The Quest for Customer Loyalty.PDF

Abstract

Creating a loyal installed base is clearly a top priority among mobile phone operators. It is also one of their greatest challenges. Previous research argues that customer switching costs play an important role in the firm’s ability to retain customers and achieve competitive advantage. Research also indicates that in the increasingly networked environment, switching costs are changing in important ways. In this paper we attempt to provide insight into switching costs’ strategic role within the networked environment by utilizing a switching cost framework to examine the mobile phone operator industry in Spain. Introduction A review of the strategy, economics, and marketing literature indicates that customer switching costs play a very strategic role in many firm’s ability to achieve superior performance (Porter 1980, 1985; Klemperer 1995; Kotler, 1997; Shapiro and Varian, 1999; Hax and Wilde II, 1999, 2001; Hess and Ricart, 2001). Customer switching costs are generally defined as costs that deter customers from switching to a competitor’s product or service. These costs include costs such as the customers’ time, effort, and knowledge they have invested in a product, service, or relationship. According to Michael Porter (1980), customer switching costs are a key element that must be considered with every strategic decision the firm makes. While switching costs have always been considered an important element in achieving competitive advantage, research indicates that they are becoming even more strategic in the increasingly networked competitive environment (Arthur, 1989, 1990, 1996; Economides, 1995; Yoffie, 1996; Bakos, 1997; Butler, et. al., 1997; Evans and Wurster, 1997; Shapiro and Varian, 1999; Hax and Wilde II, 2001). The unique characteristics of today’s expanding networked environment – high-speed low-cost communications, digitalization, globalization, and the Internet – are impacting both the potential of switching costs and the strategies needed to achieve them. We find that the mobile phone operator industry provides an ideal environment in which to study the strategic role of customer switching costs. For one, it is an industry that is entirely immersed in the networked environment – operators are simultaneously driving the expansion of the networked environment and struggling to thrive, or in some cases survive, within it. Second, deregulation of telecommunications throughout most of the world is causing the reduction or disappearance of traditional, artificial switching costs. Third, globalization and innovative technologies have combined with deregulation to unleash a range of fierce new competitors who are working to eliminate switching costs to convince customers to subscribe to their services. Finally, many mobile phone markets are approaching maturity in the developed world, which means that operators are focusing on customer retention more than ever. Thus, while switching costs have always been recognized as playing an important strategic role, we believe that this role is evolving in the increasingly networked environment. Therefore, we find a need to reexamine the role of switching costs in this new competitive landscape. Our aim in this paper is to contribute to the understanding and strategic management of customer switching costs as a key means of achieving superior performance in the increasingly networked environment. To achieve this aim we apply a switching cost framework to one of today’s key networked environments – the mobile phone operator industry. We have chosen to focus on the Spanish mobile phone market, with particular emphasis on the market leader – Telefónica Móviles. The switching cost framework is one developed by the authors in a previous work, and we believe it provides an insightful and thorough tool for managing switching costs effectively. Based on or analysis of this market using the framework, we discuss a range of potential switching cost issues to be researched as part of our ongoing work on the mobile phone industry. The paper is organized as follows. In the first section we explore the strategic role of customer switching costs and how this role is changing as a result of the increasingly networked environment. Second, we discuss a range of key issues and approaches in managing customer switching costs and present our switching cost framework. Next, we examine the mobile phone operator industry in Spain to explore how the operators are managing switching costs in their quest to attract and retain customers. Finally, we discuss the key implications of our analysis. (To simplify our discussion for the remainder of this paper, mobile phone operators will be referred to simply as moperators, customer switching costs will be referred to simply as switching costs, and the firm’s product or service will be referred to simply as the firm’s brand). 1. The Strategic Importance of Switching Costs The concept of customer switching costs has long been recognized and researched by several academic disciplines, primarily strategy, marketing, and economics (Porter, 1980, 1985; Rumelt, 1987; Lieberman and Montgomery, 1988; Klemperer, 1987a, 1987b, 1995; Kotler, 1997; Shapiro and Varian, 1999; Hax and Wilde II, 1999, 2001). From the strategy perspective, Porter (1980) consistently discusses the importance of switching costs throughout his two seminal works, Competitive Strategy (1980) and Competitive Advantage (1985). Hax and Wilde II (2001) also focus on switching cost strategies in their book The Delta Project in which the authors focus on how firms can and should strengthen their relationship, or bond, with customers in today’s competitive environment. Strategy work focusing on the areas of entrepreneurship and first mover advantage has also emphasized the important role of switching costs (Rumelt, 1987; Lieberman and Montgomery, 1988) in capturing