Switching costs and competition in retirement investment

Fernando Luco, 10 February 2014

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Switching costs deter consumers from switching to alternative products and often result in high prices. As a result, they have become a concern for policymakers who worry about how well markets perform. Examples of markets in which switching costs play a significant role include health insurance (Handel 2013, Nosal 2012) and pay TV (Shcherbakov 2013). In practice, it is difficult to implement specific policies to reduce the impact of switching costs on competition, prices, and welfare, as switching costs arise due to multiple reasons (Klemperer 1995).

Identifying the sources of switching costs

In recent research (Luco 2013), I study the Chilean retirement investment market in order to identify two sources of switching costs:

  • The cost associated with the enrolment process.
  • The cost involved in analysing the financial information available in the prospectus of pension funds.

A crucial challenge faced by empirical work studying switching costs is to separately identify switching costs from unobserved consumer heterogeneity. In order to solve this problem, I exploit the fact that the data allows me to observe when enrolees enter the market for the first time. As in Handel (2013), I then use these observations to identify consumers’ preferences and use subsequent observations to identify total switching costs.

In order to identify the different components of switching costs, I exploit institutional features of the Chilean retirement investment market in order to classify consumers in two groups:

  • Consumers who are on the market and are affected by both sources of costs.
  • Consumers who return to the market and are only affected by the cost of analysing information.

This classification allows me to decompose total switching costs by comparing choices across the two groups using a structural choice model. I find evidence that:

  • Most of the consumer inertia is explained by the cost of analysing information, though there is significant dispersion across the population.
  • Switching costs are associated with overpayment but not with lower returns.

Implications

The results suggest that policy can play a role by nudging people to choose cheaper products. However, if policy is able to reduce the cost of analysing information (e.g. by using targeted information or delegated management), or the cost of enrolment (e.g. by implementing online enrolment), consumers are likely to become more active, which in turn ultimately affects the way in which pension funds compete in the market.

For this reason, I study the equilibrium impact of policy changes by simulating a dynamic pricing game in which funds compete for enrolees whose decisions are affected by switching costs and policy. The results show that:

  • Eliminating the cost of analysing information increases consumer surplus eight times more than eliminating the cost of bureaucracy, both because of the lower switching costs and because of intensified competition.
  • Eliminating the cost of analysing information also increases consumer surplus by 8% more than eliminating both sources of switching costs.

This second result suggests that it is not only the magnitude of switching costs that matters, but also the underlying sources of switching costs.1  It implies that consumers are better off when only one source of switching costs is eliminated. Importantly, this means that it may be possible to save resources related to the cost of policy implementation, as only one of the sources of switching costs has to be targeted.

References

Arie, Guy and P Grieco (2013), “Who Pays For Switching Consumers?”

Cabral, L (2013), “Dynamic Pricing in Customer Markets with Switching Costs.”

Dubé, J P, G Hitsch, and P Rossi (2009), “Do Switching Costs Make Markets Less Competitive?”, Journal of Marketing Research 46(4), pp 435-445.

Klemperer, P (1995), “Competition when Consumers have Switching Costs: An Overview with Applications to Industrial Organization, Macroeconomics, and International Trade”, Review of Economic Studies 62(4), pp 515-539.

Handel, B R (2013), “Adverse Selection and Inertia in Health Insurance Markets: When Nudging Hurts”, American Economic Review 103(7), pp. 2643-82.

Luco, F (2013), “Switching Costs and Competition in Retirement Investment”, Job Market Paper. 

Nosal, K (2012), “Estimating Switching Costs for Medicare Advantage Plans”.

Shcherbakov, O (2013). “Measuring consumer switching costs in the television industry”.


1 Cabral (2013), Dube et al  (2009) and Arie and Grieco (2013) have also shown that small switching costs can reduce prices.

Topics: Industrial organisation
Tags: imperfect competition, insurance markets, switching costs

Ph.D. candidate, Department of Economics, Northwestern University