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Economics Letters
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Article history:
Received 6 August 2014
Received in revised form
19 November 2014
Accepted 5 December 2014
Available online 12 December 2014
JEL classification:
C7
L1
abstract
We revisit the effects of switching costs on dynamic competition. We consider stationary Markovian
strategies, with market shares being the state variable, and characterize a relatively simple Markov Perfect
pricing equilibrium at which there is switching by some consumers at all times. For the case of low
switching costs and infinitely lived consumers, we show that switching costs are pro-competitive in
the long-run (steady state) while the overall effect in the short-run (transient state) depends on market
structure. In particular, switching costs are anti-competitive in relatively concentrated markets, and procompetitive otherwise.
2014 Published by Elsevier B.V.
Keywords:
Switching costs
Continuous-time model
Markov-perfect equilibrium
Differential games
Market concentration
1. Introduction
Switching costs are widespread across a large range of products
and services. For instance, customers must bear a cost when
gathering information about a new product or service they would
like to switch to, or when adopting a new technology that has
limited compatibility with the old one. Other switching costs may
arise from contractual arrangements (e.g. service contracts with a
certain minimum term), or from loyalty programs (e.g. discount
coupons or frequent flyer cards), to name just a few.
Switching costs face consumers with a potential lock-in effect
which gives rise to dynamic market power. However, since past
choices create inertia in consumers future decisions, market share
becomes a valuable asset that firms are willing to fight for. This
http://dx.doi.org/10.1016/j.econlet.2014.12.008
0165-1765/ 2014 Published by Elsevier B.V.
151
(1)
(2)
is uniformly distributed in 12 , 12 .
When an opportunity to switch arises for a given customer, he
would opt for firm i (if currently served by firm j) provided that
ui
s
2
= vi pi
s
2
> uj = vj pj
where 2s is the switching cost incurred (s < 1). Hence, the probability that such a customer served by firm j switches to firm i, qji , is
given by
qji = Pr vj vi <
s
2
1
+ pj pi = (1 s) pi + pj
2
2. The model
ui = vi pi > uj = vj pj
add an additional parameter in the model, with only a scaling effect. One could
instead envisage a model in which the arrival rate is a function of firms prices.
However, this would further complicate the analysis, and it is out of the scope of
the current paper.
qii = Pr vj vi <
s
2
1
pi + pj = (1 + s) pi + pj .
2
Substituting qji and qii into (1) and taking the limit, as dt 0,
we obtain
x i (t ) = xi (t )(1 s) +
2 There are other recent papers showing the potential pro-competitive effect
of switching costs. See Viard (2007), Cabral (2011, 2012), Dub et al. (2009), Shi
et al. (2006), Doganoglu (2010), Arie and Grieco (2013), and Rhodes (2013). Our
paper differs from this literature, which features overlapping generation models for
finitely lived consumers and discrete time models of dynamic price competition.
3 The analysis is robust to arrival rates different from one. However, this would
s
2
1s
2
pi + pj .
4 The main conclusions of the paper are preserved if we allowed for more
sophisticated consumers. See Section 3 for further comments on this issue. See
Fabra and Garca (2013).
5 Note this assumption is consistent with Hotellings model of product
differentiation with product varieties at the extremes of a linear city uniformly
distributed in [0, 12 ]. Results are robust to allowing for more general distributions.
6 Note that q q reflects the fact that, for given prices, firm i is more likely to
ii
ji
retain a randomly chosen current customer than to steal one from firm j.
152
Substituting qji and qii into (2), we obtain the rate at which
revenue is accrued by firms 1 and 2,
1s
1 (t ) = p1 x1 (t )s +
p1 + p2
2
1+s
2 (t ) = p2 x1 (t )s +
+ p1 p2 .