entrepreneurial rents. Why Switching Costs are More Strategic in Today’s Competitive Environment Many different strategies can be implemented to achieve switching costs, and many different strengths or degrees of switching costs can be obtained. The strategies and strengths available depend in large part on the context in which the firm competes. We find that several key changes brought on by the advances in technology and the growth in the use of the Internet make switching costs a more strategic force in today’s competitive environment. These changes and their impact on switching costs are briefly outlined below. The first change is the growth in the use of the Internet and other computer and communications technologies. This enables the developed countries of the world to change from economies based on the processing of resources and raw materials to economies based on the processing of information, knowledge, and ideas (Arthur, 1996; Tapscott, 1997; Shapiro and Varian, 1999; Yoffie 1999; Ricart and Gual, 2001). As a result, in many ways the world’s economy is increasingly becoming one large network. While switching costs are an important force in all business environments, it is significantly more pronounced in network environments (Economides, 1998) because of a network’s system structure. This system structure and the need for participants in the network to have complementarity between components, network industries contain network externalities and positive feedback, also called increasing returns (Katz and Shapiro, 1985; Arthur, 1989; Shapiro and Varian, 1999). The combination of these forces makes network industries high switching cost industries. However, that not all of the changes in the new economy are leading to an increase in switching costs. The same changes in technology that provide firms with opportunities to create new switching costs are enabling customers to reduce traditional ones. The blow up of the tradeoff between richness and reach (Evans and Wurster, 1999) leads to several important changes – reductions in search costs, reductions in transaction costs, reductions in interaction costs, reductions in asymmetries of information, and an increase in choice. Each of these changes causes bargaining power to shift from sellers to buyers (Bakos, 1997; Butler, et. al. 1997; Evans and Wurster, 1999; Porter, 2001). 2. Managing Switching Costs and the Switching Cost Framework It is argued that a firm with a loyal installed base of customers has a competitive advantage over competitors and thus the potential to achieve superior performance (Porter 1980, 1985; Klemperer 1995; Kotler, 1997; Shapiro and Varian, 1999; Hax and Wilde II, 1999, 2001). We agree that switching costs plays a key strategic role and that firms that can effectively achieve a high degree of switching costs with customers can obtain an important competitive advantage. We also emphasize that both achieving switching costs and achieving them in a way that provides a competitive advantage is a complex challenge for managers. To successfully face this challenge, we believe it is essential to have a clear understanding of the concept and a useful and comprehensive framework to provide guidance. In the remainder of this section we discuss our expanded concept of switching costs, identify tools for understanding and successfully managing this challenge, and then provide our switching cost framework. Conceptualization of Switching Costs In a previous paper by Hess and Ricart (2001) the authors expand upon and refine the conceptualization of switching costs (see Table 1). For a complete review of the switching cost literature, see Hess and Ricart (2001). Table 1. Classifications of Customer Switching Costs Type of Switching Cost Description of Switching Cost 1 Category: Previous Investments This type of switching cost results from investments the customer has already made in the current brand. Durable Purchase Investments made in a durable product, the value of which exists for the economic lifetime of the product. Complementary Purchase Investments made in complementary products that are compatible with the durable equipment previously purchased. Relationship Investments made to develop relationships with suppliers. Learning/Training Investments made to learn how to use a particular brand. Search Costs Investments made to learn about the characteristics of a particular brand and to find the right supplier. Specialized Supplier Investments made in specialized products from a single supplier. Loyalty Programs Investments made in previous purchases of the brand as part of a frequent purchase program that results in accumulated discounts. This is often described as an artificiallycreated investment since the supplier strategically creates the loyalty investment program. Information and Database Investments in saving information and/or creating databases in a particular brand of hardware and software technology. Psychological The psychological cost of having to give up a brand that the customer simply like and therefore feel loyal to for non-economic reasons. Network Investments made in becoming a member of a network (such as a virtual community or chat group) which may include learning and relationship building. 2nd Category: Potential Investments This type of switching cost results from investments the customer would or could have to make if he or she wants to switch to a different brand. Durable Purchase The cost of having to make a new durable purchase. Complementary Purchase The cost of having to make new complementary purchases (if previously purchased complements are not compatible with the new durable purchase). Relationship The cost of having to develop new relationships with a new supplier. Learning/Training The cost of having to learn how to use the new brand. Search Costs The cost of having to find a new brand and supplier. Contractual Commitment The cost of having to pay a penalty for breaking a legal commitment to purchase a certain amount of a brand over a certain length of time from a specific supplier. Risk of Failure The risk that the new brand will not perform as expected. Switching Back Costs The cost of having to switch back to the previous brand if the new brand proves unsatisfactory. 