by Niloofar Abolfathi
Industry changes that lower customer frictions can be surprisingly beneficial for companies. Building on the global telecommunications industry, we document how a reduction in customer switching costs following mobile number portability increases industrywide profitability. We explain this finding based on a change in companies’ business model. When switching costs are high, companies adopt a funnel business model designed to convert customers from basic to advanced products. While advantageous for a single company, the diffusion of this business model has a depressive effect on average market prices and profitability.
What’s the background of our work?
We studied customer switching costs by looking at portability policies. Starting from the late 1990s, countries around the world started implementing number portability policies that enabled consumers to switch their service providers while keeping their contact numbers. This was in the hope of increasing industry competition and reducing prices. Because the conventional wisdom among managers at that time was that trapping customers through high switching costs can generate higher profits, not surprisingly, many didn’t favor the portability policies.
What do we find?
Analyzing data on 563 telecom operators across over 170 countries from 2000 to 2017, we examined how the firms’ pricing strategies and profits had changed in the aftermath of the number portability policy. Our findings point to an unexpected outcome: The policy led to an increase in industrywide prices and profitability.
How can we explain such counterintuitive findings?
In our paper, we argue that the key explanation behind our findings is a change in the business model of telecommunications companies. Before number portability, in the presence of significant customer switching costs, firms adopt business models that resemble funnels, designed to convert customers of basic and inexpensive versions –prepaid– into adopters of an advanced and more profitable version –postpaid. However, because firms anticipate the margins they can make on “trapped customers” who buy the advanced version, they enter into a mutually destructive price war in the basic version. Due to wide adoption of this business model, companies focus their competition within the narrow and less differentiated space of the basic-version market, making firms unable to exploit their superior differentiation in the advanced-version market. The reduction in customer switching costs can benefit firms as it breaks the conversion funnel logic and redistributes competition between the two versions.
What can we learn from this study?
Our paper suggests that strategies aimed at enhancing firm profitability exclusively through creating and maintaining customer frictions are generally not very effective in the face of competition. Prior work shows that high customer frictions generate several unexpected side effects on companies like inhibiting their resource development or the ability to exploit competitive advantage. We show that customer switching costs, rather than being a source of market power, can have a negative effect on firms by forcing them to adopt business models and pricing strategies that harm profitability. Furthermore, our study suggests that studying customer switching costs in isolation without considering strategic interactions between firms and their business model can lead to faulty conclusions.
Link to this article:
Abolfathi, N., Fosfuri, A., & Santamaria, S. (2022). Out of the Trap: Conversion Funnel Business Model, Customer Switching Costs, and Industry Profitability. Strategic Management Journal, 1–25. https://doi.org/10.1002/smj.3388
About the authors:
Niloofar Abolfathi is a Visiting Assistant Professor at NUS Business School interested in the areas of competitive and entrepreneurial strategies
Andrea Fosfuri is a Full Professor in the Department of Management and Technology at Bocconi University.
Simone Santamaria is an Assistant Professor at NUS Business School with research interests in the areas of entrepreneurship and strategy.