Swedish School of Economics and Business Administration the Yrjö Jahnsson Working Paper Series in Industrial Economics

We show that the presence of sufficiently significant switching costs, which are increasing in the degree of product differentiation, generates an equilibrium configuration with maximal differentiation within the framework of a Hotelling model with linear transportation costs. The equilibrium with maximal differentiation offers a formalization of the idea that competing firms have noncooperative incentives to establish maximal switching cost barriers. The equilibrium incentives for commitments to high switching costs can be explained with poaching profits, which are increasing in the switching costs. In fact, ex-ante competition for market shares in period 1 is unable to eliminate these poaching profits.