3rd Category: Opportunity Costs This type of switching cost results from the opportunities the customer would forego if he or she were to leave the current brand. Network The cost of leaving a network even if one has not yet invested in becoming an active member. Complements The cost of giving up the benefit of a range of complementary goods and/or services that exist for the customer’s current brand even if the customer has not yet invested in or used such complements. 4th Category: Best Product This type of switching cost results from leaving one’s current brand to a competitor’s brand that offers a higher price, less value, or both. Price/Value The cost of switching to a new brand that provides less value to the user at the same price as the previous brand, or provides a higher price for the same level of value to the user as the previous brand. Source: Adapted from Porter (1980, 1985), Klemperer (1995), Shapiro and Varian (1999), Hax and Wilde II (2001), and Hess and Ricart (2001) The Switching Cost Framework Building upon our conceptual work, we integrate and modify a variety of complementary strategy frameworks to build our switching cost framework (see Figure 1 below). The first model we integrate was developed by Hax and Wilde II (2001). In their Triangle model they distinguish among three strategic positions that firms can pursue – Best Product, Total Customer Solutions, and System Lock-in. They explain that these positions are not mutually exclusive, but that it is useful to recognize their differences. The same holds true for the switching cost strategies; they are definitely not mutually exclusive, but aligning them with the three main strategic positions helps to understand switching costs’ strategic role. Clearly some types of switching costs are easier to position than others, but the exercise of analyzing where they might best align within the strategic positions, or likewise, where they do not align, provides useful insight. In Figure 1 the different types of switching costs are aligned with the three strategic positions of the Triangle model as a way of showing which types of switching costs firms can pursue within each of the three different strategies. Another model that we integrate into our framework is the Lockin Cycle developed by Shapiro and Varian (1999) in which they emphasize the dynamic nature of switching costs. In this model they identify four sequential phases of the lock-in process: 1) brand selection, 2) sampling, 3) entrenchment, and 4) lockin, then back to brand selection to repeat the cycle. To effectively understand and manage lockin, managers must not only anticipate the four stages of the cycle, they must also anticipate the long-term effects on their customers as they pass through the cycle over and over again. The authors suggest that the strategies for managing this cycle should be based on three principles: 1) invest, 2) entrench, and 3) leverage. Investing involves building up the installed base; entrenching involves getting customers to invest in the firm’s product to generate and increase their lock-in to the product; leveraging involves maximizing the value of the installed base. Another important aspect of managing switching costs has to do with the evolution or revolution of the switching cost cycle. To deal with this issue we integrate another model from Shapiro and Varian (1999) into our framework. The model is called the Compatibility versus Performance model, and it helps to distinguish between a firm’s evolutionary and revolutionary strategies. While this framework was designed to understand the firm’s evolutionary or revolutionary strategies and their impact on the switching cost cycle, we find that it also serves as a useful framework to think about the Low Switching Costs High Switching Costs Customer Lock-in Product Economics: Low price Differentiation Customer Economics: Reduce customer costs Increase customer profits Increase customer utility System Economics: Complementor lock-in, competitor lock-out, and proprietary standards Relationship Learning/Training Contractual Commitments Loyalty Programs Search Costs Risk of Failure Switching Back Costs Switching Back Costs Durable Purchase Information and Databases Specialized Supplier Network (Opp Cost) Complements Psychological Strategic Positions Switching Cost Opportunities Best Product Total Customer Solutions System Lock-in Figure 1. The Switching Cost Framework Price Product quality Service quality Source: Adapted from Hax and Wilde II (1999, 2001), Shapiro and Varian (1999), and Hess and Ricart (2001) Switching Cost Cycle Firm Performance Evolution Invite Entrench Leverage Revolution New Switching Cost Cycle Degree of Switching Costs Achieved external environment’s impact on the switching cost cycle. Clearly, the changes affecting switching costs are not only created by the firm, but also by the firm’s competitors and other factors such as the Internet that make up the firm’s environment. Despite the models’ respective contributions, we believe that using any one of these models on its own does not provide managers with the complete picture required to understand and manage lock-in. By modifying and combining these tools, therefore, we create an integrated model that we believe offers a more complete framework for managing lock-in. The combined framework can enhance managers’ strategic decision making by equipping them with a powerful lens through which to view their strategic switching cost opportunities and to understand how they can affect firm performance. For our purposes, we evaluate firm performance based on the firm’s ability to retain customers. 