Search Costs and Switching Costs
BIEF 30283
CHIARA FUMAGALLI
Search costs
SEARCH COSTS: costs that a buyer bears to collect information about
prices/existence of products.
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Their presence induces buyers to search for the cheaper seller visiting a
limited number of stores (which depends on the level of search costs).
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A firm that decreases the price will not attract all the demand but those
buyers that, in their search, happen to visit its store.
The presence of search costs makes consumers less reactive to price changes
and makes undercutting less effecting in attracting demand and less profitable:
it is a source of market power.
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Informative advertising about prices
• Informative advertising about prices/existence of products can reduce
search costs and intensify price competition.
[Recall that, instead, informative advertising about characteristics of
products may soften price competition because it may make consumers
aware that products are differentiated.]
• There is ample empirical evidence documenting the pro-competitive effect
of advertising about prices/existence of products.
• But then, if this type of advertising reduces market power, why do firms
engage in it?
– New entrants.
– Prisoner’s Dilemma.
• Credible constraint necessary to kill incentive to deviate by undercutting
and advertising: prohibition of advertising established by deontological
codes of professionals.
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Internet and search costs
• Internet facilitates price comparison (airline prices, car insurance, price
comparator websites) and in many cases intensifies price competition
leading to lower prices.
• Sometime firms react to that by engaging in obfuscation:
– Price schedules are designed in such a way to make it difficult to
compare prices.
– Basic version of the product offered at a very low price to be ranked
high by the price comparator/search engine. Much higher prices for
upgraded versions of the product (additional items).
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Switching costs
Costs that a buyer bears when changing supplier (in an environment of repeated
purchases).
Switching costs can have different sources:
• Transaction costs: changing supplier may require time and effort;
• Learning costs: switching brand or supplier would mean spending time and
energy to learn how to use the new brand (e.g. new software, new OS), or how
to interact with the new supplier.
• Uncertainty costs: for experience goods (those good whose quality or
suitability can only be observed after purchase), a consumer who found a
suitable good may be reluctant to switch to an unknown competing brand.
Even more so with credence goods (whose quality may not be observable even
after purchase and the relationship is based on trust).
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Switching costs
The presence of switching costs makes consumers less responsive to price
decreases:
• So far, I have purchased product A.
• The supplier of product B sets pB below pA.
• In the base-line model I would buy from firm B.
• If there exist switching costs, I buy from firm B is the price cut is large
enough to compensate for the switching costs. Otherwise I continue to buy
from firm A, even though more expensive.
The presence of switching costs makes undercutting less effective in
attracting demand and thus less profitable.
Switching costs are a source of market power.
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Switching costs
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Precisely because switching costs are a source of market power, sometimes
they are artificially created by firms:
- Contracts offered by mobile phone operators with a certain minimum
term.
- Frequent flyers programs.
- Retailers’ point collection programs.
- Obstacles to number portability.
- Costs to close bank accounts/to move mortgages.
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In the latter two cases, important role of regulatory intervention to make the
market more competitive.
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Search costs and switching costs in energy markets
The production and retail segment of energy markets (gas, electricity) has
been liberalized in most of the European countries, in the 80’s and 90’s.
• Previously vertically integrated state-owned monopoly.
• Only the network segments (natural monopoly) remains a regulated
monopoly.
• However, considerable market power still exists at the retail level.
• Consumers exhibit considerable inertia: they are reluctant to change
supplier even though in the market there exists tariff plans much more
favorable to them and despite the existence of websites that compare
available plans.
• The combination of switching and search costs seems to be the source of
consumers’ inertia.
• Policy question: how can we reduce switching and search costs?
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What to take away from analysis of static price
competition
– Intensity of rivalry directly given by profitability of business stealing.
– Factors that decrease effectiveness and profitability of undercutting are
sources of market power:
– Product differentiation
– Capacity constraints
– Search costs
– Switching costs
– In the next classes we will also focus on the role of repeated
interaction in dynamic models of price competition.
– Competition erodes profits as firms fail to internalize the externalities
of their choices.
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