R1 (p2 ) =
Given the assumption of full market coverage, payoff relevant histories are subsumed in the state variable x1 [0, 1]. Assume a
discount rate > 0. A stationary Markovian pricing policy is a
map pi : [0, 1] [0, p ] where p > 0 is the maximum price ensuring full-market coverage. We restrict our attention to the set of
continuous and bounded Markovian pricing policies, say P . For a
given strategy combination (pi , pj ) P P and initial condition,
x1 ( ) [0, 1] and < , the value function is defined as
(pi ,pj )
Vi
(x1 ( )) =
(pi ,p )
R2 (p1 ) =
p2 + s x1
2
1
p1 s x1
2
1
1
2
1
2
2
,
.
2
3
1
( s a) x 1
> 0.
2
Concerning dynamics, the fact that the large firm has the high
price implies that the large firm concedes market share in favor
of the smaller one. Therefore, market share asymmetries fade
away over time. In particular, the equilibrium state dynamics are
described by
Proposition 1. Assuming s < 53 , the unique Markov Perfect Equilibrium in affine pricing strategies is7 :
x 1 (t ) = x1 (t )(1 s) +
p 1 ( x1 ) =
(s a) x1
+ p
2
1
1
+ p
p2 (x1 ) = (s a) x1
where a 0,
s
2
x1 (t ) = x1 (0)e
2a 3 2 +
7
9
s a+
2
3
s2 = 0,
(3)
and
p =
1
2
a
2(1 + )
s 1+
a
2
31+
Hi = e
[i + i x 1 ],
V
i
x 1
= i
,
pi
pi
Hi pj
Hi
= i i .
x1
p j x1
+ .
2
4
3
1
(s a) x1
x 1 < 0.
2
(4)
which capture the inter-temporal trade-offs inherent in equilibrium pricing, i.e., marginal revenue equals the (marginal) opportunity cost (value loss) associated with market share reduction, and
the HamiltonJacobi equations
1 s+32a t
whose solution is
p1 (x1 (t )) + p2 (x1 (t ))
2
1
s + 2a
1
< 0,
= x1 ( t )
1s
(5)
7 Other MPE in non-linear strategies may exist. However, a complete characterization of MPE is beyond the scope of this paper.
153
Acknowledgments
We thank Juan Pablo Rincn (Universidad Carlos III) for many
helpful suggestions. Natalia Fabra acknowledges financial support
awarded by the Spanish Ministry of Science and Innovation, Project
ECO2012-32280. She is grateful to CEMFI for their hospitality while
working on this paper.
Appendix. Proofs of lemmas and propositions
Proof of Proposition 1. The Hamiltonians are
Hi = e t [i + i x 1 ],
for i = 1, 2. The Hamiltonians are strictly concave so that first
order conditions for MPE are also sufficient (see Dockner et al.,
2000),
Hi
= 0,
pi
Hi
Hi pj
= i i ,
x1
pj x1
for i = 1, 2. These respectively lead to:
p1 =
p2 + s x1
1
2
p2
= 1 1
x1
1
1
1
p2 =
p1 s x1
+ + 2
sp1 + (1 s)1 (p1 + 1 )
p1
= 2 2 .
x1
(A.1)
(A.2)
(A.3)
(A.4)
Eqs. (A.1) and (A.3) are firms best reply functions. Using them we
can obtain equilibrium prices,
+ + (2 21 )
2
3
s
1
1
1
p2 =
x1
+ + (22 1 ).
p1 =
x1
Thus,
p1
s
p2
=
= .
x1
x1
3
Substituting into (A.2) and (A.4) we obtain
2s
2s
2 = 2 2
2s
2s
p1 + 1
1 = 1 1 .
3
p2 +
1
1
+
a2 x 1
3 3
2
2
2
1
+ b2 2a1 x1
2b1
2s
1
+ 1
a1 x 1
+ b1
3
2
1
= a1 x 1 a1 x1
+ b1
2s
x1
154
1s
p1 + p2 a1 x1
b1
= a1 x1 (1 s) +
2
2
1s
2s
1
1 + 2
= a 1 x 1 ( 1 s ) +
x1
+
2
3
2
3
1
b1
a1 x 1
2
(1 s) x1
= a1
a1 x 1
1
2
2s
x1
+ b1 + a2 x1 21 + b2
a1 x 1
a1
s 1+
x1
p1 =
a1
s
1
b1 .
