Understanding innovation in services has always been complicated by the intangibility
of the underlying offering and hence the ease of imitation by rivals. This
study extends the transaction cost approach by investigating how the switching costs
created by the interaction between a service firm and its customers impact the level
of innovation activity by the organization. Using data obtained from a sample of
221 service firms, the findings suggest that when organizations structure their service
production processes in a manner that requires a high degree of direct face-to-face
interaction with the customer, the resulting impact is an increase in customer switching
costs. This, in turn, acts as competitive protection for these firms, inducing them
to pursue greater levels of innovation. In addition, we found that certain combinations
of customer-firm interaction and innovation activity led to superior performance.
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