Bargains Followed by Bargains: When Switching Costs Make Markets More Competitive

• DOI: http://doi.org/10.1111/jems.12158
• Published date: 01 December 2016
• Date: 01 December 2016

Bargains Followed by Bargains: When Switching

Costs Make Markets More Competitive

JASON PEARCY

Montana State University

Bozeman, MT 59717

jason.a.pearcy@gmail.com

In markets where consumers have switching costs and firms cannot price-discriminate, firms

have two conflicting strategies. A firm can either offer a low price to attract new consumers and

build future market share or a firm can offer a high price to exploit the partial lock-in of their

existing consumers. This paper develops a theory of competition when overlapping generations

of consumers have switching costs and firms produce differentiated products. Competition takes

place over an infinite horizon with any number of firms. This paper shows that the relationship

between the level of switching costs, firms’ discount rate, and the number of firms determines

whether firms offer low or high prices. Similar to previous duopoly studies, switching costs are

likely to facilitate lower (higher) equilibrium prices when switching costs are small (large) or

when a firm’s discount rate is large (small). Unlike previous studies, this paper demonstrates

that the number of firms also determines whether switching costs are pro- or anticompetitive, and

with a sufficiently large (small) number of firms switching costs are pro- (anti-) competitive.

1. Introduction

When consumers have switching costs, a consumer’s previous purchase partially locks

them in to the same future purchase. Firms have two different strategies when their

previous customers are partially locked-in. A firm can offer a high price to exploit the

partial lock-in of their existing consumer base, but a high price will lead to more of its

customers switching and a decrease in future market share. Alternatively, a firm can

offer a low price to attract new consumers and invest in market share with the hope

of offering a high price in the future to more partially locked-in customers. This paper

presents conditions that determine whether equilibrium prices will be higher or lower

with switching costs and shows that the number of firms is an important factor when

considering how switching costs affect competition.

The previous literature has approached a firm’s use of pricing strategies with

switching costs in different ways.1Competition usually takes place over two periods

or infinitely many periods. Two-period models dampen the exploitation/investment

trade-off in any one period by allowing for some intertemporal substitution between

I thank Daniel Spulber (the editor), a coeditor, two reviewers, Stefano Barbieri, Michael Baye, Keith Finlay,

Eric Rasmusen, Jay Shimshack, seminar participants at Tulane University, Montana State University,Purdue

University, Quinnipiac University, Indiana University (BEPP), IUPUI, the Spring 2009 Midwest Economic

Theory Conference, and the 2010 IIOC for helpful comments and suggestions. All remaining errors are

my own. Financial support provided by the Committee on Research Summer Fellowship and the Research

Enhancement Fund at Tulane University is greatlyappreciated.

1. See Villas-Boas (2015), Farrell and Klemperer(2007), and Klemperer (1995) for surveys of the switching

cost literature.

C2015 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume25, Number 4, Winter 2016, 826–851

Bargains Followed by Bargains 827

the two different pricing strategies.2This type of behavior leads to the familiar result

of bargains-then-rip-offs (Klemperer, 1995).3If competition takes place over infinitely

many periods instead, firms must balance both investment and exploitation strategies

at once in each period.

Other approaches, such as dynamic pricing or subscription models, assume that

firms can price discriminate to offer a price for its previous customers and a different

price for new customers.4The typical result is a scenario where bargains are followed

by rip-offs, where new consumers without switching costs are offered a low price and

old customers with switching costs are offered a high price (Farrell and Klemperer,

2007).5Instead, if firms are unable to price discriminate, because they cannot identify

consumers by their past purchases, firms offer only one price to all consumers. In this

case, the exploitation and investment strategies conflict with one another and create an

explicit trade-off within each period.

This paper develops a switching cost model that exemplifies the trade-offs between

the two strategies because firms set one price for all consumers and competition takes

place over an infinite number of periods. The main purpose of this paper is to demon-

strate under what conditions switching costs lead to lower or higher prices in any

steady-state symmetric equilibrium, and under what conditions an increase in switch-

ing costs decreases the price. Both of these results depend on the number of firms, the

level of consumer switching costs, and firms’ discount factor. One of the contributions of

this paper is to show that switchings costs may be pro- or anticompetitive depending on

the number of firms in the market, and allowing for any number of firms in the model

provides the necessary insight into the main result.

The intuition of the main results and the reasoning why both results depend on the

number of firms in the market are explained by the following points. For any symmetric

equilibrium, the market share of each firm is the inverse of the number of firms. Under

the duopoly case, each firm commands half of the market and has a large consumer base

partially locked-in to their firm. If instead, there are five firms in the market, each firm

has only one-fifth of consumers with switching costs partially locked-in to their firm.

The returns to exploitation are lower when a firm is only able to exploit one-fifth of the

consumer base versus one-half. Therefore, it is more likely that the investment effect

dominates with many firms and the exploitation effect dominates with a duopoly.6

Recent empirical evidence is consistent with this intuition as well. Viard (2007)

examines a duopoly market and finds that a decrease in switching costs leads to a

decrease in equilibrium prices. Dub´

e et al. (2009) examine two markets, one with six

products and one with four, and find that as switching costs increaseequilibrium prices

decrease. The results of Dub´

e et al. also indicate that the number of firms and products

needed to lower the price in a market with switching costs may not be unreasonably

large.

2. The end-game effects of two-period models are discussed in more detail by Cabral (2014) and Rhodes

(2014).

3. Firms may have an incentive to lower prices in the second period if new consumers enter the market,

but the exploitation strategy still dominates.

4. See Armstrong (2006) and Chen (2005) for a survey of the dynamic pricing literature.

5. Note that this result is the opposite for dynamic pricing models without switching costs, see Chen and

Pearcy (2010).

6. With many firms, prices with switching costs may be lower than prices when all consumers have no

switching costs. This result indicates that the investment effect dominates the exploitation effect even in the

presence of more intense competition.