Course 109: Finding Economic Moats
High Customer Switching Costs
In this course
1 Introduction
2 About Economic Moats
3 High Customer Switching Costs
4 Economies of Scale
5 Intangible Assets
6 The Network Effect

If a business sells you something you can't get elsewhere--at least not easily--then that business has high customer switching costs. For example, if you have only one grocery store in your neighborhood, and you don't own a car, you'd be willing to pay extra to buy your food there. To get to another store, you'd have to walk a long way. Thus, there are high "costs" to switching to a different grocery store. In this scenario, the grocery store can charge higher prices and generate excess profits.

Let's look at an example from the stock market. Paychex PAYX does payroll processing for other businesses that don't want to hire and train a staff of people for this function. Since Paychex is a specialist, it can offer similar services as an in-house staff of payroll employees, but at a lower cost, more quickly, and with fewer errors. What happens if a company decides it wants to forgo using Paychex's services and bring the job in-house? Well, it's looking at hiring payroll employees and training them, buying computers, buying software, and dealing with IRS audits and employee complaints because of frequent errors. Not many small businesses would willingly make this trade-off unless the cost savings of bringing the job in-house were enormous. Thus, Paychex enjoys very high customer switching costs.

Another example: Have you ever moved to a different residence in the same city and asked the local phone company to let you keep your phone number? It's a real headache to notify everyone that your phone number has changed. The same holds true for e-mail addresses. And that's why AOL's customers don't leave once they're hooked, despite the sometimes-spotty service they may get.

Speaking of being hooked, the great granddaddy of high customer switching costs is the tobacco industry. Getting customers physically and psychologically addicted to your product is a recipe for monster profits--legal and ethical issues aside.

Next: Economies of Scale >>


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