Do Switching Costs Make Markets More or Less Competitive?: The Case of 800-Number Portability

TL;DR

This paper examines how switching costs influence market competition, using a theoretical model and empirical data from 800-number portability, showing that reduced switching costs can lead to increased competition.

Contribution

It provides a theoretical framework demonstrating the ambiguity of switching costs on competition and offers empirical evidence from the telecom industry to clarify this effect.

Findings

Switching costs can either reduce or increase market competition.

Empirical evidence shows AT&T lowered margins as portability reduced switching costs.

Results suggest high switching costs led AT&T to favor price discrimination over competitive pricing.

Abstract

Do switching costs reduce or intensify price competition in markets where firms charge the same price to old and new consumers? Theoretically, the answer could be either "yes" or "no," due to two opposing incentives in firms' pricing decisions. The firm would like to charge a higher price to previous purchasers who are "locked-in" and a lower price to unattached consumers who offer higher future profitability. I demonstrate this ambiguity in an infinite-horizon theoretical model. 800- (toll-free) number portability provides empirical evidence to answer this question. Before portability, a customer had to change numbers to change service providers. This imposed significant switching costs on users, who generally invested heavily to publicize these numbers. In May 1993 a new database made 800-numbers portable. This drop in switching costs and regulations that precluded price discrimination between old and new consumers provide an empirical test of switching costs' effect on price competition. I use contracts for virtual private network (VPN) services to test how AT&T adjusted its prices for toll-free services in response to portability. Preliminarily (awaiting completion of data collection), I find that AT&T reduced margins for VPN contracts containing toll-free services relative to those that did not as the portability date approached. This implies that the switching costs due to non-portability made the market less competitive. These results suggest that, despite toll-free services growing rapidly during this time period, AT&T's incentive to charge a higher price to "locked-in" consumers exceeded its incentive to capture new consumers in the high switching costs era of non-portability.