Dynamic Price Competition with Switching Costs

We develop a continuous-time dynamic model of competition with switching costs to show that in a relatively simple Markov Perfect equilibrium, the dominant …rm concedes market share by charging higher prices than the smaller …rm. In the short-run, switching costs might have two types of anti-competitive e¤ects: …rst, higher switching costs imply a slower transition to a symmetric market structure and a slower rate of decline for average prices; and second, if …rms’s market shares are su¢ ciently asymmetric, an increase in switching costs also leads to higher current prices. However, as market structure becomes more symmetric, price competition turns …ercer and in the long-run, switching costs have a pro-competitive e¤ect. When switching costs are asymmetric and consumers are myopic, in the long-run, the …rm from which it is costlier to switch is able to attain (and maintain) a degree of market dominance while charging higher prices. This may explain the prevalence of certain business practices (e.g. loyalty cards and frequent ‡yer miles). Keywords: Switching costs, continuous-time model, Markov-perfect equilibrium, market share asymmetries. Corresponding author: Alfredo García, email: [email protected]. We thank Juan Pablo Rincón (Universidad Carlos III) for many helpful suggestions. Natalia Fabra acknowledges …nancial support awarded by the Spanish Ministry of Science and Innovation, Project 2010/02481/001. She is grateful to CEMFI for their hospitality while working on this paper.