Michael Waterson Presentation prepared for Encore conference, the Hague, April 2006

1. Switching and switching costs Michael Waterson Presentation prepared for Encore conference, the Hague, April 2006

2. Plan • Theoretical issues and basic mechanisms • Types of switching and empirical implications- links to other literatures • Analysis of cases- when will welfare increase through switching? Extended examples of Petrin and GWW. • Competition in energy supply- impact on consumers • Broader implications and conclusions

4. Types of switching costs: • Transaction costs • Learning costs- different facilities etc • Artificial switching costs- compatibility etc. • Switching costs of all types have the effect of relaxing competition

5. Klemperer- mechanism

6. Reflecting on the theory • Klemperer: consumers face a cost in switching between one firm and another. They are reluctant to switch, and therefore firms can get away with high prices • Shaffer and Zhang (+ others): firms are able to identify which consumers are their own old ones and which are customers of rivals. They can then decide whether to discriminate in price between these groups. • not clear whether it is better to set a lower price for new customers (pay to switch) or a lower price for loyal customers • in some circumstances, prices fall to both groups of consumers, a prisoners’ dilemma for the firms but better for consumers, so that: • Price discrimination has some desirable features.

7. Categories of switching

8. Links • Examining the impact of new products is similar in principle to examining the impact of competition in new areas. • Note the link to cost-benefit analysis techniques.

9. Brown and Goolsbee: The role of the internet in improving information • Examine real price of term life assurance, controlling for age, State, etc. • 10% increase in numbers using the internet reduces average prices by 5%, after accounting for controls • Variance in prices is non-monotonic.

10. Petrin- JPE 2002 • Valuing the introduction of a new good- the “minivan” • Introduced by Chrysler 1984; imitated rather imperfectly by GM and Ford in 1985 and 1986. • Chrysler’s product an immediate success • Markups are high initially on minivans but fall somewhat, markups on station wagons fall - the other firms lost significant profits as a result.

11. Petrin (contd)- conceptually

12. Petrin- (contd) • Utility specification where X is observed characteristics, xis unobserved characteristics, n is idiosyncratic tastes for characteristics, g measures heterogeneity in tastes for the observed characteristic in the population. Demand and costs are estimated.

13. Petrin- results: welfare increases a good deal, most to consumers, 43% to non-minivan consumers

14. Giulietti, Waddams, Waterson- EJ October 2005 • Switching in UK domestic gas market • involves both search and switching activity • Useful example of the development of competition • How competitive has the market become?

15. Who switches gas supplier?- results of bivariate probit model • Middle – high income • high expected potential savings • Savings important • ease of switching unimportant • supplier reputation unimportant • Know bill • Changed house, car insurance, phone • Expect less than an hour to switch

16. Market beliefs and switching behaviour • Importance of beliefs regarding how your current supplier will react • Strategic position of incumbent?

17. Implications • Switching has affected a significant proportion of consumers- now around 47% in gas • However, many are remaining with their incumbent, and incumbents (gas and electricity) recognise they can maintain high prices to this group • Corroborative evidence on company purchase of incumbent consumers • Beliefs of consumers about competition matter

19. Why the big welfare differences between Petrin (large) and GWW (small)? • No explicit switching cost in Petrin- since people will be switching from an older vehicle • In Petrin, the new product reduces the price of the old product to consumers, but also adds significantly to consumer welfare because it satisfies many needs better. • The new product has a big positive impact on consumers and a smaller and largely negative impact overall on producers. • In GWW, the benefits to consumers are largely gains at the expense of producers. Demand overall very inelastic, so little net social welfare gain. • Introduction costs and reorganisation costs (essentially ignored in Petrin). • No consideration of cost reductions in GWW.

20. Implications of the comparison • There will be significant distributional impacts, between producers and consumers and within consumer groups • But in many cases, the net benefits of a new product that largely replaces an old one for consumers will be small, particularly if demand rather inelastic. • How do we know whether new products that satisfy needs better will not be forthcoming? They may indeed be. The point is that we have not conceived of them yet. • Inevitably, introducing choice where there has been none before is somewhat of a leap in the dark, because certain of the benefits only arise if firms find new ways of doing old things.

21. Benefits of supply competition • Is it the fact of competition/ allowing switching, the impact on users, or the ability to bargain on tariffs that matters in determining price? • What is the impact?

23. There does seem to be a measurable impact of supply competition on prices paid by consumers of electricity and, perhaps, gas. • Electricity-

26. Benefits from competition • Lower prices • Innovation? • Choice BUT: • Distributional changes • Mistakes by consumers and others • Costs on the system • Limited new suppliers

27. What is the optimal degree of switching? No switching consistent with: • No search or • Everyone happy. • There can be too much switching- it imposes costs on the system • Is it better to allow “special deals” or uniform category pricing? • Role of contract length.

28. If I were a psychologist… • Are people more easily fooled in new choice situations? • Do they look to the longer term? • Is it sensible to move from 100% paternalism to 0% paternalism? • What about guided or “framed” choice? • Should there be a “backstop”?