Download Lecture slides Chap 5 and 7

Part III. Sources of market power
Chapter 5. Product differentiation
Slides
Industrial Organization: Markets and Strategies
Paul Belleflamme and Martin Peitz
© Cambridge University Press 2009
Introduction to Part III
Case. Competition in the banking deposit market
• There exists market power
• Positive intermediation margins
• Lerner index: US, 23% / Japan, 20% / EU, 15%
• Where does it come from?
• Consequence of firms’ conduct
• Marketing mix: Price - Product - Promotion
• Price  analysis of pricing strategies, see Part IV
• Product  Product differentiation  Chapter 5
 Web-banking, network of ATM, ...
• Promotion  Advertising  Chapter 6
 Informative: “Call 1-800 ING Direct. Hang up richer”
 Persuasive: “Britain’s best business bank” (Allied Irish)
 Complementary: “Washington Mutual. More human
interest”
© Cambridge University Press 2009
2
Introduction to Part III
Case. Competition in the banking deposit market
• Where does it come from?
• Consequence of market environment
• Consumer inertia  Chapter 7
• Because of a lack of information
 It’s time-consuming to compare deposit rates of
competing banks (and read the small prints)
 Source of price dispersion
• Because of switching costs
 Moving accounts from one bank to another takes time
(and possibly money)
 “Bargain-then-rip-off” pricing
 Customer poaching
© Cambridge University Press 2009
3
Chapter 5 - Objectives
Chapter 5. Learning objectives
• Understand that product differentiation involves
two conflicting forces: it relaxes price
competition, but it may reduce the demand that
the firm faces.
• Be able to distinguish between horizontal and
vertical product differentiation.
• Reconsider the question of entry into product
market.
• Be exposed to some basic approaches to
estimate differentiated product markets.
© Cambridge University Press 2009
4
Chapter 5 - Views on product differentiation
Views on product differentiation
• Product differentiation depends on consumers’
preferences.
• Characteristics approach
• Preferences are specified on the underlying
characteristics space
• Discrete choice approach
• Consumers have heterogeneous preferences and choose
one (and only one) product among the available products
• e.g., Hotelling model
• Representative consumer approach
• Consumers are assumed to be identical and have a variable
demand for all products
• e.g., linear demand model with 2 goods used in Chapter 3
© Cambridge University Press 2009
5
Chapter 5 - Views on product differentiation
Views on product differentiation
• Discrete choice approach
• Horizontal product differentiation
• Each product would be preferred by some consumers.
• Vertical product differentiation
• Everybody would prefer one over the other product.
• More formally: if, at equal prices,
• consumers do not agree on which product is the preferred
one  products are horizontally differentiated;
• all consumers prefer one over the other product  products
are vertically differentiated.
• Note 1: to account for supply side characteristics, modify the
definition by replacing “at equal prices” by “prices are set at
marginal costs”.
• Note 2: Not easy to draw the distinction in practice
© Cambridge University Press 2009
6
Chapter 5 - Horizontal differentiation
A simple location model
• Suppose constant price (e.g., regulated price): p
• Decision for firms: how to position product (where
to locate) in product space (in “linear city”): l1 ,l2 0,1
• Consumers
• Mass 1 uniformly distributed on ; location = ideal
point in product space; linear transportation cost
• Consumers buy at most one unit from one of the firms
• From product i, consumer x derives utility
vi (x)  r   x  li  p
• Indifferent consumer (l1 < l2): x̂  (l1  l2 ) / 2
• Firms’ demands:
Q1 (l1 ,l2 )  (l1  l2 ) / 2, Q2 (l1 ,l2 )  1  (l1  l2 ) / 2
© Cambridge University Press 2009
7
Chapter 5 - Horizontal differentiation
A simple location model
• Firms maximize profits w.r.t. their product
location given the location of the competitor

( p  c)(li  l j ) / 2
if li  l j


( p  c) / 2
if li  l j
 i (li ,l j )  

