What are Switching Costs?

Switching costs are the costs a customer faces when changing suppliers. The customer could be a consumer, or a business which receives parts or services from another business. The costs can include direct financial costs and more general costs such as time. Switching costs are significant as they can mean a company can have higher costs than a rival without necessarily losing business.

The most obvious switching costs are financial. These usually come in the form of penalty payments for ending a contract. A common example is with cellphone customers who have received a subsidy from their chosen network when buying a phone and in return must pay an exit fee when changing networks before their minimum contract term ends.

There are also practical costs which can be converted to cash. This could include the time it takes to set up a new deal and spend the time on the administration of changing suppliers. This time can be converted to a financial cost by looking at the staff costs incurred by a company while switching. Some switching costs are harder to quantify as they are more emotion-based. This includes the way many customers follow a "better the devil you know" philosophy when choosing a supplier. It's also arguable that inertia and laziness can contribute to switching costs, since people often don't bother switching to a new supplier even when they know it would save them money.

Switching costs play an important role in economics. They help undermine one of the most basic principles of a market economy: that if two suppliers offer identical goods or services, customers will always choose the cheaper option. In theory the switching cost could even be built into a company's pricing decision, meaning the company can keep prices a fixed level above their rivals, knowing they'll still retain the customer. In practice, the difficulties in quantifying all switching costs means companies will do this through judgment or trial and error rather than precise calculation.

The concept of switching costs plays an important role in a theory developed by economist Michael Porter. He argues that five forces determine how competitive a particular market is: the availability of close alternatives to the market's product, the likelihood of new firms entering the market, the bargaining power of consumers, the bargaining power of suppliers, and the inherent competitiveness of the market's firms. Switching costs plays some role in all but the latter of these forces.