Published in Strategic Management Journal, 43(9), 1872–1896. D1OI: 10.1002/smj.3388
Out of the trap: Conversion funnel business
model, customer switching costs, and industry
profitability
Niloofar Abolfathi1 | Andrea Fosfuri2 | Simone Santamaria1
1
NUS Business School, National
University of Singapore, Singapore Abstract
2
Department of Management and
Research Summary: Across many industries, firms
Technology and ICRIOS, Bocconi employ a conversion funnel business model to attract
University, Milan, Italy customers with basic and affordable products, generate
Correspondence lock-in, and then sell them more advanced and expen-
Niloofar Abolfathi, NUS Business School, sive products. We argue that this business model,
National University of Singapore, 15 Kent
coupled with high customer switching costs, results in
Ridge Drive, 119245, Singapore.
Email: a market outcome characterized by aggressive pricing
and reduced profits. A sudden reduction in customer
switching costs disrupts the conversion funnel and can
eventually increase industrywide prices and profitabil-
ity, an outcome that contradicts conventional wisdom
in strategy research. We develop a stylized model to
formalize our ideas and provide supportive evidence
using a difference-in-differences methodology with
staggered treatment for a large, global sample of mobile
telecommunications operators.
Managerial Summary: Industry changes that lower
customer frictions can surprisingly be beneficial for
companies. Building on the telecommunications indus-
try, we document how a reduction in customer
switching costs following mobile number portability
increases the profitability of mobile operators. We
explain this finding based on a change in companies'
business model. When switching costs are high, compa-
nies adopt a funnel business model designed to convert
customers from basic to advanced products. While
advantageous for a single company, when strategic
, interactions are accounted for, the diffusion of this
business model has a depressive effect on average mar-
ket prices and profitability. A reduction in customer
switching costs breaks the funnel and decouples prod-
uct pricing decisions that, counterintuitively, can lead
to higher industrywide prices and greater profitability.
KEYWORDS
business model, conversion funnel, customer switching costs,
industry profitability, market frictions
1 | INTRODUCTION
Extant strategic management (Chatain & Zemsky, 2011; Denrell, Fang, & Winter, 2003;
Porter, 1996; Shi, Chiang, & Rhee, 2006) and industrial organization (Beggs & Klemperer, 1992;
Klemperer, 1995; Tirole, 1988) literature defines customer switching costs as a source of market
power, leading to higher prices and increased firm profits. Switching costs can generate a lock-
in effect on customers (Porter, 1985), thus favoring incumbents (Brush, Dangol, &
O'Brien, 2012; Go mez & Maícas, 2011; Wei & Zhu, 2018) and reducing rivalry (Mas-Ruiz, Ruiz-
Moreno, de Guevara, & Martínez, 2014). Therefore, reducing customer switching costs should
arguably increase competition and reduce firm profits. Such anticipated outcomes lead to efforts
to increase online identity and data portability across online platforms as a means to reduce the
power of internet giants like Facebook or Google (Gans, 2018; Geradin & Kuschewsky, 2013).
Some of these interventions, designed to reduce customer switching costs, have generated the
expected outcomes (Viard, 2007); others, however, have produced unintended consequences
(Shi et al., 2006; Wei & Zhu, 2018), as firms can strategically respond to these changes.1 Surpris-
ingly, little attention in strategy research has focused on how firms respond to changes in cus-
tomer switching costs, despite the strategic importance of such market friction (Abolfathi,
Santamaria, & Williams, 2021; Burnham, Frels, & Mahajan, 2003; Chatain & Zemsky, 2011;
Mahoney & Qian, 2013). In this article, we develop a game-theoretic model to show how firms
modify their business models and adapt their pricing strategies in reaction to an exogenous
reduction in customer switching costs and test its empirical predictions in the global mobile
telecommunications industry. Contrary to conventional wisdom in strategy research, our find-
ings show that a reduction in customer switching costs has a positive effect on firms' average
price and profitability.
