DP4996 Two at the Top: Quality Differentiation in Markets with Switching Costs

Author(s): Thomas Gehrig, Rune Stenbacka
Publication Date: April 2005
Keyword(s): natural oligopoly, poaching, quality choice, switching costs
JEL(s): D43, L15
Programme Areas: Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4996

We explore the effects of switching costs on the subgame perfect quality decisions of oligopolists with repeated price competition. We establish a strong strategic quality premium. We show that competition for the establishment of customer relationships will eliminate low-quality firms in period 1 and that low-quality firms can survive only based on poaching profits. The equilibrium configuration is characterized by an agglomeration of two providers of top-quality as soon as switching cost heterogeneity is sufficiently significant. We demonstrate a finiteness property, according to which the two top-quality firms dominate the market with a joint market share exceeding 50%.