 ( p  c) 1  (li  l j ) / 2  if li  l j
• Unique Nash equilibrium: l  l  1 2
• Lesson: If duopolists choose product locations
1
2
(but do not set prices), they offer the same
product (no differentiation).
• Insufficient differentiation from social viewpoint
• To minimize total transport: l
1
© Cambridge University Press 2009
 1 4 , l2  3 4
8
Chapter 5 - Horizontal differentiation
Hotelling model
• Now, firms choose location and price.
• 2 stage model
•
•
1. Location choice (long term decision)
2. Price choice (short term decision)
We already studied (in Chapter 3) the price stage
with extreme locations (i.e., 0 and 1).
We repeat the analysis for any pair of locations
 2 scenarios:
•
•
Linear transportation costs
Quadratic transportation costs
© Cambridge University Press 2009
9
Chapter 5 - Horizontal differentiation
Linear Hotelling model
• Consumers
• Mass 1 uniformly distributed on ; location = ideal
point in product space; linear transportation cost
• Consumers buy at most one unit from one of the firms
• From product i, consumer x derives utility
• Firms
vi (x)  r   x  li  pi
• Choose first li in  and then pi
• Constant marginal cost of production, c
• We look for subgame perfect equilibria.
© Cambridge University Press 2009
10
Chapter 5 - Horizontal differentiation
Linear Hotelling model (cont’d)
• Price stage
•
•
•
Label firms such that l1  l2
If price difference “not too large”, there exists an
indifferent consumer located in [l1, l2]
l1  l2 p1  p2
r   ( x̂  l1 )  p1  r   (l2  x̂)  p2  x̂ 

2
2
What does “not too large” price difference mean?
x̂  l1  p1  p2   (l2  l1 )
x̂  l2  p1  p2   (l2  l1 )
© Cambridge University Press 2009
11
Chapter 5 - Horizontal differentiation
Linear Hotelling model (cont’d)
© Cambridge University Press 2009
12
Chapter 5 - Horizontal differentiation
Linear Hotelling model (cont’d)
• Price stage (cont’d)
•
•
•
What if price difference is “too large”?
Discontinuity in demand:
for p1  p2   (l2  l1 ), no demand for firm 1
for p1  p2   (l2  l1 ), no demand for firm 2
Profits

0

l1 l2
(
p

c)
 1 ( p1 p2 ;l1 ,l2 )   1
2 

( p1  c)


p2  p1
2
© Cambridge University Press 2009

if p1  p2   (l2  l1 ),
if p1  p2   (l2  l1 ),
if p1  p2   (l2  l1 ).
13
Chapter 5 - Horizontal differentiation
Linear Hotelling model (cont’d)
2 local suprema
  not quasiconcave in p1
Price equilibrium
may fail to exist
Happens when
locations are too
close.
© Cambridge University Press 2009
14
Chapter 5 - Horizontal differentiation
Linear Hotelling model (cont’d)
• Location stage
•
•
•
Price equilibrium fails to exist for some pairs of
location  no subgame perfect equilibrium
Where price equilibrium exists, firms want to move
towards zone where price equilibrium does not
exist.
Instability in competition
• Lesson: Although product differentiation relaxes
price competition, firms may have an incentive
to offer better substitutes to generate more
demand, which may lead to instability in
competition.
© Cambridge University Press 2009
15
Chapter 5 - Horizontal differentiation
Quadratic Hotelling model
• Only difference: transport costs increase with the
square of distance
vi (x)  r   (x  li )2  pi
• Indifferent consumer
l1  l2
p1  p2
r   ( x̂  l1 )  p1  r   (l2  x̂)  p2  x̂ 

2
2 (l2  l1 )
2
2
• Price stage
max p1 ( p1  c)x̂( p1 , p2 ) and max p2 ( p2  c)1  x̂( p1 , p2 )

p1*  c  3 (l2  l1 )(2  l1  l2 )

p  c  3 (l2  l1 )(4  l1  l2 )
*
2
© Cambridge University Press 2009
(unique price equilibrium)
16
Chapter 5 - Horizontal differentiation
Quadratic Hotelling model (cont’d)
• Location stage
̂ 1  181  (l2  l1 )(2  l1  l2 )2
̂ 2   (l2  l1 )(4  l1  l2 )
1
18
2

