Do Switching Costs Make Markets Less Competitive ?

The conventional wisdom in economic theory holds that switching costs make markets less competitive. This paper challenges this claim. We formulate an empirically realistic model of dynamic price competition that allows for differentiated products and imperfect lock-in. We calibrate this model with data from frequently purchased packaged goods markets. These data are ideal in the sense that they have the necessary variation to separately identify switching costs from consumer heterogeneity. Equally important, consumers exhibit inertia in their brand choices, a form of psychological switching cost. This makes our results applicable to the broad range of products that are distinctly identified (i.e. branded) rather than just to those products for which there is a product adoption cost or explicit switching fee. In our simulations, prices are as much as 18 per cent lower with than without switching costs. All correspondence should be addressed to Peter Rossi, Graduate School of Business, University of Chicago, 5807 S. Woodlawn Avenue, Chicago, IL 60637; or via e-mail: [email protected]. We are grateful for comments and suggestions from Alan Sorenson, Matt Gentzkow, Ariel Pakes, Peter Reiss, Miguel Villas-Boas, and seminar participants at the University of British Columbia, the University of Chicago structural IO lunch, Erasmus University in Rotterdam, HEC Montreal, New York University, Northwestern University, the University of Minnesota, Universiteit van Tilburg, Yale University, the Canadian Competition Bureau, the Chicago Federal Reserve Bank, the 2006 NBER summer I.O. meetings, the 2006 SED conference, the 2007 Summer IO conference at UBC and Yahoo! Inc.. Support from the Kilts Center for Marketing, Graduate School of Business, University of Chicago is gratefully acknowledged.