Examples of `switching costs' include the transactions costs of closing an account with one bank and opening another with a competitor, the learning cost incurred by switching to a new make of computer, and the artificial costs created by `frequent-flyer' programmes. In Discussion Paper No. 704, Research Fellow Paul Klemperer notes that consumers' incentives to continue purchasing from one firm in such markets enable firms to exert monopoly power so that current market shares are major determinants of their future profits. This may explain managers' concern for market share rather than short-run profit and phenomena such as price discounts to attract new purchasers, price wars to gain or retain market share, and strategic behaviour to deter new entry.

In such markets, each firm faces a trade-off between charging low prices that attract new customers and charging high prices that capitalize on, but also run down its current market share. Klemperer shows that this trade-off implies that prices will be relatively low in new or growing markets but will rise with interest rates, reflecting variations in the importance firms attach to the future. Import prices will be relatively insensitive to current exchange rate changes, which foreign exporters will counteract with offsetting price changes, but they may be highly sensitive to expectations of future exchange rates, since there are strong incentives to raise prices to `take profits' before an anticipated weakening of the importer's currency. Price-cost margins vary across the business cycle, but they may be either pro- or countercyclical depending on demand variations.

Klemperer demonstrates that firms' incentives to exploit repeat- purchasers generally dominate their incentives to attract new customers, so prices in such markets are typically higher than elsewhere, while incentives to differentiate products functionally are also reduced. Thus public policy should seek to minimize switching costs. Switching costs may also account in part for multi-product firms, since single-product firms place themselves at a disadvantage by forcing consumers to incur switching costs or forgo variety. Explicit modelling of these costs' effects should yield further insights into the nature of competition between multi-product firms.

Competition When Consumers Have Switching Costs: An Overview
Paul Klemperer

Discussion Paper No. 704, July 1992 (AM)