there would be no difference in subscription retention between months with card replacements and months without.

Unsurprisingly, Einav et al. find evidence of customer inertia, and the effects are large and consequential for firms selling subscriptions:

We use the estimated model to perform counterfactual exercises that assess how much more quickly consumers would cancel their subscriptions if there was no inertia, which corresponds to fully attentive consumers (inattention model) or default cancellation every month (switching cost model). We find that seller revenues (or equivalently average subscription durations) are significantly higher due to subscriber inertia with important heterogeneity across services. Specifically, in the inattention model, we find that inertia increases seller revenues by 87 percent on average, with increases that range from 14 percent to more than 200 percent depending on the service. In the switching cost model, inertia raises revenue by 120 percent on average, with a range of 17 percent to 259 percent.

So, there are strong incentives for firms to engage in the selling of subscriptions, and to take advantage of customer inertia in subscriptions. However, many consumers are clearly spending more on subscriptions than they need or necessarily want to. Think about yourself as an example - how many subscriptions do you have right now that you rarely use and probably should cancel? I don't have any, but that's only because writing this post made me think about this and cancel one that I was no longer really using!

Subscriptions can provide important benefits for consumer though, including reducing transaction costs (it is simpler to pay a monthly subscription than to buy goods or services individually over and over), and reducing service interruptions (because a subscription makes it more likely that the consumer won't run out of the good they are buying a subscription for). However, we might still be concerned that customer inertia makes some customers with subscriptions worse off overall. So, Einav et al. then turn to evaluating what the most appropriate policy response is. They focus attention on a rule requiring firms to provide consumers with an active renewal decision at regular intervals. Using their two models, Einav et al. find that:

In the inattention model, we find that requiring active choices at a six-month frequency would reduce the excess revenue from inattention by 45 percent. The switching cost model makes a similar quantitative prediction; moving from default renewal to default cancellation once every six months would reduce excess revenue by 48 percent.

Those are quite substantial effects, which again illustrates just how much consumers are giving away to subscription firms for subscriptions that they no longer make the best use of and should be cancelling. What becomes clear from this paper is that one important reason why firms that previously would have sold products instead prefer to sell subscriptions is that consumer inertia can make them substantially more profitable.

Read more:

• The subscription economy as price discrimination
• The switching costs of online subscriptions
• More on the switching costs of online subscriptions
• Cancelling subscriptions and customer lock-in

The business economics of The Summer I Turned Pretty

I tell my students that, once they start to understand some economics, they start to notice it everywhere. It's not just a throwaway line. It really is true. As an example, one of my ECONS101 students excitedly shared with me a short example on the business economics of Prime Video's show The Summer I Turned Pretty. That show is not really my cup of tea (I prefer something like The Witcher). However, the pricing strategy that Amazon employed with The Summer I Turned Pretty is quite interesting to tease out. Specifically, when season 3 of The Summer I Turned Pretty was released on Prime Video, Amazon simultaneously released seasons 1 and 2 for free on YouTube. What was Amazon trying to do?

I believe that this was an example of Amazon using customer lock-in to increase the number of subscribers to Prime Video. Customer lock-in occurs when consumers find it difficult to change once they have started purchasing a particular good or service. High switching costs (the cost of switching from one good or service to another, or from one provider to another) are likely to generate customer lock-in, because a high cost of switching can prevent customers from changing to substitute products.

Where are the switching costs here? With a television show, viewers get invested in their favourite characters and in following particular storylines. If a viewer was to watch something else instead, they face a switching cost of missing out on knowing what their favourite characters are doing, or how the storylines that they were following play out. So, once a viewer starts watching a particular television series that they like, they are reluctant to stop. This is the switching cost in action - the viewer is locked into watching that series.

By releasing the first two seasons of The Summer I Turned Pretty for free on YouTube, Amazon is hoping that will attract new viewers, who will become locked into watching it, and then pay for a subscription to Prime Video in order to continue watching season 3. More Prime Video subscribers equals more revenue (and profits) for Amazon. And because very few consumers would be attracted to Prime Video for the first two seasons of this show, making them available for free didn't really have a high opportunity cost for Amazon (and the challenge of cancelling subscription services creates a further degree of lock-in). 

This strategy is essentially a form of multi-period pricing - setting the price low initially (free for the first two seasons), before raising the price once consumers are locked in (since they have to have a paid subscription to watch season 3). This works because locked-in customers have less elastic demand for a product (they are less price sensitive). So, charging a higher price to locked-in customers than to those who are not (yet) locked in is a profit-maximising strategy.

There is a further aspect of this strategy that I find equally interesting. The student I was speaking with noted that some of her friends had waited until the last episodes of The Summer I Turned Pretty were released, before subscribing to Prime Video for one month and binge-watching the whole season and then cancelling their subscription. In contrast, my student was more impatient and watched each episode as it was released. However, that meant paying for three months of Prime Video subscription.

This sounds a lot like price discrimination - charging different prices to different consumers for the same good or service (and where the difference in price doesn't reflect a difference in costs). In this case, super-fans of the show will be impatient and wanting to watch each episode as it is released. They have short time horizons (they want to watch now), so their demand is less elastic. And with less elastic demand, the profit-maximising price is higher. In contrast, casual fans of the show will be more patient, and happy to wait and binge-watch the whole season in a day. They have longer time horizons, so their demand is more elastic. And with more elastic demand, the profit-maximising price is lower.

By releasing one episode a week, Amazon is able to effectively price discriminate for both groups. The impatient fans (with inelastic demand) pay for three months of Prime Video (a higher price), while the patient fans (with more elastic demand) pay for one month (a lower price). Even better, Amazon doesn't even need to be able to tell these fans apart, because the fans make the decision themselves about what price to pay.

Economics is all around us. You just need to keep your eyes open, and you will see it.

[HT: Georgie from my ECONS101 class]

Black Mirror Season 7 illustrates the ultimate version of customer lock-in

[This post contains spoilers. You have been warned.]

I love the TV show Black Mirror. Charlie Brooker (the writer of almost all episodes of the show) is an evil genius. Nearly every episode depicts some dystopian near-future that is just plausible enough to make you both worry, and think. The first episode of the latest (seventh) season, titled Common People, is a perfect illustration of this. It is also a perfect illustration of customer lock-in, albeit at an extreme level. From the Wikipedia description of the episode:

Welder Mike Waters (Chris O'Dowd) and schoolteacher Amanda (Rashida Jones) have been married for three years and are trying to conceive a baby. One day while teaching, Amanda collapses, and doctors discover she has an inoperable brain tumor. Mike is introduced to Gaynor (Tracee Ellis Ross), a representative from tech startup Rivermind Technologies. Gaynor explains that Rivermind can remove the tumor and replace her excised brain tissue with synthetic tissue powered by their servers. While the surgery is free, the couple agree to pay a monthly subscription fee to give Amanda a chance at living a normal life again.

