The Econophysics Blog

This blog is dedicated to exploring the application of quantiative tools from mathematics, physics, and other natural sciences to issues in finance, economics, and the social sciences. The focus of this blog will be on tools, methodology, and logic. This blog will also occasionally delve into philosophical issues surrounding quantitative finance and quantitative social science.

Thursday, May 10, 2007

Switching Costs

In his weekly Financial Times column, 'The Undercover Economist,' Tim Hartford wrote about research into the costs of switching goods and services (April 27, 2007). One might expect (especially with the 'rational man' presumption of most economists) that people would make the switch away from goods and services they have been accustomed to unfamiliar goods and services in order to save money. The research and examples Tim Hartford cites, however, contradicts this: People often lose money by making switches.

Why? There are many possible reasons for this. One possible reason is that searching for alternatives is itself costly. But this rationale doesn't seem to apply here since the article talks about scenarios where people searched for alternatives, made the conscious decision to switch, and, yet, it still costs them more than if they had stayed with their prior commitments.

The better explanation for higher switching costs (under these circumstances) is a combination of information asymmetry and just plain confusion about the true costs of making the switch. One of the examples the article cites is switching electricity suppliers. Consumers get confused about the different tariffs and pricing schemes involved in switching utilities suppliers. Another example the article cites is hedge funds. Investors have a hard time figuring out whether a particular group of hedge fund managers are good or not. The information asymmetry can come in because suppliers -- whether they supply electricity or hedge fund investment management -- can 'exploit' this confusion or lack of information/knowledge on the part of consumers.

All of this turns on its head the usual presumption in economics that prices efficiently reflect all available (and, in the most strongest forms, even all or most private) information. So, even assuming that consumers are acting rationally, prices don't seem to serve as an efficient means of delivering information and making 'rational' economic decisions. This suggest a sort of 'shadow' or 'undercover' prices; perhaps, it takes an Undercover Economist to point that out.

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