̂ 1 / l1  0 for all l1 [0,l2 )
̂ 2 / l2  0 for all l2 (l1,1]
• Subgame perfect equilibrium: firms locate at the
extreme points  maximum differentiation
• 2 forces at play
• Competition effect  differentiate to enjoy market power
 drives competitors apart
• Market size effect  meet consumers preferences
 brings competitors together
• Balance depends on distribution of consumers, shape of
transportation costs function and feasible product range
© Cambridge University Press 2009
17
Chapter 5 - Horizontal differentiation
Quadratic Hotelling model (cont’d)
• Lesson: With endogenous product differentiation,
the degree of differentiation is determined by
balancing
• the competition effect (drives firm to  differentiation)
• the market size effect (drives firm to  differentiation).
© Cambridge University Press 2009
18
Chapter 5 - Vertical differentiation
Vertical product differentiation
• All consumers agree that one product is
preferable to another, i.e., has a higher quality
• Consumers
• Quality is described by si [s, s ]  
• Preference parameter for quality:  [, ] 

• larger   consumer more sensitive to quality changes
• Each consumer chooses 1 unit of 1 of the products
• Uniform distribution on [, ], mass M    
• Utility for consumer  from one unit of product i
r  pi   si
© Cambridge University Press 2009
19
Chapter 5 - Vertical differentiation
Vertical product differentiation (cont’d)
• Firms
•
•
•
Duopolists
1. Choose quality: s1, s2
2. Choose price: p1, p2
Constant marginal cost, c 
Price stage
•
•
Suppose s1  s2
Indifferent consumer is determined by the ratio of
price and quality differences:
p2  p1
r  p1  ̂ s1  r  p2  ̂ s2  ̂ 
for ̂ [ , ]
s2  s1
© Cambridge University Press 2009
20
Chapter 5 - Vertical differentiation
Vertical product differentiation (cont’d)
• Price stage (cont’d)

0

p2  p1
p
 1 ( p1 p2 ; s1, s2 )   1 s2  s1  

 p1 (   )