Initially the service seems to help Amanda, but as time passes they find that it has several limitations which can only be bypassed by subscribing to the costlier "Plus" tier, as opposed to their current "Common" tier. Unbeknownst to Amanda, she begins interjecting brief advertisements into her daily speech.

As I describe in my ECONS101 class, customer lock-in occurs when consumers find it difficult to change once they have started purchasing a particular good or service. High switching costs (the cost of switching from one good or service to another, or from one provider to another) are likely to generate customer lock-in, because a high cost of switching can prevent customers from changing to substitute products. High switching costs could also, in some cases, prevent consumers from stopping buying the good or service - that is, the switching cost causes the consumers to keep buying the good even if they would want to stop (if there was no switching cost). This is the case for subscriptions, for example (see here or here or here).

In this case, Rivermind appears to have discovered the ultimate form of customer lock-in. The switching cost that Mike and Amanda face if they try to cancel their Rivermind subscription is that Amanda dies (or becomes comatose - the episode is somewhat unclear on this point). That switching cost is obviously very high and provides a strong incentive for Mike and Amanda to keep their subscription going. They are locked into the subscription, which is quite expensive.

Rivermind doesn't just profit from Mike and Amanda through their subscription. Rivermind also engages in a form of multi-period pricing. Typically, firms engage in multi-period pricing by starting new consumers with a low price, and then raising the price once those consumers are locked in. This is what utility firms are trying to do when they offer a discounted rate for electricity or broadband for new customers (for a limited time!). The price is initially low, and then when the new customers are locked in, the price increases (because the discount ends).

Rivermind's approach is somewhat different to the standard case of multi-period pricing. Instead of directly raising the price of the service that Mike and Amanda receive, Rivermind degrades the quality of that service (by introducing advertising). Rivermind then introduces an advertising-free tier that is more expensive (which Mike and Amanda are invited to 'upgrade' to, even though tit is really just a more expensive price for the service they started with). Rivermind then also introduces more tiers of subscription with greater coverage and more perks (and even higher prices).

The Black Mirror episode focuses on the increasingly desperate ways in which Mike tries to keep the subscription going. However, my takeaway is that it illustrates how firms can lock consumers in with switching costs that are non-monetary, and then profit from those locked in consumers. Thanks Charlie Brooker - now you've given me something else to worry about in the dystopian near-future.

Read more:

• The subscription economy as price discrimination
• The switching costs of online subscriptions
• More on the switching costs of online subscriptions
• Cancelling subscriptions and customer lock-in

Qantas tries to execute a break-out of Air New Zealand's locked-in customers

As I noted in this post last week, customer lock-in occurs when consumers find it difficult (costly) to change once they have started purchasing a particular good or service. Having locked-in consumers is quite profitable for firms. They can raise their prices without fear of losing those consumers, or they can leverage their locked-in status to sell them other things.

Of course, if another firm wants to compete with a firm that has locked in its consumers, the competing firm may need to find some way of breaking those consumers out of being locked in. That usually involves trying to lower the switching costs that are keeping the consumers locked in. We saw an example of this late last year, when Qantas made a bid to lure away Air New Zealand's frequent flyers, as reported in the New Zealand Herald in November:

Qantas is targeting Air New Zealand’s upper-tier Airpoints members as it looks to grow its loyalty programme here beyond one million members.

As part of an aggressive push into New Zealand, Qantas will fast-track Gold members of other airline loyalty programmes into its scheme.

Those who hold Gold or higher equivalent status with other ‘‘select airlines’' can fast-track to Qantas Gold by earning 100 status credits in 90 days on flights with Qantas, Jetstar and partner airlines.

Gold status is usually obtained by earning 700 status credits in a membership year.

In addition, participating members will get access to the airline’s network of Qantas Club lounges and extra checked baggage during the 90-day fast-track offer...

Qantas is also targeting a wider range of New Zealanders to ensure they take advantage of points they already have.

Qantas Frequent Flyer will remove the $60 join fee on its website later this month.

Loyalty schemes, like frequent flyer programmes, lock consumers in because if they switch to a different programme, they lose the benefits that their current programme provides, and their frequent flyer points or airmiles will eventually expire (those are the switching costs). Qantas is trying to reduce those switching costs by fast-tracking Air New Zealand Gold Airpoints members to Qantas Gold, meaning that consumers who switch wouldn't lose their frequent flyer benefits (or wouldn't lose them for long). The switching costs aren't eliminated, because their Air New Zealand frequent flyer points will eventually expire, but they are substantially reduced. The lower cost of switching would probably attract at least some Air New Zealand frequent flyers to make the switch. As the article notes:

Qantas made a similar offer to Air NZ Gold members in 2020 which [Qantas Loyalty chief executive Andrew] Glance said had been successful.

Taking advantage of switching costs and customer lock-in is an important way that firms use to increase their profitability. It isn't surprising that firms have discovered countermeasures to restrict their competitors' ability to lock-in customers. What might be more surprising is that Air New Zealand didn't appear to retaliate by offering a similar deal for Qantas frequent flyers!

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.

Cancelling subscriptions and customer lock-in

I posted last week about customer lock-in, and briefly discussed subscription services as an example. Then on Monday, The Conversation published this article by Katharine Kemp (UNSW):

Subscription business models have become common – many products are now provided in the form of software, an app or access to a website. Some of these would once have been a physical book, newspaper, CD or exercise class.

Most people who use online services have experienced the frustration of finding a credit card charge for an unwanted, unused subscription or spending excessive time trying to cancel a subscription.

Businesses can make it difficult for consumers to stop paying for unwanted subscriptions. Some do this by allowing consumers to start a subscription with a single click, but creating multiple obstacles if you want to end the subscription.

This can include obscuring cancellation options in the app, requiring consumers to phone during business hours or making them navigate through multiple steps and offers before terminating. The report points out many of the last-ditch discounts offered in this process are only short term. One survey respondent said:

I wasn’t able to cancel without having to call up and speak to someone. Their business hours meant I had to call up during my work day and it took some time to action.

