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

Effective marginal tax rates, and work incentives for older people

Tax rates matter for work incentives. When tax rates are high, there is less incentive for people to work. They may pass up additional work and choose leisure time instead. However, it isn't just taxes that matter. It is the loss of other entitlements as well. All of these are bound up in what is called the effective marginal tax rate (EMTR), which is the amount of the next dollar of income a taxpayer earns that would be lost to taxation, decreases in rebates or subsidies, and decreases in government transfers (such as benefits, allowances, pensions, etc.) or other entitlements.

Because they relate not just to tax rates, but to the loss of other entitlements, EMTRs can get very high (sometimes over 100 percent), and present a strong disincentive for work. This article in The Conversation this week, by Peter Martin (Australian National University) presents one example for Australia:

Pensioners who do go over the $227 per week limit lose half of every extra dollar they earn in a cut to their pension.

Plus tax, this means they lose a total of 69% of what they earn over the limit where their tax rate is 19%, and 82.5% on the portion of earnings taxed at 32.5%.

And this is after the boost designed to “incentivise pensioners into the workforce”.

So, the EMTR for older people in Australia could be as high as 82.5 percent. And the consequence of this, in comparison with New Zealand (where there is no reduction in national superannuation for older people who work):

In Australia, 15.1% of the population aged 65 and older are in some kind of paid work, up from 14.7% a year earlier.

In contrast, in New Zealand the proportion has just hit 26%. That’s right: more than one-quarter of New Zealanders aged 65 and older are employed.

That's a substantial difference, that is almost certainly explained in part by the difference in EMTRs between New Zealand and Australia. Now, sometimes government may have a good reason for high EMTRs and the work disincentives they create. For example, tertiary students in New Zealand who receive a student allowance face an EMTRs of 100 percent beyond the first $258.08 of additional work earnings. That ensures that students don't spend so much time working that they can't concentrate on their studies. However, it's hard to make a similar argument for older people. Would the Australian government want a high EMTR on older people who that they don't spend so much time working that they can't concentrate on their retirement?

Most governments want older people to work more, not less, in order to mitigate labour force shortages (e.g. see the Older Workers Employment Action Plan for New Zealand). Australia seems to be getting this wrong. As Martin concludes:

...New Zealand is certainly making it easier for retirees to work legitimately, rather than stay at home or accept cash in hand.

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.

Consumer preferences may explain the pricing puzzle that is diamond engagement rings

On the Marginal Revolution blog last month, Alex Tabarrok presented a bit of a puzzle:

DeBeers also produces lab-grown diamonds and they have a very strange pricing strategy:

De Beers started selling its own lab-grown diamonds in 2018 at a steep discount to the going price, in an attempt to differentiate between the two categories. The company expects lab-grown prices to continue to tumble, in what it sees as a tsunami of more supply coming on to the market, Rowley said. That should create an even bigger delta in prices between natural diamonds and lab grown, helping differentiate the two products, he said.

What? Ordinarily, the bigger the price between a competitor and its substitute the greater pressure on the competitor to lower prices! Yet DeBeers is gambling that the bigger the difference in price between natural and lab grown diamonds the bigger the demand for natural diamonds! Strange. The only way I see this working is if the fiancée knows the price of the ring, which maybe they do! In that case, the buyer still has to spend 10k and doesn’t care whether it’s 10k on synthetic diamonds or 10k on natural grown diamonds. But 10k on synthetic diamonds will get you more carats so we need an equilibrium in which a smaller diamond signals more expensive. But that runs against hundreds of years of expectations! And remember natural and lab grown diamonds are indistinguishable by the naked eye. It’s one thing for the fiancée to know the price of the diamond but surely her friends judge by what they can see, namely the size of the ring. Which signal is the most important to send?

