Who Pays for Switching Costs

Abstract

Earlier work characterized pricing with switching costs as a dilemma between a short-term 'harvesting' incentive to increase prices versus a long-term 'investing' incentive to decrease prices. This paper shows that small switching costs may reduce firm profits and provide short-term incentives to lower rather than raise prices.

We provide a simple expression which characterizes the impact of the introduction of switching costs on prices and profits for a general model. We then explore the impact of switching costs in a variety of specific examples which are special cases of our model. We emphasize the importance of a short term 'compensating' effect on switching costs.

When consumers switch in equilibrium, firms offset the costs of consumers that are switching into the firm. If switching costs are low, this compensating effect of switching costs causes even myopic firms to decrease prices. The incentive to decrease prices is even stronger for forward looking firms.

Keywords: Switching Costs, Dynamic Oligopoly, Oligopoly Pricing

JEL Classification: D43, L13, C73