if p1  p2   (s2  s1 ),
if  (s2  s1 )  p2  p1   (s2  s1 ),
if p1  p2   (s2  s1 ).
Solving the system of F.O.C.:
p1*  13 (  2 )(s2  s1 )
p2*  13 (2   )(s2  s1 )
(parameter restriction:   2 )
 Even the price of the lowquality firm increases with the
quality difference!
© Cambridge University Press 2009
21
Chapter 5 - Vertical differentiation
Vertical product differentiation (cont’d)
• Quality stage
•
Substitute for second-stage equilibrium prices in
profit function:  (s , s )  1 (  2 )2 (s  s )
1
•
1
2
9
2
1
 2 (s1, s2 )  19 (2   )2 (s2  s1 )
Both profits  in the quality difference  equilibrium
quality choices:
• Simultaneous: (s1 , s2 )  (s, s ) or (s , s)
•
Sequential: 1st (2nd) chooses highest (lowest) quality
• Lesson: In markets in which products can be
vertically differentiated, firms offer different
qualities in equilibrium so as to relax price
competition.
© Cambridge University Press 2009
22
Chapter 5 - Vertical differentiation
Case. VLJ industry: “Battle of bathrooms”
• Very Light Jets
• 4 to 8 passengers, city-to-city, 60 to 90-minute trips
You are not
going to have
women on a
plane unless
it has a
lavatory.
Jim Burns,
Founder of Magnum Air
Vertical differentiation
Ed Iacobucci,
CEO of DayJet Corp.
VS
Adam Aircraft A700
More expensive
Has a lavatory
Having a bathroom on board is
not an issue
for short trips.
Eclipse 500
Less expensive
No lavatory
© Cambridge University Press 2009
23
Chapter 5 - Vertical differentiation
Vertical differentiation and natural oligopolies
• Analysis of Chapter 4
•
•
•
Natural bounds to number of firms in oligopolistic
markets  main source: scale economies
Number of firms determined by entry process
In the presence of vertical differentiation
•
•
There may be a limited number of firms even for
negligible amount of scale economies.
Intuition from previous model
•
•
•
•
Recall equilibrium prices:
p1*  13 (  2 )(s2  s1 ), p2*  13 (2   )(s2  s1 )
Does not hold if
  2
In that case, if entry cost (however small), low-quality firm
does not enter  natural monopoly
Can be generalized to an n-firm oligopoly (see book)
© Cambridge University Press 2009
24
Chapter 5 - Empirical analysis
Probabilistic choice and the logit model
• Discrete choice models
•
•
Important to have consumers choosing differently to
have a ‘smooth’ aggregate demand.
How to formalize this?
•
•
Consumers are heterogeneous by nature.
 assumption made in this chapter (& in most of the book)
Alternative: probabilistic choice theory
 Ex ante (before some random variable is realized):
customers are the same.
 Ex post (after this realization): customers are different
 heterogeneity results from randomness.
 Modelling customer behaviour as probabilistic is
motivated by experimental evidence from the
psychology literature.
© Cambridge University Press 2009
25
Chapter 5 - Empirical analysis
Probabilistic choice and the logit model (cont’d)
• Random utility
•
Indirect utility function for a homogeneous good
vi  r  pi   i  vi
•
  i where E i  0
‘Observable’ or
‘measured’ utility
Reflects the preferences of
a subpopulation for good i
in expectation
Binary discrete choice model
•
•
•
Consumers face 2 alternatives, 1 and 2
Denote ei the realization of i
Choose alternative i if
vi  v j  e with e  realization of   1   2 , and E  0
© Cambridge University Press 2009
26
Chapter 5 - Empirical analysis
Probabilistic choice and the logit model (cont’d)
• Binomial logit
•
•
•
Assume that  is logistically distributed
F(e)  1 / [1  exp{e / }]
Probabilistic demand is then of the form
1
exp{v1 / }
Q1 

1  exp{(v1  v2 ) / } exp{v1 / }  exp{v2 / }
Multinomial logit
•
Extension to n products
Qi 