The quote embedded above is from this Bloomberg article. In producing its own lab-grown diamonds, De Beers is competing with itself (as I noted in this post in 2018). In that post, I noted that De Beers was engaged in rent-seeking behaviour:

Synthetic diamonds are a close substitute for natural diamonds, and natural diamonds represent a highly profitable business for De Beers. If some of De Beers' competitors (like Chatham or Diamond Foundry) start producing high-quality synthetic diamonds and selling them relatively cheaply, then some diamond consumers will be induced to switch from natural diamonds to synthetic diamonds, and De Beers will lose profits. By selling synthetic diamonds itself at a very low price, clearly De Beers' goal is to make it unprofitable for the synthetic diamond producers to operate, by seriously undercutting their prices - a tactic known as predatory pricing. The synthetic diamond competitors won't be able to compete with De Beers for long at the low prices, and will soon go out of business (at least, that is what De Beers is hoping). At that point, De Beers can quietly exit the synthetic diamond industry and resume claiming high profits from natural diamonds (having taken a bit of a hit to its profits from both synthetic and natural diamonds in the meantime).

I noted that the problem with that strategy for De Beers is that there needs to be some barrier to entry to keep competitors out once De Beers had exited the synthetic diamond industry and wanted to resume high profits in the natural diamond industry. Tabarrok presents a different problem, and potential puzzle: if consumers can't tell a lab-grown (synthetic) diamond and a natural diamond apart, why would lab-grown diamonds sell at a discount?

I thought that the solution related to signalling, as Tabarrok suggested. That is, until I started writing this post, and then ended up back at the puzzle. But I think I have a solution. So, let's work it through. As I noted in this 2015 post, spending on engagement rings (and weddings, as I noted here) is a signal. In fact, there are two potential signals. But first, let's take a step back and think about why signalling is necessary.

Signalling is a solution to an adverse selection problem. Adverse selection arises when one of the parties to an agreement has private information that is relevant to the agreement, and they use that information to their own advantage and to the disadvantage of the other party. Adverse selection is a problem of 'pre-contractual opportunism', and can cause markets to fail. Signalling is one way that markets have adapted to deal with adverse selection problems. With signalling, the informed party finds a way to credibly reveal the private information to the uninformed party (a signal). There are two important conditions for a signal to be effective: (1) it needs to be costly; and (2) it needs to be costly in such a way that those with lower quality attributes would not want to attempt the signal (and one way this criteria is fulfilled is if it is more costly for those with lower quality attributes).

In the case of engagement rings, there are two adverse selection problems that the engagement ring signal might solve. First, the person proposing marriage has private information about their quality as a future partner. The person receiving the proposal may not know this information. If the proposer is a low-quality partner, they have an incentive to hide this information until it is too late and they are already married! The engagement ring provides an effective signal, that reveals the quality of the proposer. An engagement ring is an effective signal because it is costly, and because it is costly in a way that a low-quality partner would not want to attempt. That's because the proposer would lose their investment in the ring if they are low quality and the relationship breaks up. Going one step further, the more valuable the ring (relative to the income of the proposer), the higher the quality of the signal.

The second adverse selection problem arises because the couple have private information about their quality as a couple (as I noted in this post about the cost of weddings). The people attending their wedding likely do not know this information. The couple receives gifts at their wedding, and wedding attendees are more likely to want to provide gifts to couples who will be successful. So, low-quality couples have an incentive to hide from wedding attendees that they are low quality. Is an engagement ring a good signal here? I'm not so sure. Yes, the engagement ring is costly. But is it costly in such a way that a low-quality couple wouldn't want to attempt? A low-quality couple could buy a wedding ring, receive the wedding gifts, then divorce and sell the engagement ring to re-coup their initial outlay. It seems to me that this signal is not nearly as effective as the overall cost of a wedding (which is not recoverable).

Ok, so I think we have established that an engagement ring is an effective signal from one partner to another, but not necessarily from a couple to others. A more valuable ring provides a higher quality signal. Does whether the diamond is natural or lab-grown matter? In theory, it shouldn't - they are indistinguishable to the untrained eye. However, in practice they may be very different. Natural diamonds are scarce. Lab-grown diamonds are less scarce. Perhaps, in the minds of consumers, a natural diamond is a more desirable product, even if they are indistinguishable? After all, a motivated consumer can find out (through an expert appraisal) whether a diamond is natural or lab-grown. In that case, the perceived quality of the diamond really matters - a smaller natural diamond would provide the same quality of signal as a larger lab-grown diamond. And for two diamonds of the same size, a natural diamond would be priced higher than a lab-grown diamond. In other words, consumer preferences (for natural rather than lab-grown diamonds) would explain this pricing puzzle.