2
3
(A.6)
x1
2a2
2
3
1
1
2
a1 x 1
a2 x 1
+ b2
2s
1
3
(b1 + b2 )a2 +
sa
s 1+
a
2
+ +
2
2(1 + )
3(1 + )
s 1 + 2a
sa
1
1
a
p2 =
x1
+ +
.
3
2
2
2(1 + )
3(1 + )
3
x1
2
3
( s a) x 1
3
5
1s 1s
,
,
2
a
1
a
x1
1+
s
2
s
1 1
2 s
a
s 1
1 a
+
+ 1
+
.
31+ 3 3
2
3
3
2 s
a2
b2 .
(A.7)
The second term is negative, while the sign of the first term
cannot be determined in general. Solving for x1 , expression above
is positive if and only if
x1 >
x1 ( s) =
a2
a
1
a
x1
+
s
2
s
1 1
2 s
a
s 1
1 a
+
+ 1
+
.
31+ 3 3
2
3
3
2 s
s
1
= 1
a2 + (a1 + a2 )a2 a2
3
3
s
2s
2s
+ (2b2 b1 ) + b2 1
x1
p1
1
=
s
3
s + s(2a2 a1 ) + 1
9
p2
1
=
s
3
1
2
b2 .
2(1 + )
4s + 7a
a
=
(0, 1).
s
9(2 + ) 7s 12a
+ b 1 + a2 x 1
3(1 + )
s2 = 0.
+ b1 + a2 x1 21 + b2
p1 (x1 ) p2 (x1 ) =
1
a2 x 1
b2
2
1
2s
1
= a2 (1 s) x1
x1
1
2
2
3
s a+
+ 2b2 a1 x1
b1
2s
1
+ 1
a2 x 1
+ b2
3
2
1
= a2 x 1 a2 x1
+ b2
2
2s
1
1s
x1
= a2 x 1 ( 1 s ) +
a1 x 1
Or equivalently,
(b1 + b2 )a1 +
a
2
(A.5)
In a similar fashion,
2s
+ (a1 a2 ) = 0.
+ + (2 21 ),
2 3
1
1
1
s
x1
+ + (22 1 ).
p2 =
p1 =
2s
s
1
= 1
a1 + (a1 + a2 )a1 a1
3
3
s
2s
2s
(b2 2b1 ) + b1 1
=
b1 =
(a1 + a2 ) + s + 1
s + s(2a1 a2 ) + 1
9
2s
b1 .
2a2 3 2 +
(A.8)
2 s
1+ 3 3
2
s
1
1 a
1
a
+ 1
+
+
1+
.
3
3
2 s
2
s
1 s
p
1
follows since s1
2
1
, as the first term
2
is weakly increasing in
x1 and
< 0 for x1 =
becomes as < 0.
(iii) As s increases, the average price changes as follows:
(p1 p2 )
x1
p2
p (t )
=
x1 + (p1 p2 )
+
.
s
s
s
s
The first term is positive given that an increase in s enlarges
the difference between the prices charged by the two firms. This
follows from the fact that the price differential p1 p2 is directly
proportional to s a and, as shown above, as < 1. However, the
second and third terms are negative. Hence, the sign of the effect of
s on average prices is ambiguous. In particular, an increase in s leads
to a reduction in the average price only when firms are sufficiently
symmetric, i.e., if x1 <
x1 . Note that
x1 >
x1 (s) as x1 <
x1 (s) is a
sufficient condition for the average price to go down in s, as both
firms prices are decreasing in s (part (ii)).
Proof of Lemma 2. (i) It follows from the fact that p (t ) is inversely
proportional to sa and, as shown above, as < 1. (ii) The transition
to the steady state occurs at a rate which is inversely proportional
to s+32a , and as shown above, as > 0.
Proof of Proposition 2. Steady-state prices are
lim pi (t ) = p =
1
2
a
2(1 + )
s 1+
a
2
3(1 + )
< 0,
s
2(1 + ) s
3(1 + )
6(1 + ) s
where the inequality follows from as (0, 1) and a <
s
.
2
155
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