Other businesses badger consumers with frequent emails or messages after they cancel. One respondent said a business made “the cancellation process impossible by making you call and then judging your reason for cancellation”.

Let me reiterate some points from last week's post (as well as posts here and here about online subscriptions). Making it difficult to unsubscribe creates a form of switching cost. Switching costs provide sellers with a lot of opportunity to extract additional profits from consumers. That's because high switching costs create customer lock-in - customers are unwilling to change provider, or stop buying, because they would then face the costs of switching.

We often think about switching costs in monetary terms, like the contract termination fee on a mobile phone contract, or a break fee on a fixed mortgage. However, switching costs can be highly effective even if they are not monetary. In fact, they could even be more effective. Take the example from Kemp's article - in order to unsubscribe, you have to call up and speak to someone. That takes time and effort (a switching cost). Add to that the fact that the call has to be made during business hours (increasing the switching cost). Being bombarded with emails or messages after cancelling adds a switching cost (although one that can be easily avoided by automatically sending all those emails to the junk folder).

Part of Kemp's article highlights these switching costs, and raises some justifiable concerns (at least, justifiable from a consumer's perspective). As a solution, she highlights firms that try to make it 'easy' to unsubscribe, noting that:

Businesses focused on a short-sighted cash grab fail to realise that consumers might cancel but later return if treated well.

However, consumers don't all return, regardless of how well they are treated. Because of that, it is more profitable for many firms to try and lock consumers in (if it wasn't profitable to do this, the firms wouldn't bother).

That brings us to the second aspect of Kemp's article, which is about how firms profit from their locked-in customers. In my ECONS101 class, I talk about two main ways that firms profit from these customers. First, firms may engage in multi-period pricing. This involves selling at a low price initially (sometimes an artificially low price, like a free trial), and then raising the price once a customer is locked in. This is why drug dealers may give away their highest-quality product for free! Second, firms may profit by selling complementary goods and services. This is how the manufacturers of coffee pod machines make their money - not from selling the machines, but from selling the pods. These firms can afford to give quite generous bonuses to their sales staff because each sale is going to generate a lot of coffee pod profits.

Kemp argues that 'unfair practices' should be legislated against. It is hard to argue against preventing unfairness. However, in practical terms, it may not be as simple as Kemp makes it out to be. Some ways that firms lock customers in can easily be re-framed in terms of customer privacy. Why does Firm XYZ make customers call during business hours to cancel their subscription? Because they want to be sure that the request to cancel is genuinely coming from the subscribed customer, and not from some identity thief. It would be difficult to legislate against a firm making customers who want to unsubscribe prove their identity.

On the other hand, some (but not all) of the ways that businesses profit from locked-in customers are clearly unfair and could be legislated against. Kemp discusses free trials that automatically transition to a paid subscription, or subscriptions that auto-renew. There is little justification that firms can provide for the former, and for the latter they would have to rely on 'customer convenience'. Neither is a particularly good justification, when set aside the costs that consumers face when firms engage in those practices. Certainly, subscription services are something that governments should be taking a closer look at.

Read more:

• The subscription economy as price discrimination
• The switching costs of online subscriptions
• More on the switching costs of online subscriptions

Google's strategy of search engine user lock-in

The Financial Times reported earlier this month (paywalled):

A US federal judge has ruled that Google spent billions of dollars on exclusive deals to maintain an illegal monopoly on search, in a landmark win for the Department of Justice as it seeks to rein in Big Tech’s market power...

The ruling follows a weeks-long trial in which the DoJ argued the search giant paid tens of billions of dollars a year for anti-competitive deals with wireless carriers, browser developers and device manufacturers — and in particular Apple. These payments, which cemented Google as the default search engine, totalled more than $26bn in 2021, according to the decision...

Google’s years-long agreement with Apple to make it the default search engine on the iPhone’s Safari browser has long drawn scrutiny. Unsealed court documents showed that Google paid Apple $20bn in 2022 alone. This would amount to a substantial portion of Apple’s $85bn-a-year services business, which includes its App Store and Apple Pay...

Also at issue in the case were contracts the tech giant reached over the years with browser developer Mozilla, Android smartphone makers Samsung, Motorola and Sony, and wireless carriers AT&T, Verizon and T-Mobile.

Clearly, despite paying billions of dollars to Apple, Samsung, and others, Google was able to make this strategy pay off. Otherwise, they wouldn't do it. To see how this works for Google, we need to understand customer lock-in. Customer lock-in occurs when customers find it difficult (costly) to change once they have started purchasing (or, in this case, using) a particular good or service. The switching cost could be explicitly monetary, like a contract termination fee, or it could simply be the time and effort required to switch.

In the case of search engines, Google relies on customer inertia to keep them locked in. Once a user has a default search engine set up on their phone, or their internet browser, or operating system, the user is unlikely to change. Sure, there are alternatives to Google available, like Bing or DuckDuckGo. But there is a switching cost involved in changing to those other search engines. The user would have to spend time and effort to set up the new default search engine. Why spend that time and effort, when they already have a search engine ready to go?

The extent of customer lock-in arising from customer inertia is arguably fairly low, because the switching cost is actually very low. And yet, this can be particularly profitable for firms. In my ECONS101 class, I use the example of subscription services. All of us probably have various subscriptions on the go that we aren't using, and some that we haven't used for some time. And yet, we keep those subscriptions going because of the time and effort required to cancel. That is customer inertia at work.

Unlike subscriptions though, Google isn't benefiting from charging a monthly subscription fee to the users of their search engine. In my ECONS101 class, we talk about selling complementary goods and services as one way that firms can profit from locked-in customers. Usually, we're considering firms selling complementary goods to its locked-in customers. However, as an intermediary in a platform market that connects search engine users and advertisers, Google has two customer groups. It offers one side of the market (search engine users) access for free, and benefits from them being locked in. It then sells access to the locked-in users to the other side of the market (advertisers). The larger the locked-in user base, the more advertisers are willing to pay for advertising, and the more profitable selling advertising can be for Google. And Google is immensely profitable (as I noted in this post last year).

Coming back to the antitrust case against Google, it seems obvious that signing exclusive contracts with the likes of Apple and Samsung reduces competition in the market for search engines, and therefore reduces competition in the market for search engine advertising. It will be interesting to see what happens on appeal. These cases can take years (decades, even) to resolve.

