Reimbursing Consumers’ Switching Costs in Network Industries

This paper investigates firms’ decisions to reimburse consumers’ switching costs in network industries. Prior literature finds that switching costs incentivize firms to harvest their locked-in consumers rather than price aggressively for market dominance, thereby resulting in a lower market concentration. Using a dynamic duopoly model, we show that this result is reversed if firms have the option to reimburse consumers’ switching costs. In that case the larger firm reimburses a greater share of the switching cost than the smaller firm does, as an additional instrument to propel itself to market dominance. Consequently, an increase in the switching cost increases market concentration. Compared to the case without switching cost reimbursement, allowing firms the option to reimburse results in greater consumer welfare despite having a higher market concentration, as consumers are helped by larger network benefits and often lower effective prices.