exp{vi / }
n
j 1
exp{v j / }
© Cambridge University Press 2009
27
Chapter 5 - Empirical analysis
Empirical analysis of horizontal differentiation
• Demand side
•
•
Consumers can choose among n products (+ an
outside good, noted 0, with utility = 0)
Market shares using multinomial logit (with )
i 
•
exp{vi }
1   j 1 exp{v j }
n
All consumers have the same mean utility level
vi   xi  i   pi
Vector of observed
characteristics
mean utility derived from
unobserved characteristics
© Cambridge University Press 2009
28
Chapter 5 - Empirical analysis
Empirical analysis of horizontal differentiation
• Demand side (cont’d)
•
•
•
Linear market shares in unobserved characteristics:
logi  log0   xi  i   pi
If we consider i as an error term, we can estimate
demand parameters () from this structural
model.
Supply side
•
•
Nash equilibrium in prices
ci   wi   i
Costs:
Relevant observable product
characteristics on the cost side
mean cost derived from
unobserved characteristics
© Cambridge University Press 2009
29
Chapter 5 - Empirical analysis
Empirical analysis of horizontal differentiation
• Estimation of the model
•
•
Firm i’s profits:  i  ( pi  ci )M  i
From F.O.C.:
pi  ci 
•
i
 i / pi
  wi 
 i / pi
  i   wi 
1
i
  i / vi
Using multinomial logit:
pi   wi 
•
i
1
1
 i
 1  i
Can be jointly estimated with
logi  log0   xi  i   pi
© Cambridge University Press 2009
30
 i
Chapter 5 - Empirical analysis
Extension: the nested logit model
• Limitations of the logit model
•
Restrictions are imposed on substitution patterns.
•
•
•
May be unrealistic
Example: product introduction in the family van segment
has different effects on the market share of a car in that
segment or on an SUV.
Possible answer: nested logit model
•
•
Group different products together in different nests.
Consumers select first among nests and then within
the selected nest.
© Cambridge University Press 2009
31
Chapter 5 - Review questions
Review questions
• In which industries is product differentiation
important? Provide two examples.
• What makes firms locate close to each other in
the product space? And what does it make them
to differentiate themselves from their
competitors?
• When is vertical product differentiation present in
an industry? Discuss demand and cost
characteristics.
© Cambridge University Press 2009
32
Chapter 5 - Review questions
Review questions (cont’d)
• Does the number of firms in an industry with
constant marginal costs necessarily converge to
infinity as the entry cost turns to zero? Explain.
• Why are we interested in empirically estimating
models of product differentiation? (After all, to
understand the intensity of competition in the
short run, we only need to know the Lerner
index.)
© Cambridge University Press 2009
33
Part III. Sources of market power
Chapter 7. Consumer inertia
Slides
Industrial Organization: Markets and Strategies
Paul Belleflamme and Martin Peitz
© Cambridge University Press 2009
Chapter 7 - Objectives
Chapter 7. Learning objectives
• Understand how firms can enjoy market power
when consumers are imperfectly informed about
the existence and prices of available products.
• Identify the sources of spatial and temporal price
dispersion.
• Examine how switching costs and consumer
lock-in affect competition.
• Study the dynamic problem that arises in
markets where firms are able to identify from
whom consumers have bought in the past.
© Cambridge University Press 2009
35
Chapter 7 - Uninformed consumers and search costs
Context
• Previous chapter
• Consumers didn’t know about existence, price or
characteristics of certain products.
• They obtained passively information through ads.
• This chapter
• Same lack of information but consumers search for
information themselves.
• Main results
• Positive search costs  market power (even when firms
produce a homogeneous good and compete in prices)
• Equilibria can exhibit price dispersion.
© Cambridge University Press 2009
36
Chapter 7 - Uninformed consumers and search costs
Price dispersion
• Price dispersion is observed in many industries
• At any point in time, prices for essentially the same
product are different across firms.
• Possible explanation
• Some consumers are better informed than others and
obtain a better deal than the less informed.
• 2 situations
• Spatial price dispersion
• One firm focuses on locked-in uninformed consumers,
enjoys a large markup but sells few units.
• The other firm also sells to all informed consumers; it
sacrifices on its margin but sells many units.
• Temporal price dispersion
• All firms randomize over price.
© Cambridge University Press 2009
37
Chapter 7 - Uninformed consumers and search costs
Spatial price dispersion
• A simplified (numerical) model
• 700 consumers, same demand: q  p
• 2 firms, same product, same marginal cost: c  
• 100 consumers know the prices of both firms.
• The other 600 only know the price of their neighboring
firm; 300 buy at each firm.
• Equilibrium of price competition?