Two economic reasons gamification works to increase profits for firms

My ECONS101 class has been covering pricing and business strategy this week. So, I was interested to read this article in The Conversation last week, by Adrian Camilleri (University of Technology Sydney), which discusses 'gamification' in the context of business:

Gamification – the use of game elements in non-game contexts to increase participation – is on the rise.

Businesses use it to attract customers, boost sales and motivate employees to complete activities to drive profits.

The global gamification market is expected to increase in value from AU$23.6 billion in 2024 to AU$74.8 billion by 2029. This is the total revenue generated from products and services related to gamification, including software, platforms and applications.

The use of goals, points, badges, opportunities to level up and leader boards is now common in many industries ranging from education to health and wellbeing...

There’s a good reason why gamifying in business is growing – it works.

It works so well some engagement platform providers advertise gamifying a platform will increase website traffic by 50% and double social engagement.

Academic research is mounting to support the claim gamification increases customer engagement, which in turn increases positive word-of-mouth and boosts brand loyalty.

A good example is the annual McDonald’s Monopoly promotional marketing game. Based on the classic Monopoly board game, customers receive game pieces with their purchase of certain menu items.

By collecting these pieces, they can win prizes, either instantly or by completing sets. Of course, some pieces are rarer than others, encouraging customers to keep spending until they get a full set.

According to one analysis, the chance of winning a major prize is well over one in a million.

Camilleri 's article focuses on psychology (extrinsic and intrinsic motivation) to explain why gamification works in business. However, there are also complementary economic explanations for why gamification works, so let me provide two that use the economics I cover in my ECONS101 and ECONS102 classes.

First, gamification works because it locks customers into buying from a particular seller. Customer lock-in occurs when customers find it difficult (costly) to change once they have started purchasing a particular good or service. The seller can then profit by increasing the price for their locked-in customers, or by selling them complementary goods or services.'

Take the example of the McDonald's Monopoly promotion. Once a customer starts collecting the Monopoly game pieces, there is a switching cost of going to eat somewhere else - the opportunity cost of missing out on additional Monopoly game pieces, and the chance to win a big prize. That switching cost, albeit small, is enough to encourage customers to go back to McDonald's more than they otherwise would. This explanation also covers the loyalty schemes that Camilleri uses as an additional example (as I have discussed before here).

Second, gamification generates transaction utility. Usually, we consider transaction utility arising when a consumer feels that they are 'getting a good deal', and this makes them happier (higher utility) with the process of purchasing, and more likely to buy (as I have discussed before here). Camilleri uses the example of the 'Temu wheel of discounts', which provides a perfect example of this. But with gamification, the discount may not even be necessary in order to generate transaction utility. If the game is fun or rewarding in its own right, then the consumer will receive utility from playing the game (which is another form of transaction utility).

So, while extrinsic and intrinsic motivation may be good explanations for the success of gamification, there are economic explanations that are equally helpful in understanding why gamification may be a successful strategy for business.

Loss leading with free puncture repairs

Driving to work this morning, I saw an advertisement on the back of a bus for free puncture repairs from Top Town Wheel and Tyre in Te Rapa. Why would a tyre retailer offer to fix punctures for free? As I note in my ECONS101 class, when we see an interesting pricing strategy in the real world, it is likely that it is a strategy that is working for the firm.

In this case, the free puncture repair offer is an example of loss leading, which I discussed with my ECONS101 class a couple of weeks ago. Loss leading happens when a firm sells some of their goods or services intentionally at a loss, in order to encourage more customers to visit them, with the goal of getting those customers to buy other goods and services that the firm can profit from. Offering free puncture repairs, which costs the retailer some staff time and some consumables, will make a loss.

What is the tyre retailer hoping to profit from? Once a customer arrives at Top Town with their punctured tyre looking for a repair, Top Town can easily up-sell the customer to a replacement tyre (which is not free) if the puncture cannot be repaired. That is probably the case fairly often (in my experience, more than half the time when I go to get a puncture repaired, the tyre has been damaged beyond repair). Top Town then profits from the replacement tyre, which they wouldn't have sold if the customer hadn't been encouraged (by the free puncture repair offer) to go to Top Town in the first place.

There is also a soft form of customer lock-in at work here too. Having discovered that their puncture cannot be repaired, the customer could go to a different tyre retailer to get a replacement tyre. However, that involves some additional hassle, time, and effort. Why go somewhere else, when they are already at a tyre retailer? In other words, there is a switching cost here - the additional time and effort required to find and travel to a different tyre retailer represents the cost of switching to an alternative seller. That switching cost, however minor, may lock many customers into buying their replacement tyre from Top Town, rather than going somewhere else. By doing so, they avoid the switching cost.

So, offering free puncture repairs is a smart pricing strategy for Top Town, which likely increases their profits. The surprising thing may be that every tyre retailer doesn't do the same.

Customer lock-in for frozen embryos

This week, my ECONS101 class covered pricing and business strategy, and one aspect of that is customer lock-in. Customer lock-in occurs when customers find it difficult (costly) to change once they have started purchasing a particular good or service. The seller can then profit by increasing the price for their locked-in customers, or by selling them complementary goods or services.

There are lots of examples of customer lock-in (once you know what to look for). Any time a customer finds it difficult (or costly) to switch, then they are to some extent locked in. Think of mobile phone contracts, where there is a termination fee that constitutes a switching cost. However, the switching cost need not be monetary. Most people don't switch often between Apple and Windows computers, or between Apple and Android phones, or between GMail and Outlook, because of the cost of learning the new system, transferring files and photos and contacts, etc.

As another example, consider this article (possibly paywalled) from the Washington Post last month:

Allison Puca, 41, a project manager in Bethesda, Md., started her journey to become a single mother by choice in 2019 after dreaming of being a mother her whole life.

She underwent four intrauterine insemination attempts using sperm from two donors.

After doing one in vitro fertilization cycle during the coronavirus pandemic, Puca was able to get four embryos. She now has a 16-month-old daughter.

She spent about $10,000 on donor sperm from a total of four donors.

After her fertility treatments, Puca says she was spending $50 per month to keep one vial of donor sperm frozen and another $60 per month to keep her three remaining embryos frozen. “My rates were just going up and up,” she said.

Puca is debating whether to give her daughter a sibling, and is not considering destroying or donating her embryos. But in March 2023, she decided to discard a vial of sperm she spent $1,200 on.

There was a $15 online notary fee to discard the sperm, Puca said. “It was just like salt to a wound, in a sense. I had paid so much already. It felt like nonsense,” she said.

