Vertical integration and exclusivity contracts when consumers have switching costs

This paper extends the literature on switching costs by considering what happens when retailers and manufacturers are separate entities and some customers are locked in with retailers. This separation introduces a dynamic inconsistency problem as manufacturers face the problem of extracting too much surplus from the retailer in which case the retailer has no incentive to build a subscriber base. It is shown that different trading relationships arise according to the nature and magnitude of switching costs. When switching costs are high, then integrated structures are always predicted (or exclusive dealerships in case vertical integration is banned). Vertical integration should be allowed as it provides high-powered incentives to acquire market shares. * I am grateful to Jonathan Hamilton (the Editor), two anonymous referees, Pedro Pita Barros, Patrick Rey, John Sutton, seminar participants in Lisbon, London, Milan, Stockholm, Toulouse, and conference participants at the annual meetings of ESEM, EARIE, and TPRC for useful discussions and comments.