• If firm only sells to uninformed consumers
• Optimal price: pm   profit u 3x x .
• For any price set by firm 1, one should ask whether
firm 2 has no incentive to set a slightly lower price, so
as to serve the informed consumers itself.
© Cambridge University Press 2009
38
Chapter 7 - Uninformed consumers and search costs
Spatial price dispersion (cont’d)
• Equilibrium (cont’d)
• Firm 1 won’t accept a profit lower than u.
•  p1 such that u  (3) p1 ( p1) 
• Candidate equilibrium: p1  and p2 
p1 
• Both firms have the same profit.
• Firm 2 only sells to its uninformed consumers.
• Firm 1 sells to the informed consumers (on top of its
uninformed ones).
• Firm 2 has no incentive to deviate.
• But firm 1 has ... (by selling at a price between 10 and 20, it
keeps the informed consumers and makes a larger profit).
•  there is no pure-strategy equilibrium in the
simultaneous price game.
© Cambridge University Press 2009
39
Chapter 7 - Uninformed consumers and search costs
Spatial price dispersion (cont’d)
• Sequential game
• Suppose firm 1 chooses first.
• If 1 sets p1 , 2 finds it profitable to set p2  p1.
•  There is a subgame perfect equilibrium in which
firm 1 sets p1   and firm 2 sets p2   .
• But there exists another equilibrium in which firm 1
sets p1   and firm 2 sets p2  .
• One checks that no firm has an incentive to deviate.
• Lesson: A homogeneous product market with
informed and uninformed consumers and
sequential price setting may exhibit spatial price
dispersion  one firm consistently charges a
high price and the other a low price.
© Cambridge University Press 2009
40
Chapter 7 - Uninformed consumers and search costs
Temporal price dispersion
• Same starting point
• 2 groups of consumers: some are informed about all
the prices and others are not
• Similar result
• Although all firms sell the same product, the law of
one price is violated: some consumers pay more than
others.
• What changes
• Price dispersion is temporal: the same firm sets
different prices at different points in time.
• Equilibrium in mixed strategies: firms choose a
probability distribution over some range of prices.
© Cambridge University Press 2009
41
Chapter 7 - Uninformed consumers and search costs
Temporal price dispersion (cont’d)
• Why do firms set “random prices”?
• Reason A. This prevents consumers from learning by
•
experience which is the firm that sets the lowest price
on the market  This reduces consumers’ incentive
to search for price information.
• Reason B. This makes it harder for competitors to
gain market shares through undercutting  There are
fewer “price wars”, which increases profits.
Formal model: see math slides
• Lesson: If firms compete in a market with
informed and uninformed consumers, the market
may exhibit temporal price dispersion; that is, at
equilibrium, firms randomize over prices.
© Cambridge University Press 2009
42
Chapter 7 - Uninformed consumers and search costs
Consumer search
• So far, information acquisition was exogenous
• Now: endogenous process
• Consumers decide whether or not they want to
acquire information (at some cost).
• Previous results carry over if we assume that search
costs (to know all prices) are high for one group and
low for the other group.
• In other situations, there is an incremental cost to
know one more price  consumers have to form
expectations about possible prices.
• We look for equilibrium configurations such that
consumers don’t regret, on average, their decision to
search for information.
© Cambridge University Press 2009
43
Chapter 7 - Uninformed consumers and search costs
The Diamond paradox
• Model (Diamond, 1971)
• Oligopoly producing homogeneous good at constant
marginal cost c.
• Consumers
• Learn (for free) existence and price of the product of 1 firm
(randomly drawn).
• If they want more information (about at least one additional
product), they must incur a cost z.
• Equilibrium?
• If search was free: p  c for all firms.
• No longer an equilibrium with z  Why?
• Suppose all other firms set p  c.
• Any firm can slightly  its price without losing its consumers,
because these consumers, observing this price, anticipate
that it’s not worth searching for additional information.
© Cambridge University Press 2009
44
Chapter 7 - Uninformed consumers and search costs
The Diamond paradox (cont’d)
• Equilibrium (cont’d)
• Equilibrium prices don’t tend to c when z tends to 0.
• Unique equilibrium: all firms set monopoly price, pm.
•
•
•
•
Consumers expect all firms to set pm.
 they have no incentive to search for information.
 a firm cannot  profit by unilaterally setting p  pm.
Same reasoning holds for all price below pm that all firms
would choose. But in this case, any firm would have an
incentive to deviate by setting a slightly higher price.
• Any price above pm cannot be an equilibrium.
• Lesson: If all consumers have positive search
costs, oligopolistic firms will set price equal to the
monopoly price.