She lamented opaque and inconsistent pricing around storage costs. “You just feel chained,” she said. “They have your genetics, and they can just throw them away if you don’t pay. It’s like you don’t have control.”

Once a prospective parent has frozen embryos (or eggs, or sperm) at a facility, they must keep paying the monthly storage costs in order to keep them viable. They can't simply pick them up and store them at home. They are locked in, for as long as they hope to become a future parent. There are several other examples in the article.

This is likely to be a highly profitable situation for the storage facility to be in. Their customers could (in theory) transfer their frozen embryos to a competing facility, but that is both costly and risky. So, once stored in one location, they will tend to be kept there. The facility then has a locked-in customer paying storage fees.

It would be interesting to know if storage facilities offer some form of inducement to attract new customers. For example, they could offer the first three months of storage for free. That would be an example of multi-period pricing - setting the price initially low, then profiting later from the locked-in customer by having a higher regular price. That wouldn't surprise me at all, but it isn't mentioned in the article (and a casual Google search didn't turn up anything like that). However, most storage facilities are attached to IVF clinics, and that industry is quite profitable so perhaps there isn't a need to try and extract additional profits by attracting storage customers from other facilities. At the margin though, it might be something we would expect to see.

In any case, locked-in customers provide a key source of additional profits, and this is another example.

[HT: Marginal Revolution]

More on the switching costs of online subscriptions

On Thursday, I posted about switching costs in the context of online subscriptions, and noted that sellers can take advantage of customers that are locked into buying from them because of high switching costs. However, the idea that subscriptions lock customers in was based on the theoretical notion that the more difficult (costly) it is to cancel a subscription, the more likely we consumers are to simply keep the subscription in place. This is backed up by anecdotal experience, so it would be sensible to question whether there is real empirical evidence to support this.

It turns out that there is, as noted by Tim Harford in this article in the Financial Times earlier this month:

A new working paper from economists Liran Einav, Benjamin Klopack and Neale Mahoney attempts an answer. Using data from a credit and debit card provider, they examine what happens to subscriptions for 10 popular services when the card that is paying for them is replaced. At this moment, the service provider suddenly stops getting paid and must contact the customer to ask for updated payment details.

You can guess what happens next: for many people, this request reminds them of a subscription they had stopped thinking about and immediately prompts them to cancel it. Relative to a typical month, cancellation rates soar in months when a payment card is replaced — from 2 per cent to at least 8 per cent. Einav and his colleagues use this data to estimate how easily many people let stale subscriptions continue. Relative to a benchmark in which infallible subscribers instantly cancel once they decide they are no longer getting enough value, the researchers predict that subscribers will take many extra months — on average 20 — to get around to cancelling.

Don’t take the precise numbers too seriously — as with most social science, this is not a rigorously controlled experiment but an attempt to tease meaning out of noisy real-world data. What you should take seriously is the likelihood that you are swimming in barely noticed subscriptions, some of which you would choose to cancel if you were forced to pay attention to them for a few minutes.

The NBER Working Paper by Einav et al. is available here (ungated version here). So, there is empirical evidence that supports the idea that subscriptions lock consumers into buying, because in that research, as soon as the lock-in was broken, many consumers stopped buying. Subscriptions clearly do provide a source of customer lock-in.

Read more:

• The subscription economy as price discrimination
• The switching costs of online subscriptions

The switching costs of online subscriptions

Switching costs provide sellers with a lot of opportunity to extract additional profits from consumers. That's because high switching costs create customer lock-in - customers are unwilling to change provider, or stop buying, because they would then face the costs of switching. For example, there may be a disconnection fee if you try to change your mobile phone service. Or, it may simply be difficult to make a change - perhaps you have to fill in some forms, and go into a store with valid photo identification, in order to change to the new mobile phone service. Those sorts of costs can be quite effective in keeping customers locked in.

Switching costs and customer lock-in are important aspects of business strategy, especially for firms offering subscription services, who want to ensure that their customers remain buying from them over the long term. The Financial Times had a good article back in June related to this (ironically, paywalled):

Put your hand up if you have looked at a credit card statement recently and spotted a charge for a subscription that you had forgotten signing up for.

You’re not alone. The number of new subscriptions per US consumer peaked last year and cancellations are now outpacing new sign-ups. But for many services, getting out can be a lot more complicated than getting in, as I discovered when I tried to end my monthly payment to Amazon’s Audible recorded books membership.

If I cancelled, the app warned, I would lose the three book credits that I have already paid for but not used. Instead, it touted a “pause” button that would put off the next payment for three months. Not wanting to set that money on fire, I dutifully obliged and set a calendar reminder to cancel in October.

The more difficult (costly) it is to cancel a subscription, the more likely we consumers are to simply keep the subscription in place. That creates an incentive for sellers to make the cancellation process as onerous as possible, to increase the switching cost, and ensure that we continue to subscribe. The seller can also use our locked-in status in order to sell us other products or services. However, regulators have recently started to push back:

In the EU, pressure from Brussels led Amazon to begin allowing customers to end their Prime subscription with just two clicks using a clearly labelled “cancel” button. It also changed its UK policies around that time, but only altered US cancellations this year, ahead of the FTC lawsuit. The company, which plans to fight the case, insists that its cancellation procedures are “clear and simple . . . by design”.

A simple 'cancel' button effectively minimises the switching costs, allowing consumers to free themselves from the shackles of an ongoing subscription. However, sellers have no incentive to offer this unless they are forced to by regulators. And, there is little to stop the seller from sending consumers to a new screen after they click 'cancel', pointing out some special offer that the consumer is missing out on, in the hopes that they will re-subscribe. And, they have consumers' contact details, so no doubt they will continue to spam their former subscribers unless they separately follow the procedures to 'unsubscribe' from the mailing list.

Subscriptions are very profitable for sellers, and are only growing in importance in the modern economy. We can expect sellers to try their best to keep the switching costs high.

New Zealand banks' resistance to open banking and bank account number portability

Earlier this year, open banking was in the news. For instance, take this NewsHub article from March:

Amid pressure for the Government to do a deep dive into banks and their profits, there are calls to make it easier for Kiwis to switch banks.

That is on its way with open banking legislation and Newshub can reveal how the Government wants to pay for it: fees and another tax.

Remember back in the day when phones were bricks? And if you changed your mobile provider you couldn't take your number with you?

Well that changed, and when number portability came in, Tex Edwards used it to set up 2degrees. Now he wants the same thing for bank accounts.

"It would be a lot easier to change banks," he said. 

