DP6229 Price Competition in Markets with Customer Testing: The Captive Customer Effect

Author(s): Heidrun C. Hoppe-Wewetzer, Ulrich Lehmann-Grube
Publication Date: April 2007
Keyword(s): Hotelling, Iterated elimination of strictly dominated strategies, Mixed strategy, Price competition, Testing
JEL(s): D83, G21, L13
Programme Areas: Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6229

We introduce product differentiation into the analysis of price competition in markets where suppliers test customers in order to assess whether they will pay for received goods or services. We find that, if the degree of differentiation is sufficiently high, suppliers may improve the average probability that their clientele will pay by charging higher prices. This helps suppliers to sustain high prices in equilibrium. Moreover, endogenizing locations in product space, we demonstrate that the high price level can be implemented in a pure-strategy subgame-perfect equilibrium with a high degree of differentiation. This is in contrast to the original Hotelling model with linear travel costs where a pure-strategy subgame-perfect equilibrium fails to exist.