Our model builds on the notion that, in the presence of significant customer switching costs,
firms develop business models that resemble funnels, designed to convert customers of a basic
and inexpensive version of a product into adopters of an advanced and more profitable version.
Firms enjoy market power with their advanced version due to customer switching costs, yet
1
Viard (2007) finds that the portability of 800-numbers reduced prices for toll-free telephone services. In contrast, Shi
et al. (2006) provide evidence that wireless number portability led to discriminatory pricing schemes by large firms,
which increased market concentration. Similarly, Wei and Zhu (2018) show that larger firms were able to exercise
market power and keep prices high even after a reduction of customer switching costs.
, they also compete more aggressively with their basic version because they take into account the
rents from the conversion of customers to the advanced version. Put differently, by creating a
link between the pricing of the two versions, a conversion funnel business model shifts the
locus of competition toward the basic version market. The removal of customer switching costs
can be beneficial for firms as it breaks the conversion funnel logic and redistributes competition
between the two versions. Our model shows that average prices and profits increase after the
removal of customer switching costs if the advanced version market is more differentiated than
the basic version market.
The mobile telecommunications industry constitutes an attractive context to test our model
predictions. Most large mobile telecommunications firms have both prepaid and postpaid ser-
vice subscribers (Banker, Chang, & Majumdar, 1998; Shi, Li, & Bigdeli, 2016). Prepaid services
are relatively affordable and suitable for cost-conscious customers who want to try out the
mobile plan; postpaid services tend to be more expensive and address customer needs as they
evolve over time and as customers become more experienced users (Gruber, 2005). Firms typi-
cally offer prepaid services to attract new customers and then seek to generate lock-in effects,
with the ultimate goal of converting customers to more profitable postpaid services. This pro-
cess reflects a conversion funnel business model. In the late 1990s, countries around the world
started implementing mobile number portability (MNP) policies that have enabled customers to
switch their service providers while keeping their contact numbers, thereby substantially reduc-
ing switching costs. We explore how pricing strategies and profits have changed in the after-
math of MNP policy.
We collect data on mobile telecommunications operators worldwide from 2000 to 2017.
Because the implementation of MNP was staggered across countries, we can apply a difference-
in-differences approach. The results are consistent with our predictions. After the implementa-
tion of MNP, the price of prepaid services increased, while the price of postpaid services barely
changed. Moreover, the increase in the prepaid service price prompted a shift toward purchases
of postpaid services. The resulting change in customer composition (more customers buying
postpaid services) and the price increase in the prepaid segment increased firms' profits. Fur-
thermore, the effect of removing customer switching costs on prices is stronger in concentrated
advanced version markets where firms have high market power (arguably due to high differen-
tiation). Various robustness checks confirm and establish the theorized mechanism.
In turn, we make two primary contributions. First, we provide new insights into the strate-
gies firms adopt in the face of market frictions (Abolfathi et al., 2021; Burnham et al., 2003;
Chatain & Zemsky, 2011; Mahoney & Qian, 2013; Mawdsley & Somaya, 2018). Although several
studies have shown how customer switching costs help improve firm performance by creating
market power over locked-in customers (Brush et al., 2012; G omez & Maícas, 2011; Mas-Ruiz
et al., 2014), we suggest that when strategic interactions are accounted for, the picture becomes
more complex. We show how firms' business models interact in nontrivial ways with changes
in customer switching costs to determine firms' pricing strategies and profitability, which can
increase when market frictions are removed. Our attention to business models (Amit &
Zott, 2001; Teece, 2010; Zott & Amit, 2008) suggests a new contingency through which firm
profitability increases when rivalry restraints diminish (Makadok, 2010, 2011). Our findings can
likely be extended to other industries in which firms adopt a funnel business model to attract
new customers by offering an affordable basic version of a product in the hope that a significant
fraction of these customers subsequently shifts to a more advanced and expensive version.