Changing banks can be an arduous process but there's a push to make that a whole lot easier.

"Elsewhere in the world you have bank account number portability and that has created more competition and its brought prices down, mortgage rates down and term deposits up," said Sam Stubbs, the managing director at Simplicity.

Bank account portability is on its way as part of open banking, which is two-ish years away.

The banks are in no hurry though.

It should be no surprise that the banks are in no hurry. Open banking increases their costs. However, one particular aspect of open banking, being bank account number portability, is probably the real issue for them. That's because a lack of portability generates profit opportunities, because of switching costs, and customer lock-in.

Switching costs are, unsurprisingly, the costs of switching from one good or service to another, or from one provider to another. Switching costs can be monetary (for example, a contract termination fee), or they can be non-monetary (for example, the time and effort required to make the switch). When bank account numbers are not portable, the switching costs of changing banks are quite high. If a customer wants to change banks, they need to set up new direct debits for all of their regular payments, change their banking details with their employer, with Inland Revenue, and with every other organisation that needs the customer's bank details. Changing all of those details is onerous for the bank customer, constituting a high switching cost.

Switching costs create customer lock-in. They make it unattractive for customers to switch to other providers, because customers would have to first face the switching cost. For banks, this customer lock-in means that bank customers tend to stay with their existing bank for longer than they otherwise might. Banks can then exploit their locked-in customers through higher prices for services (higher interest rates, or higher banking fees), or by selling them complementary products (like credit cards or insurance). Having locked-in customers is incredibly profitable for banks. If their customers weren't locked in, the banks would have to work harder to keep their existing customers, to avoid them being lured away by other banks. And that is why New Zealand banks are so resistant to open banking.

Drip pricing and quasi-rational behaviour

In an interesting article in The Conversation last month, Ralf Steinhauser (Australian National University) explains the idea of drip pricing:

You see a fantastic offer, like a hotel room. You decide to book. Then it turns out there is a service fee. Then a cleaning fee. Then a few other extra costs. By the time you pay the final price, it is no longer the fantastic offer you thought.

Welcome to the world of drip pricing – the practice of advertising something at an attractive headline price and then, once you’ve committed to the purchase process, hitting you with unavoidable extra fees that are incrementally disclosed, or “dripped”.

Drip pricing – a type of “junk fee” – is notorious in event and travel ticketing, and is creeping into other areas, such as movie tickets. My daughter, for example, was surprised to find her ticket to the Barbie movie had a “booking fee”, increasing the cost of her ticket by 13%.

Steinhauser then goes on to explain why consumers are susceptible to drip pricing, blaming present bias and loss aversion:

In the case of booking that hotel room, you could abandon the transaction and look for something cheaper once the extra charges become apparent. But there’s a good chance you won’t, due to the effort and time involved.

This is where the trap lies.

Resistance to the idea of starting the search all over again is not simply a matter of laziness or indecision. There’s a profound psychological mechanism at play here, called a present-bias preference – that we value things immediately in front of us more than things more distant in the future...

Beyond the challenge of starting over, there’s another subtle force at work when it comes to our spending decisions. Drip pricing doesn’t just capitalise on our desire for immediate rewards; it also plays on our innate fear of losing out.

This second psychological phenomenon that drip pricing exploits is known as loss aversion – that we feel more pain from losing something than pleasure from gaining the same thing...

Imagine you’re booking tickets for a show. Initially attracted by the observed headline price, you are now presented with different seating categories. Seeing the “VIP” are within your budget, you decide to splurge.

But then, during the checkout process, the drip of extra costs begins. You realise you could have opted for lower-category seats and stayed within your budget. But by this stage you’ve already changed your expectation and imagined yourself enjoying the show from those nice seats.

Going back and booking cheaper seats will feel like a loss.

In my view, Steinhauser is absolutely correct that drip pricing exploits consumers' quasi-rationality (that is, that consumers are subject to biases in their decision-making). However, he is not fully correct about the sources of the quasi-rational behaviour.

First, present bias would tend to work against drip pricing, because (using Steinhauser's example) consumers are weighing up the cost of the tickets (which they face now) against the benefit of the concert they will attend (which is in the future). If consumers weigh the present more heavily than the future, then the costs weigh more heavily than the benefits, which would work against the consumers paying the junk fees.

Second, Steinhauser is correct about loss aversion, but for the wrong reason. Nobel Prize winner Richard Thaler noted that people engage in mental accounting related to particular decisions. People like to keep their mental accounts in positive balances, and are reluctant to give up on something if the mental account has a negative balance, because that would result in 'booking a loss'. Since people are loss averse, they will only want to close mental accounts that have a positive balance.

What does that mean for a consumer buying a concert ticket? They have spent some time and effort selecting their seats and completing most of the booking process. That puts their mental account for the concert into a negative balance. So, facing a small additional fee seems like a good deal, when compared to closing the mental account with a loss. The consumer pays the fee. They don't necessarily feel happy about it, but it is better than the alternative. The only way to get their mental account for the concert into a positive balance is to attend the concert.

A related way of thinking about the process of buying concert tickets with junk fees is the concept of switching costs. Switching costs are the costs of switching from one seller to another, or from one good or service to another. In this case, for a quasi-rational consumer who is running a mental account for the concert, giving up on buying the ticket when they are faced with the junk fees creates a switching cost - the loss in their mental account. When consumers face high switching costs, they can become locked in to buying a product. The seller can then take advantage of their locked in consumers by increasing the price (which is what the junk fees effectively do).

If you are a strong believer in the tenets of neoclassical economics, then the consumer response to drip pricing seems somewhat at odds with rational behaviour. For a purely rational consumer, the time and effort spent on the booking process up to the time that they face the additional of the junk fees is a sunk cost. It shouldn't affect the decision about whether to proceed with buying the ticket or not, because that decision should depend only on the costs and benefits of attending the concert. If the junk fees increase the costs of attending the concert to such an extent that they are higher than the benefits of attending the concert, a purely rational consumer would stop the ticket-buying process at that point. However, a quasi-rational consumer, who is running a mental account for the concert, would be more likely to proceed with the purchase even when presented with the junk fees.

So, overall, drip pricing leads to more sales if consumers are quasi-rational than if consumers are purely rational. It's lucky (and very profitable) for the ticket sellers that so many of us are not purely rational consumers.