© Cambridge University Press 2009
45
Chapter 7 - Uninformed consumers and search costs
Empirical investigation of price dispersion
• How to measure price dispersion?
• Start from price distribution.
• To compare levels of price distribution across time
and markets, use coefficient of variation (standard
deviation / mean)
• Alternative measure: sample range (difference between
largest and lowest observed prices in the sample)
• How to measure search intensity?
• Proxy: variables that affect benefits or costs of search
• Prediction: items that account for a large share of the
budget or that are purchased with a higher frequency
 more search  lower price dispersion
• Compare online & offline markets (search more costly
in offline markets).
© Cambridge University Press 2009
46
Chapter 7 - Uninformed consumers and search costs
Case. Does search intensity affect price dispersion?
• Lower price dispersion for items that...
• ...account for a large share of searcher’s budget?
• Stigler (1961): coefficient of variation of
 Coal (small share of government’s budget): 14.7%
 Automobile (large share of household’s budget): 1.7%
• ...are bought more frequently?
• Sorensen (2000): market for prescription drugs  purchase
frequency measured by dosage and duration of therapy
 Price ranges for one-time prescriptions are estimated to
be 34% larger than those for prescriptions that must be
purchased monthly.
• Online vs. offline markets
• Mixed set of findings; price dispersion is still very
present online although information costs 
© Cambridge University Press 2009
47
Chapter 7 - Switching costs
Switching costs
• Definition
• A consumer makes investments specific to buying
from a firm  it is more valuable to buy different
goods, or goods at different dates, from that firm.
• Switching costs give rise to consumer lock-in
• 2 contrasting effects on competition
• Ex post. Once a consumer has bought from some
firm, she is willing to pay more to continue buying
from this firm (up to the switching costs she avoids to pay)
 demand is less elastic for “locked-in” consumers
 firms have more market power on those
consumers
• Ex ante. Competition to get consumers locked-in in
the first place is fiercer the larger the switching costs.
© Cambridge University Press 2009
48
Chapter 7 - Switching costs
Case. Examples of switching costs
• Transaction costs
• Specialized suppliers (a critical component may be supplied by a
single supplier)
• Search costs (finding and evaluating new suppliers costs time)
• Contractual costs
• Breaking contracts can lead to compensatory damages
• Loyalty programs (switching can cause customers to lose out on
program benefits)
• Compatibility costs
• Durable purchases (replacing existing equipment can be expensive)
• Information and databases (new systems are needed when
companies change formats)
• Learning costs
• Brand-specific training (e.g., switching software means your team has
to learn a new interface)
• Uncertainty costs  experience goods
• Psychological costs  credence goods
© Cambridge University Press 2009
49
Chapter 7 - Switching costs
Competitive effects of switching costs
• Monopoly
• Overall effect is neutral: average price and allocation
remain unaffected
• Illustration: 2 periods, unit demand; pm = monopoly price in
the absence of switching costs; z = switching cost
• Optimal prices: 1st period: pm z; 2nd period: pm z
• Imperfect competition
• 2 contrasting effects
• Ex post: Lock-in  price-setting power   one expects
higher prices
• Ex ante: consumers are more valuable  more competition
for new consumers  one expects lower prices
• Net effect???
© Cambridge University Press 2009
50
Chapter 7 - Switching costs
Competitive effects of switching costs (cont’d)
• Imperfect competition (cont’d)
• 2-period duopoly model (extension of Hotelling model)
• Period 1: all consumers are inexperienced; they buy a
differentiated product, anticipating potential lock-in in period 2
• After period 1, a share of consumers leave the market and
are replaced by the same number of new consumers.
• Period 2: all remaining consumers from period 1 face a
switching cost if they buy from another firm than in period 1.
• Firms set prices in each period  2nd-period profits depend
on 1st-period prices (through 1st-period market shares)
• 2 scenarios
• Old consumers keep their preference from period 1 to 2.
• Preferences in the 2 periods are unrelated.
• See details in book.
© Cambridge University Press 2009
51
Chapter 7 - Switching costs
Competitive effects of switching costs (cont’d)
• Imperfect competition: summary of results
• Old consumers inherit 2nd-period preferences
• Firms sell at a discount in the 1st period but still at a higher
price than the one that would prevail absent switching costs.
•  Switching costs relax price competition.
• Old consumers newly draw 2nd-period preferences
• Firms sell at a discount in the 1st period.
• 1st-period price is below and 2nd-period price is just equal to
