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.

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.

Tim Harford on the network effects, switching costs, and the enshittification of apps

This week, my ECONS101 class has been covering pricing and business strategy. As we discuss in class, pricing strategy is essentially about creating and capturing value - the firm creates value for consumers (or other businesses), and then finds creative ways to capture that value back from the consumers (or businesses) as profits. So, it was timely to read this post by Tim Harford this week, looking at apps:

The writer and activist Cory Doctorow has coined a memorable term for this tendency for platforms to fall apart: enshittification. “Here is how platforms die,” he wrote in January. “First, they are good to their users; then they abuse their users to make things better for their business customers; finally, they abuse those business customers to claw back all the value for themselves.”...

Nevertheless, I’m quite sure enshittification is real. The basic idea was sketched out in economic literature in the 1980s, before the world wide web existed. Economic theorists lack Doctorow’s gift for a potent neologism, but they certainly understand how to make a formal model of a product going to the dogs.

There are two interrelated issues at play. The first is that internet platforms exhibit network effects: people use Facebook because their friends use Facebook; sellers use Amazon because it’s where the buyers are, while buyers use Amazon because it’s where the sellers are.

Second, people using these platforms experience switching costs if they wish to move from one to another. In the case of Twitter, the switching cost is the hassle of rebuilding your social graph using an alternative such as Mastodon, even if all the same people use it. In the case of Amazon, the switching cost includes saying goodbye to your digitally locked eBooks and audiobooks if you move over to a different provider. Doctorow is fascinated by the way these switching costs can be weaponised. His short story, Unauthorized Bread, describes a proprietorial toaster that only accepts bread from authorised bakers.

Both switching costs and network effects tend to lead to enshittification because platform providers see early adopters as an investment in future profits. Platforms run at a loss for years, subsidising consumers — and sometimes suppliers — in an effort to grow as quickly as possible. When switching costs are at play, the logic is that companies attract customers who they can later exploit. When network effects apply, companies are trying to attract customers because they will draw in others to be exploited. Either way, exploitation is the goal, and the profit-maximising playbook will recommend bargains followed by rip-offs.

All of this comes back to creating and capturing value. First, the firm uses its shiny new app to create value for consumers. The app can create a lot of value if the consumers can access it for free. That sucks the consumers into the network. A large network then creates value for advertisers, because it represents a large audience for their advertising. Finally, the firm can capture that value back from the advertisers in the form of profits. Although, as Harford's post notes, the process of capturing value back from advertisers reduces the value that consumers get from the app. However, since those consumers face switching costs to change to some other app, they are locked in to using the app. So, the firm is probably fairly unconcerned about the consumers' loss of value, so long as they continue to use the app (and create value for advertisers).

Just because pricing strategy is about creating and capturing value, that doesn't necessarily mean that firms are focused on creating value for consumers, if they can be more profitable by creating value for someone else, in this case advertisers.

Megan McArdle on network effects

A recent Bloomberg article by Megan McArdle does a great job of explaining network effects:

So just what is a network effect? The term describes a product that gets more valuable as more people adopt it, a system that becomes stronger as more nodes are added to the network. The classic example of network effects is a fax machine. The first proud owner of a fax machine has a very expensive paperweight. The second owner can transmit documents to the guy with the pricey paperweight. The thousandth owner has a useful, but limited, piece of equipment. The millionth owner has a pretty handy little gadget.

McArdle's article also does a nice job of explaining switching costs, and how they are different from network effects. Both concepts are covered in ECON100 at Waikato because of their importance to business decision-making. As McArdle notes, network effects are really important because they can create a situation where the equilibrium number of firms in the market is one (a monopoly), which confers a large degree of market power on that firm.

How does this arise? Normally, the demand curve for a good is downward sloping. Consider a good where each person can only buy one unit. At a given price, only the people that value it more than the price will buy. As the price falls, the number of buyers increases because the marginal value of the good to those additional buyers is now above the (lower) price.

However, a good with network effects works differently. The value to the buyer depends on two things: (1) the standard downward-sloping price effect described above; and (2) the number of other users, with value increasing as the number of users increases. So, the demand curve for a good with network effects looks like the figure below (MV is marginal value). For the first few buyers the value is low (but not zero - some people like to have expensive paperweights), but as more users buy the good its marginal value to each additional user rises. However, eventually the first effect offsets this (some potential users are not attracted by your product, no matter how many users it has), and we end up with the more standard downward-sloping demand curve.

Now consider how you choose to price the good with network effects. Let's say you priced your new network-effect good at the price P0. No consumer would buy this product. Why? Because the price is above the marginal value for the first consumer. Buying this product would make them worse off. This is why firms with network-effect goods often start by giving their product away for free. To get to the point where the marginal value is greater than the price of P0, you would need to give away at least Q0 units of the good. After that the marginal value for every additional buyer is greater than the price, until we get to the equilibrium quantity at Q1. In other words, once you've got past the tipping point, market demand for your network-effect good will accelerate, potentially generating large profit opportunities.

However, that's not the end of the story. McArdle cautions:

When your network is growing rapidly, things are splendid! Every new user increases the value of your network and encourages even more people to join. But there’s a small catch: What happens if your network starts shrinking? Suddenly, it’s getting less valuable, which means more people are likely to leave, which makes it even less valuable. Rinse and repeat all the way to the court-appointed receiver’s office.

So, while network effects can be a source of market power and monopoly rents, these benefits are not permanent, and not guaranteed. One look at the roll-call of failed network goods (MySpace, Bebo, Betamax tapes), or formerly successful network goods (Microsoft operating systems, landline telephones, VHS tapes) should be enough to tell you that.