Optimal Pricing of Services with Switching Costs

Customer switching costs are an important factor in account-based services such as telecommu-nications, financial, insurance and brokerage services. In these businesses, existing customersincur significant costs if they switch to another provider. Such costs include physical config-uration and installation costs, contractual costs (e.g. termination fees) and cognitive costs oflearning. These switching costs enable a firm to extract more revenue from incumbent customersby charging them higher prices. However, higher prices disproportionately deter new customersfrom buying, because, ex ante, they face similar set-up and learning costs with all providers andhence are more price sensitive. This raises an important question of how best to balance thetradeoff between short-term revenue gains and long-run account growth. We develop an optimalcontrol model to study this tradeoff. We show that a simple target market share policy is theoptimal strategy. In particular, there exists a target price and target market share such that thefirm should price to reach the target market share as fast as possible, at which point it shouldswitch to the target price. We also examine how these targets change with the competitiveoutside price, shopping frequency of customers, firm’s discount rate and market growth rate. Inaddition, we extend the basic monopoly model to the duopoly case in which two firms competefor market share and maximize their expected discounted revenue. We also look at the situationin which a firm is able to charge a lower introductory price to attract new customers.