3. The Mobile Phone Operators in Spain The mobile phone operator industry provides an excellent setting in which to explore the strategic role of switching costs and its impact on customer retention. First, customer retention, or the creation of a loyal installed base, is one of the main priorities for the operators. However, it is an industry with a relatively high customer churn rates (or turnover), estimated to be around 30%. Second, these operators are competing within (while at the same time building) a networked environment, which enables us to analyze role of switching costs within the networked environment. Finally, switching costs appear to be changing in important ways within this industry. We have chosen to focus our analysis on the Spanish mobile phone market because we find it offers additional attractive features. First, the Spanish market has grown extremely rapidly over the past few years, currently situated as one of Europe’s largest mobile phone markets with over 26 million users out of a total population of around 40 million. In fact, the number of mobile phone numbers in use has recently surpassed the number of fixed line numbers in use throughout the country. The result is an extremely high penetration rate of almost 70% as of the end of the third quarter 2001. With over 1 Forrester Research 2 Expansión two thirds of the population already owning a mobile phone, Spanish operators are focusing less on attracting customers and more on retaining and profiting from them. Thus, to capitalize on this growth, much of the battle until now has been waged on the pricing front in efforts to attract new subscribers (i.e., with free or subsidized handsets). Currently, however, operators appear to be shifting their efforts from competing on price to competing on value added services. Their goal is to differentiate themselves in order to keep the customers they have invested so much in to acquire, and switching cost strategies appear to be playing an important role in these efforts. Another second attractive feature of the Spanish market relates to the key drivers behind the market’s incredible growth and the way in which they are affecting switching costs. For one, competition has greatly increased and is continually evolving. The Spanish mobile industry was founded in 1990 by Telefónica, who remained a monopolist until 1995 when Airtel (now Airtel Vodafone S.A.), the market’s number two operator, entered the market. The third operator, Amena Auna Móvil S.A. began offering service in January of 1999. The Spanish telecommunications industry was deregulated in 1995 when. In addition to the three main operators, eight mobile virtual network operators (MVNOs) have been granted licenses to compete in Spain. MVNOs lease network capacity from the three main operators’ infrastructure, and then they market and sell mobile services under their own brand name to their own customers. Because the market is so saturated, these MVNOs are going to have to target the three main operators’ existing customers. Third, legislation has recently made number portability (the ability of users to switch operators and to take their phone number with them) mandatory as of November 2000. Although problems still appear to exist in enforcing this policy, it does represent an important change in a key switching cost within the telecommunications industry. In addition, mobile users in Spain are changing their usage of mobile phones. For one, they are increasingly replacing fixed line phones with mobile phones. Second, they are 3 A fourth operator in Spain called Xfera has a license only for 3G technology, and therefore has been unable to enter the market until 3G infrastructure is in place. increasingly sending data, mainly in the form of short text messages known as short messaging service (SMS), and instant messaging (IM). Third, the Spanish market continues to experience explosive demand for prepaid (non-contractual) mobile services. Well over 50% of all Spanish mobile users are prepaying customers. Such customers have lower switching costs (no contract) and are therefore more difficult to retain. Market saturation, the changing focus of operator strategies, increasing competition, new competitors, the change in regulation, and the evolution in mobile phone usage are all affecting switching costs and the operators’ ability to develop a loyal installed base. We argue that because of these changes, switching costs are becoming even more strategic, and understanding and effectively managing them even more critical in the moperators’ performance. Telefónica Móviles Our main focus is on Telefónica Móviles S.A. (TM), the wireless subsidiary of Telefónica Espana, S.A. The main reason for focusing on TM is its leadership position: it finished the third quarter of 2001 with 15.6 million active customers, up 22% from one year ago, and about two thirds of these customers (almost 10 million) are prepaid customers. Thus, with approximately a 55% market share in Spain and a high percentage of prepaid customers it is faced with the greatest challenge of retaining customers. M-Operator Competitive Activities To understand the switching cost strategies available to TM and is competitors, it is useful to identify the full range of competitive activities that the mobile phone operators can undertake. Becerra and Fjeldstad (1999) provide a useful classification based on three main types of competitive activities: 1) infrastructure operations, 2) promotion, and 3) service layering. In Table 2 below we show the full range of these activities. Having identified the full range of competitive actions the operators can engage in, we

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@inproceedings{Hess2001TheQF, title={The Quest for Customer Loyalty.PDF}, author={Mike Hess and Joan Enric Ricart}, year={2001} }