A prominent feature in many network industries is the existence of switching costs: consumers can switch between networks but it is costly (in terms of money and/or effort) for them to do so. Examples include PC operating systems, wireless phone services, DVD players, etc. In fact, according to Shy (2001), switching costs are one of the main characteristics of network industries that distinguish them from other types of industries. While there have been many studies that analyze network effects and switching costs separately, few have looked at them jointly, and it is unclear whether the findings thus far can be applied to markets in which those two factors coexist.
This paper focuses on the effects of switching costs in network industries. I build an oligopolistic model of price competition that incorporates both network effects and switching costs. Firms dynamically optimize. A Markov perfect equilibrium is numerically solved for, and I assess the effects of switching costs on the frequency with which market dominance occurs. The effects of switching costs on prices and welfare are also investigated.
I find that results are markedly different when we go from a setting with only switching costs to one with both network effects and switching costs. In particular, the literature on switching costs without network effects finds that switching costs have a fat cat effect, which makes the larger firm price less aggressively and lose consumers to the smaller firm. This effect tends to prevent market dominance, and as a result, markets with switching costs tend to be stable (Beggs and Klemperer (1992), Chen and Rosenthal (1996), Taylor (2003)). When network effects are incorporated into the analysis, switching costs also have a network solidification effect, which reinforces network effects by heightening the exit barrier for locked-in consumers and making a network size advantage longer-lasting. This effect facilitates tipping towards market dominance.
When there does not exist an outside good so that the market size is fixed, at low switching costs the network solidification effect dominates, and an increase in switching costs can change the market from a sharing equilibrium to a tipping equilibrium. But at high switching costs the fat cat effect takes over, and an increase in switching costs can change the market from a tipping equilibrium to a sharing equilibrium. When there exists an outside good, the fat cat effect is dampened by the competition from the outside good and switching costs tend to increase the likelihood of market dominance. The effects of switching costs on prices and welfare also critically depend on the strength of the network effect and the quality of the outside good.
Research on the effects of switching costs in network industries has significant policy relevance, especially in light of the regulations that are implemented or proposed to reduce switching costs in various network markets, such as phone number portability in wireless phone services markets in many countries and account number portability in retail banking and payments systems markets in the EU (ECAFSS (2006)). A good understanding of how market dominance, prices, and welfare are affected by switching costs will allow regulators to make informed decisions.
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Switching Costs and Dynamic Price Competition in Network Industries