Second, we contribute to studies on competition through business models (Casadesus-
Masanell & Zhu, 2010, 2013), highlighting how the presence of market frictions can force firms
Out of the trap: Conversion funnel business
model, customer switching costs, and industry
profitability
Niloofar Abolfathi1 | Andrea Fosfuri2 | Simone Santamaria1
1
NUS Business School, National
University of Singapore, Singapore Abstract
2
Department of Management and
Research Summary: Across many industries, firms
Technology and ICRIOS, Bocconi employ a conversion funnel business model to attract
University, Milan, Italy customers with basic and affordable products, generate
Correspondence lock-in, and then sell them more advanced and expen-
Niloofar Abolfathi, NUS Business School, sive products. We argue that this business model,
National University of Singapore, 15 Kent
coupled with high customer switching costs, results in
Ridge Drive, 119245, Singapore.
Email: a market outcome characterized by aggressive pricing
and reduced profits. A sudden reduction in customer
switching costs disrupts the conversion funnel and can
eventually increase industrywide prices and profitabil-
ity, an outcome that contradicts conventional wisdom
in strategy research. We develop a stylized model to
formalize our ideas and provide supportive evidence
using a difference-in-differences methodology with
staggered treatment for a large, global sample of mobile
telecommunications operators.
Managerial Summary: Industry changes that lower
customer frictions can surprisingly be beneficial for
companies. Building on the telecommunications indus-
try, we document how a reduction in customer
switching costs following mobile number portability
increases the profitability of mobile operators. We
explain this finding based on a change in companies'
business model. When switching costs are high, compa-
nies adopt a funnel business model designed to convert
customers from basic to advanced products. While
advantageous for a single company, when strategic
, interactions are accounted for, the diffusion of this
business model has a depressive effect on average mar-
ket prices and profitability. A reduction in customer
switching costs breaks the funnel and decouples prod-
uct pricing decisions that, counterintuitively, can lead
to higher industrywide prices and greater profitability.
KEYWORDS
business model, conversion funnel, customer switching costs,
industry profitability, market frictions
1 | INTRODUCTION
Extant strategic management (Chatain & Zemsky, 2011; Denrell, Fang, & Winter, 2003;
Porter, 1996; Shi, Chiang, & Rhee, 2006) and industrial organization (Beggs & Klemperer, 1992;
Klemperer, 1995; Tirole, 1988) literature defines customer switching costs as a source of market
power, leading to higher prices and increased firm profits. Switching costs can generate a lock-
in effect on customers (Porter, 1985), thus favoring incumbents (Brush, Dangol, &
O'Brien, 2012; Go mez & Maícas, 2011; Wei & Zhu, 2018) and reducing rivalry (Mas-Ruiz, Ruiz-
Moreno, de Guevara, & Martínez, 2014). Therefore, reducing customer switching costs should
arguably increase competition and reduce firm profits. Such anticipated outcomes lead to efforts
to increase online identity and data portability across online platforms as a means to reduce the
power of internet giants like Facebook or Google (Gans, 2018; Geradin & Kuschewsky, 2013).
Some of these interventions, designed to reduce customer switching costs, have generated the
expected outcomes (Viard, 2007); others, however, have produced unintended consequences
(Shi et al., 2006; Wei & Zhu, 2018), as firms can strategically respond to these changes.1 Surpris-
ingly, little attention in strategy research has focused on how firms respond to changes in cus-
tomer switching costs, despite the strategic importance of such market friction (Abolfathi,
Santamaria, & Williams, 2021; Burnham, Frels, & Mahajan, 2003; Chatain & Zemsky, 2011;
Mahoney & Qian, 2013). In this article, we develop a game-theoretic model to show how firms
modify their business models and adapt their pricing strategies in reaction to an exogenous
reduction in customer switching costs and test its empirical predictions in the global mobile
telecommunications industry. Contrary to conventional wisdom in strategy research, our find-
ings show that a reduction in customer switching costs has a positive effect on firms' average
price and profitability.
