As explained, switching costs are those costs that are levied by the banking industry, or other financial institutions to loan borrowers who wish to transfer these loans to other institutions. The philosophy behind these costs is to make it expensive for borrowers to make this switch, so as to ensure that customers remain with their initial loan providers.
In the Australian loans market, there existed a number of switching costs that, as the government noted were actually not related to the actual processing costs of the switching process and that is why it was decided that these costs need to be eliminated. The costs include the following; Early exit or deferred establishment fee, which was also banned from July. Depending on the lender, this fee can be as high as $2,000 sometimes even higher.
Another cost is normally where the loan rate of interest is fixed, and break costs are normally levied. These break costs; sometimes go into thousands, depending on the contract, as well as the lender. In Australian home loan market, there is also an account closing fees, amounting to between $ 300 to $ 500. These are not the only switching charges that are levied when one wishes to switch loans. On the side of the new loan provider, there are still other charges. These include;
Discharged and registration of mortgage fees amounting to approximately $ 190, between $ 100-$250 settlement fees and the obvious application and valuation fees, that could amount to close to $ 600. These costs, all aggregated are quite deterrent and therefore, make one stay at a loan even when they are dissatisfied, but when they calculate the costs of switching and its extremely high, they would rather maintain their current loans.
b) Explain how these switching costs might increase the market power of suppliers inthose markets?
Switching costs, as explained are meant to ensure that once a client takes a home loan with a given bank, then they will find it difficult to leave that lender for another one, since the costs involved are extremely high and deterrent.
The source of market power for lenders in this market originates, partly from their ability to lock in these customers, who would otherwise have left them if they could freely switch to their competitors. Look at a situation where a lender locks in thousands of borrowers from switching to competitors, it means that these lenders remain powerful in the market.
Another example is when we have a cheaper lender in the market who wishes to attract as many clients as possible (Burnham et al 2003). While there are thousands of these clients who would wish to switch to this new lender, they are restricted from doing so due to the high costs involved in making the switch. Assuming that the new lender is giving lower rates, the existing customer will have to compute the expected switching costs and compare with the new gains and in the event that the switching costs are high, then it’s apparent that they may not make the switch owing to the costs and benefits analysis. This means that the existing market players retain significant market power due to the inability of new comers to make the switch.
c) How would you expect this to affect the prices charged by those suppliers, and theirprofits?
The intervention of the Australian government in removing those costs that have no relationship with the costs of processing the switch will of course have far reaching impacts on the prices offered, as well as the profitability of the home loan providers in Australia.
Price
In terms of price, it’s important to note that switching costs were a form of monopoly. The home loan provider was free to charge whatever prices they deemed, and even increase the rates arbitrarily since they were almost assured that the clients would not be able to switch to their competitors, due to the highly deterrent switching cost. Removal of these switching costs would mean that the home loan provider is no longer a ‘monopoly’, since in the event that new lenders come up, then the clients will freely and easily switch to the new lenders (Caruana, 2004). This has the effect of reducing the prices charged by the lenders.
Profit
The profits of these institutions will definitely be negatively affected, and in three fronts. First and foremost, the additional revenue that resulted from these switching costs would no longer be realized as this stream of income will be closed, since the government is abolishing these costs (Colgate and Hedge, 2001) Secondly, the many clients who have been frustrated by the existing home loan lenders, but have been unable to move due to these switching costs will ultimately make the switch, and this is lost revenue for the home loan lenders. Lastly, as a result of decreased market power due to the removal of these switching costs means that these lenders will have to reduce their prices and this will ultimately lead to a reduction in their profit margins.
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Colgate, M. and Hedge, R. (2001), “An Investigation into the Switching Process in Retail
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