In many markets, `switching costs' give consumers a strong incentive to continue buying from the same firm, even if other firms are selling functionally identical products. This may rationally explain managers' observed concern with market shares rather than short-run profits, since firms' monopoly power over their customers makes current market share an important determinant of future profits. There may also be implications at the macroeconomic level concerning the counter-cyclical behaviour of price-cost margins over the business cycle and the slow response of trade balances to exchange rate changes.

In Discussion Paper No. 436, Alan Beggs and Research Fellow Paul Klemperer present a multi-period model of a market with switching costs that allows both for varying consumer expectations of future prices and for the fact that not all new consumers buy from one firm. New customers arrive and a fraction of old and new customers leave the market in every period. In the last period, firms' power over existing customers leads to high prices, while in the first period they typically set low prices. In all other periods a firm trades off the desire to exploit its current customer base against the need to attract new customers. Beggs and Klemperer show that the incentive to set high prices dominates: prices and therefore profits are higher as a result of switching costs, and new entry may therefore be more attractive, even though part of the market is locked into the incumbent's product.

Beggs and Klemperer examine the evolution of market shares and prices after new entry and show that market shares converge to a stable equilibrium, and if the firms face identical costs their shares will be equal in the long run. Further, in the presence of switching costs, prices rise if firms increase their discount rate, but they fall if consumers do so. Prices fall with increases in consumer turnover or the rate of growth of the market. Beggs and Klemperer distinguish analytically between switching costs that are real such as transaction costs and those that are artificial created by contracts or repeat-purchase discounts, but they show that these both types have very similar effects.

Finally, Beggs and Klemperer argue that the profitability of exploiting current market share vis-à-vis the expected future benefit from increasing market share varies over the business cycle, so consumer switching costs may therefore explain observed variations in price-cost margins, and they also examine the effects of expected changes to taxation or the exchange rate on current behaviour. Although the model formally represents a market with switching costs, similar results may also apply to markets in which a firm's future profitability depends on its current market share for other reasons, such as `search' costs to consumers, the fact that past sales advertise a firm's product or even `irrational' brand loyalty.