McDonald's is price discriminating on its app, not price gouging

Once you know what to look for, you start to see price discrimination everywhere. Price discrimination is the practice of a firm offering different prices to different consumers for the same product, and where the different price doesn't depend on a difference in costs. A price-discriminating firm would want to charge a lower price to its more price-sensitive consumers, and a higher price to its less price-sensitive consumers.

One somewhat counter-intuitive example I use in my ECONS101 class is Delta Airlines charging higher prices to their frequent fliers (as noted in this Forbes article from 2015). The frequent fliers are less price sensitive (they have less elastic demand) because for them, there are few close substitutes for flying Delta Airlines. They have accumulated air miles on Delta, and they want to build up their balance. They don't get Delta air miles from other airlines, making them reluctant to switch to other airlines, even if the price is higher. Consumers who are not Delta frequent fliers are more price-sensitive (they have more elastic demand) because all other airlines are substitutes for Delta on the same route.

It seems that Delta Airlines is not alone in this counter-intuitive approach, as the New Zealand Herald reported earlier this week:

Users of McDonald’s popular mobile app have raised fears that frequent customers are being hit with higher prices than others, a practice they claim is “price gouging”.

The claims were raised on Reddit, where one user highlighted that he was being charged up to $3 more than his partner for some items, despite them both accessing the app on the same day, from the same location.

The only difference between their accounts? He had more than double the number of loyalty points, showing he had used the app more in the past.

To be clear, this isn't 'price gouging', it is price discrimination, pure and simple. McDonald's justified its actions as follows:

The Herald approached McDonald’s NZ for comment on the claims and a spokesperson said the differences might be due to lower prices being used entice customers to return to the app.

Noting that personalised deals had been in place since the loyalty programme was rolled out last year, the spokesperson said details of how benefits were offered and data was used is spelled out in the terms and conditions.

“Individual offers will differ between users, based on a variety of factors,” they told the Herald.

“Due to the personalisation of our app, not all customers will see the same deals, and as an example a deal may be offered to encourage use of the app on the customer’s next visit.”

Just like Delta Airlines' frequent fliers, frequent users of the McDonald's app are less price-sensitive. That might be because they want to build up points on the app (just like air miles), or it might simply be that McDonald's has found that the most loyal McDonald's users are less sensitive to price, and more likely to use the app. In both cases, for these consumers there are fewer close substitutes to McDonald's than there are for infrequent app users, and so the frequent users' demand is less elastic than the infrequent app users. McDonald's therefore offers lower prices to infrequent users of the app, because they are more price sensitive.

Despite any complaints that users of the app may have, none of this is illegal. Firms are free to offer different prices to different consumers. As noted in the article:

The Herald approached Consumer NZ about the claims of price gouging and the watchdog said it had not received any complaints about pricing on the app.

“The Fair Trading Act states businesses can’t mislead shoppers about prices, and the Privacy Act requires companies to disclose to consumers what data is being collected and how it’s being used,” a Consumer NZ spokesperson said.

“If McDonald’s is using personalised pricing, or their customers’ data to set different prices based on factors like what products they’ve searched for in the past, or their location – they should be upfront about it,” they added, pointing towards a Consumer guide to personalised pricing.

“While personalised pricing may not be inherently bad, it relies on businesses applying it fairly, responsibly, and transparently.”

Personalised pricing is a particular form of price discrimination (first-degree price discrimination), where every consumer may be charged a different price for the good or service (for more on this, see this post). If executed perfectly, the firm would charge a price equal to the maximum the consumer is willing to pay. Fortunately (for consumers, not for firms), personalised pricing is mostly a theoretical curiosity. However, the more data that firms have about consumers, the closer they can get to estimating their consumers' willingness-to-pay.

Apps like the McDonald's app are a very handy tool for firms to collect information about their consumers, what they are willing to pay for different goods and services (and what they are not willing to pay). That data can then be used to set prices in the future. It's a point that I've made before. Give it time - if consumers keep giving firms their data, pretty soon we'll all face personalised prices for most of the things that we buy.

[HT: Max from my ECONS101 class]

Jetstar profits from selling flights, but doesn't only profit from selling flights

Jetstar has been in the news this week for its birthday celebrations. As the New Zealand Herald reported:

Jetstar is marking its 14th year of flying New Zealand domestic routes with fares as low as $29.

The airline is also offering fares from Wellington to the Gold Coast starting at $155.

The low-cost airline launched services within New Zealand on June 10, 2009...

Jetstar’s head of New Zealand, Shelley Musk, said the airline remains committed to New Zealand.

“For the past 14 years we’ve been offering Kiwi customers great-value fares and choice so they can decide how they want to fly."

Aren't Jetstar great? Out of an abundance of kindness towards New Zealand travellers, they're offering really low fares. Or maybe not. As I noted in this post from 2017, airlines are known for taking advantage of having locked-in consumers in order to increase profits. Here's what I said then:

In the usual discussion of customer lock-in, customers become locked into buying from a particular seller if they find it difficult (costly) to change to an alternative seller once they have started purchasing a particular good or service. Switching costs (like contract termination fees) typically generate customer lock-in, because a high cost of switching can prevent customers from changing to substitute products.

In this case, once the airline customer has purchased a ticket from an airline, they are locked into travelling with that airline (and often, they are locked into a particular flight, if they have selected a ticket type that is non-transferable). The airline knows that the customer won't switch to another airline (or flight) if they charged additional fees for complementary services... such as for checked bags, in-flight meals, selecting their own seat, and so on.

This is a highly profitable proposition for the airlines... and this is because customer demand for those extra services is relatively inelastic. Once you have purchased a plane ticket for a given flight, there are few (if any) substitutes that allow you to get your checked baggage to the same destination as you are going. So your demand for checking a bag onto your own flight (if you have a bag that needs checking in) is probably very inelastic. Similarly, if you are not prepared for your flight and buy some snacks to take onto the plane with you (and/or you don't have a meal before boarding and are unwilling to wait until you land to eat), there are no substitutes to buying a meal while in the air. When there are few substitutes for a good or service, demand will be relatively more inelastic, and the optimal mark-up over marginal cost is high. As many of you will have observed, the mark-up on in-flight snacks and meals is very high. It is these high mark-ups that leads these extra charges to be highly profitable for the airlines.

While the extra charges have been increasing, ticket prices have been declining. 

Is that what Jetstar is doing? You be the judge. From the New Zealand Herald article:

“By keeping our starter fares low, customers can choose to add a meal, select a seat or bundle their bags — it’s all about choice.’'...

The airline’s business model is to operate with low costs and maximum ancillary revenue. Before the pandemic, revenue from add-ons such as seat selection, paid baggage and food and drinks grew 38 per cent.