the price that would prevail absent switching costs.
•  Switching costs intensify price competition.
• Comparison
• In both scenarios: ‘bargain-the-rip-off’ prices (p1  p2)
• Net effect on prices depend on the degree of lock-in  no
clear recommendation in terms of regulation
© Cambridge University Press 2009
52
Chapter 7 - Switching costs
Coupons and endogenous switching costs
• Previous analysis: exogenous switching costs
• Here: endogenous switching costs
• Firms can reward ‘loyal’ consumers with coupons
 encourages repeat purchase
• Overall, coupons  the competitiveness of markets
• Lesson: Suppose that all consumers stay in the market
for 2 periods and newly draw their taste parameter in the
2nd period. Firms find it profitable to create switching
costs by announcing coupons in the 1st period that loyal
customers can redeem in the 2nd period. Coupons relax
price competition: 1st- and 2nd-period prices are higher
than in the absence of coupons (although loyal
customers pay a lower price in the 2nd period).
© Cambridge University Press 2009
53
Chapter 7 - Switching costs
Estimating switching costs
• Econometric methods
• Direct: choice modelling to estimate values that
consumers place on different product attributes
• Compare choice probabilities of old and new consumers
• Quantify impact on consumer choices of product feature that
is expected to create switching costs
• Indirect: use aggregate market data
• Estimate cross-price elasticities of consumption of a
particular brand between periods.
• Test predicted effects on prices of change in switching costs
• Non-econometric methods
• Measure the actual level of customer switching?
• Questionable: switching behaviour and switching costs are
not necessarily negatively correlated.
© Cambridge University Press 2009
54
Chapter 7 - Switching costs
Case. Impacts of number portability
• Switching costs and consumers’ valuation of
number portability service in the Korean mobile
communications market (Lee et al., 2006)
• Probabilistic choice model  compare choice
probabilities of new vs. current customers
• Absent switching costs, new and current consumers sharing
the same preferences should make the same choice.
• If current customers tend to choose the same alternative as
the one they chose in the past with a higher probability than
new customers  may indicate presence of switching costs.
• Conclusions
• Switching costs have been lowered considerably since
number portability has been in force.
• But, a significant level of switching costs still remains despite
number portability.
© Cambridge University Press 2009
55
Chapter 7 - Customer poaching
Customer poaching
• What is ‘customer poaching’?
• Firms make distinct offers to their rivals’ past
customers in order to attract them.
• Firms need to keep records of their customers.
• Particular case of behaviour-based price discrimination
(see Chapter 10)
• Issue for competition authorities
• Does customer poaching lead to higher overall prices?
• Model to address this question:
• 2 period duopoly model; horizontal product differentiation
• Firms can set different prices in period 2 depending on
whether or not consumers have bought the good in period 1.
© Cambridge University Press 2009
56
Chapter 7 - Customer poaching
Customer poaching: main results
• Lesson: Customer poaching is an equilibrium
phenomenon. It leads not only to lower prices for those
consumers who switch firms, but also to lower prices for
those consumers who do not, compared to a situation in
which conditioning on past consumer behaviour is not
possible. Consequently, firms make lower profits in the
second period.
• Lesson: Customer poaching with forward-looking
consumers relaxes price competition in the first period
but intensifies it in the second period. In total, firms would
be better off if they could agree not to poach each other’s
customers. On the opposite, poaching makes consumers
globally better off.
© Cambridge University Press 2009
57
Chapter 7 - Review questions
Review questions
• What is the effect of search cost on equilibrium
prices? In particular, what happens if all
consumers have positive search costs?
• Provide two examples of industries in which
search costs are likely to be important, and two
examples of industries exhibiting switching
costs.
• Many markets exhibit price dispersion. In light of
the theoretical analysis presented in this
chapter, how can one explain such a
phenomenon? Relate your discussion to the
analysis in Chapter 3 in which firms have private
information about costs.
© Cambridge University Press 2009
58
Chapter 7 - Review questions
Review questions (cont’d)
• How can one (i) measure price dispersion, and
(ii) empirically estimate switching costs?
• Does an increase in switching costs lead to
more relaxed or more intense competition?
Discuss.
• How do markets work in which firms poach
customers?
© Cambridge University Press 2009
59