Our model builds on the notion that, in the presence of significant customer switching costs,
firms develop business models that resemble funnels, designed to convert customers of a basic
and inexpensive version of a product into adopters of an advanced and more profitable version.
Firms enjoy market power with their advanced version due to customer switching costs, yet
1
Viard (2007) finds that the portability of 800-numbers reduced prices for toll-free telephone services. In contrast, Shi
et al. (2006) provide evidence that wireless number portability led to discriminatory pricing schemes by large firms,
which increased market concentration. Similarly, Wei and Zhu (2018) show that larger firms were able to exercise
market power and keep prices high even after a reduction of customer switching costs.
, they also compete more aggressively with their basic version because they take into account the
rents from the conversion of customers to the advanced version. Put differently, by creating a
link between the pricing of the two versions, a conversion funnel business model shifts the
locus of competition toward the basic version market. The removal of customer switching costs
can be beneficial for firms as it breaks the conversion funnel logic and redistributes competition
between the two versions. Our model shows that average prices and profits increase after the
removal of customer switching costs if the advanced version market is more differentiated than
the basic version market.
The mobile telecommunications industry constitutes an attractive context to test our model
predictions. Most large mobile telecommunications firms have both prepaid and postpaid ser-
vice subscribers (Banker, Chang, & Majumdar, 1998; Shi, Li, & Bigdeli, 2016). Prepaid services
are relatively affordable and suitable for cost-conscious customers who want to try out the
mobile plan; postpaid services tend to be more expensive and address customer needs as they
evolve over time and as customers become more experienced users (Gruber, 2005). Firms typi-
cally offer prepaid services to attract new customers and then seek to generate lock-in effects,
with the ultimate goal of converting customers to more profitable postpaid services. This pro-
cess reflects a conversion funnel business model. In the late 1990s, countries around the world
started implementing mobile number portability (MNP) policies that have enabled customers to
switch their service providers while keeping their contact numbers, thereby substantially reduc-
ing switching costs. We explore how pricing strategies and profits have changed in the after-
math of MNP policy.
We collect data on mobile telecommunications operators worldwide from 2000 to 2017.
Because the implementation of MNP was staggered across countries, we can apply a difference-
in-differences approach. The results are consistent with our predictions. After the implementa-
tion of MNP, the price of prepaid services increased, while the price of postpaid services barely
changed. Moreover, the increase in the prepaid service price prompted a shift toward purchases
of postpaid services. The resulting change in customer composition (more customers buying
postpaid services) and the price increase in the prepaid segment increased firms' profits. Fur-
thermore, the effect of removing customer switching costs on prices is stronger in concentrated
advanced version markets where firms have high market power (arguably due to high differen-
tiation). Various robustness checks confirm and establish the theorized mechanism.
In turn, we make two primary contributions. First, we provide new insights into the strate-
gies firms adopt in the face of market frictions (Abolfathi et al., 2021; Burnham et al., 2003;
Chatain & Zemsky, 2011; Mahoney & Qian, 2013; Mawdsley & Somaya, 2018). Although several
studies have shown how customer switching costs help improve firm performance by creating
market power over locked-in customers (Brush et al., 2012; G omez & Maícas, 2011; Mas-Ruiz
et al., 2014), we suggest that when strategic interactions are accounted for, the picture becomes
more complex. We show how firms' business models interact in nontrivial ways with changes
in customer switching costs to determine firms' pricing strategies and profitability, which can
increase when market frictions are removed. Our attention to business models (Amit &
Zott, 2001; Teece, 2010; Zott & Amit, 2008) suggests a new contingency through which firm
profitability increases when rivalry restraints diminish (Makadok, 2010, 2011). Our findings can
likely be extended to other industries in which firms adopt a funnel business model to attract
new customers by offering an affordable basic version of a product in the hope that a significant
fraction of these customers subsequently shifts to a more advanced and expensive version.
Second, we contribute to studies on competition through business models (Casadesus-
Masanell & Zhu, 2010, 2013), highlighting how the presence of market frictions can force firms