The airline aims for similar growth rates over the next five years as it adds more optional extras and technology to enable buying them easier. It is also getting bigger and more efficient A321 aircraft into its fleet.

Seems to me like it's working well for them. Especially when they can get good press for their 'low fares', while maintaining their profitability through the 'ancillary revenue'. As I note in my ECONS101 class, there are many ways for firms to increase profits, and they need not sell every good and service at its individual profit-maximising price.

Read more:

• How airlines use extra charges to boost their profits

What would happen if perfect personalised pricing was possible?

In my ECONS101 class, we discuss price discrimination, which comes in three forms: (1) first-degree price discrimination (or personalised pricing), which involves setting a different price for every consumer; (2) second-degree price discrimination,  (or menu pricing), which involves creating a menu of options for consumers to choose from which involves the consumer paying a declining price for each additional unit that is purchased; and (3) third-degree price discrimination (or group pricing), which involves setting different prices for known groups of consumers. Personalised pricing is intriguing, because if the firm knew the maximum amount that every consumer was willing to pay for the good or service, they could set that price for each consumer, thereby extracting the maximum possible amount of profit from every consumer.

To date, this sort of perfect personalised pricing remains a theoretical proposition. Although many firms collect a lot of data about their consumers, they still don't know exactly what each consumer is willing to pay. But what if they did? What other aspects of the market would then matter? Would the degree of competition in the market matter? How would a firm's competitors react?

Those are the sorts of questions addressed in this recent working paper by Patrick Kehoe, Bradley Larsen, and Elena Pastorino (all Stanford University). Specifically, they:

...take an extreme forward–looking view by supposing that personalized pricing is feasible and analyze the resulting equilibrium pricing patterns and its efficiency properties.

The paper is understandably theoretical (since perfect personalised pricing is still not possible). However, they also apply their model to eBay data on purchases of Apple and Samsung smartphones and tablets. In this context, the branding of the products matters, as does the experience nature of the goods (the consumer doesn't know what the quality of the good is until after they have purchased it. Kehoe et al. show using their theoretical model that:

...the strategic interaction among firms is complex: firms not only compete directly to attract a consumer in the current period, but also strategically manage the information flow to the consumer. Specifically, by appropriately choosing the prices for its product varieties, a firm can make a certain variety the most attractive and hence control how much is learned about a consumer’s taste for its products...

In other words, firms use pricing to obtain information about consumers' willingness to pay, and then use that information to price in the future. Would personalised pricing make consumers worse off? It seems like it should. However, using the smartphone and tablet eBay data combined with their theoretical model, Kehoe et al. find that:

...a significant fraction of consumers benefit from the introduction of price discrimination. Specifically, consumers who benefit are those with relatively similar beliefs about their tastes for Apple’s products or Samsung’s products, whereas consumers who are harmed are those who have a high taste for the products of only one firm. This latter group is more “captive” and, correspondingly, firms’ profits from these consumers are higher under discriminatory pricing than under uniform pricing.

The finding that, if personalised pricing was possible, then some consumers may actually be made better off, is somewhat surprising. However, those consumers who benefit are those who are most willing to switch products. In contrast, those who are unwilling to switch find that the price will be much higher. In my ECONS101 class, we discuss customer lock-in, and one of the ways that firms can lock customers in is through brand loyalty. Customers who are loyal to a particular brand are less willing to switch, and that may be especially the case where owning a particular brand becomes part of the consumer's identity (as is often the case for Apple users). Locked-in consumers often face higher prices, since the firm knows that those consumers will be less willing to switch to alternative products.

I hadn't considered the interaction between price discrimination and customer lock-in before, but it makes a lot of sense. It also works the other way of course. Firms will obtain a lot more information about consumer preferences from consumers who are locked into purchasing from them. Fortunately for those consumers, we are still not yet at the stage where this is any more than a theoretical possibility.

Open banking as a way to break out of bank customer lock-in

Bank profits have been in the spotlight this week (for example, see this story from Stuff from earlier this week). Banks are wildly more profitable in New Zealand than in comparable countries, and have been for many years (see here and here). If banks are more profitable here than they are elsewhere, that must be making bank customers worse off than those same customers would be in other countries.

The whole discussion about bank profitability has me a little confused. What exactly is Kiwibank doing? If the foreign-owned banks are milking their customers for excess profits (as many people claim), then why isn't Kiwibank simply undercutting their mortgage rates and fees, and paying higher deposit rates, and taking their customers away? Looking at mortgage rates as of today, Kiwibank and ANZ have essentially the same rates. I'm sure that ANZ isn't cross-subsidising its New Zealand mortgage rates from elsewhere, because if they were, their profits wouldn't be so high. If we want an inquiry into banking, we should be looking at how Kiwibank is failing to create more competition in retail banking.

Anyway, coming back to the discussions on bank profitability, one of the things that has arisen in these discussions is the idea of 'open banking'. I've seen various definitions of open banking in recent years (and there is a good explainer on The Conversation). However, one aspect of open banking that some commentators have focused on is bank account portability - the ability for bank customers to shift from one bank to another, without having to change their bank account number (in the same way that customers can change mobile phone providers, without changing their phone number).

Bank account portability is probably not a silver bullet for high bank profits, but it might help to explain at least some of the high bank profitability in New Zealand. To see why, let's consider what happens when there is no bank account portability (as is the case right now).

When there is no bank account portability, then it becomes costly for bank customers to switch banks. The cost is not monetary though. It is the time and inconvenience of switching over all automatic payments, direct debits, and so on to a new bank account number. Economists refer to those costs as switching costs. When switching costs are high, customers become locked in to a longer-term relationship with the seller (in this case, their bank). Customer lock-in is very profitable situation for a seller, because it means that they can increase prices without their customers leaving. In the case of banks, a lack of bank account portability locks customers into their current bank, and means that banks can raise mortgage rates (and reduce deposit rates) without losing their customers.

If bank account portability was introduced, then bank customers would no longer be locked in to the relationship with their current bank (or, at least, not to the same extent - there is still some time cost associated with changing banks, even if you can take your existing account numbers with you). Banks would then have to compete for new customers, rather than relying on milking their current locked-in customer base for profits.

If we want to improve the situation for bank customers in New Zealand (and reduce bank profits as a consequence), then open banking (and bank account portability specifically) is likely to be part of the solution. It works for mobile phones. It should work for bank accounts as well.