Subsidizing customer acquisition is bad for (nearly) everyone

I had an interesting discussion some time ago about the validity and soundness of a special business model: What happens when a company subsidizes customer acquisition. In other words, what happens when a NEW customer pays less than the full cost of a service or product?

Today, a number of industries follow this pattern: Home & Auto Insurance, Telecoms, Electricity, Cable… If so many large and arguably smart companies engage in this behavior, it must make strong business sense right? Actually, I am going to try and prove the opposite to you. Let’s start from the beginning:

INNOCENT BEGINNINGS:

In a competitive industry, a small player decides to grow its book of business by offering a discount for new customers. The idea is that after a little while, the price will move back up to normal, profitable levels. Basically, companies bank on customer inertia, where a new customer either:

(a) believes the acquisition price is the forever price, or

(b) decides to keep the product due to high switching costs, real or perceived.

The first case is clearly a case of confused customer; hopefully, no large, ethical & savvy company would purposefully engage in a confusing behavior.

The second case does often occur however. I’ll take my household as an example: I know full well that I could save decent money by switching cable companies or cellular phone providers when my contracts runs out – yet the (perceived?) switching costs prevent me from doing it: I would have to return my DVR (and figure out what all these cables behind my TV do) or port my phone number to another network (and I think I heard an horror story a couple of weeks ago – or was it last decade?)… true or not, this just seems like a lot of work.

In some other industries however, the switching costs are truly minimal. For my home and auto insurance needs for example, I systematically pit 2 or more providers against each other. How much time does it take me? Probably 10 minutes: Insurers already have my information so I either contact them directly or – even better – ask an insurance broker to do it for me. The best part about these brokers is, they always remind me when it is time to look at the market again!

Now that we understand how the business model started, let’s look at what happens next:

WHAT IT MEANS TO THE COMPANY:

1. The company loses money in the short term

… which leads to …

1. The company needs to either raise prices on every other customer, and/or raise prices to this new customer in the future

… which ultimately results in:

1. Existing customers pay more than they should, and/or
2. New customers satisfaction dips when their introduction price goes up, and are more likely to look around for a cheaper alternative
3. Other companies start losing customers due to price, and feel pressure to adopt a similar strategy

WHAT IT MEANS TO THE CUSTOMER:

1. The new customer believes the initial price is the right price
2. When a customer stays with a company for a while, he/she will see the price inch up over time. Before long, that price will actually be higher than it would have been without this pricing model: the company needs to make up for the early discount (see chart). From then on, it is highly unlikely the price ever goes back down to what it would have been without customer acquisition subsidies
3. If the customer realizes what is happening, he/she typically becomes very unhappy with the company and often takes his/her business elsewhere. This single negative customer experience can even turn strong advocates into fierce detractors, former customers now turning friends and family away from the company they previously gave their business to

OVERALL IMPACT:

We now have a situation with 1 winner and 2 losers:

1. Savvy customers learn to look at price rather than at a product’s qualities, and quickly understand they would benefit by switching on a regular basis. These customers do save money in the long run

2.Unsuspecting shoppers end up subsidizing the savvy ones and over pay significantly over time

1. Industry profits take a dive since nearly everyone competes almost exclusively on price and the number of savvy customer steadily increases as more people learn about this

CONCLUSION:

At the end of the day, subsidizing customer acquisition is a very slippery slope, with unlikely benefits and even some ethical issues. Refusing to play that game once a competitor starts is very hard, and typically leads to significant customer loss. Even the first company to engage in the practice is likely to lose money in the end. If you are a business, the conclusion seems clear: just don’t start it! If you are a consumer however, do your research and don’t trust that your provider will take care of you.