Competition and market dynamics in duopoly: the effect of switching costs

A dynamic game framework is developed to study market dynamics between two manufacturers/service providers competing on pricing and switching costs. In this game, a portion of consumers may choose to upgrade their products by repurchasing from one of the providers in each period. The switching cost is the one-time costs when consumers “switch” from one provider to another. Switching costs provide consumers an incentive to continue buying from the same firm even if its competitors offer functionally identical but incompatible products. In practice, the switching costs can be increased or decreased by firms through designing products. A mixed logit demand model, which can arbitrarily closely approximate any discrete choice behavior of consumers, is adopted to characterize the dynamic market evolution under stochastically varying consumer preferences. We find that switching costs are usually beneficial to the firm with a dominant market share. Moreover, large switching costs can be detrimental to the firm with a disadvantaged market share, so it wants to decrease switching costs. On the contrary, small switching costs have a negative effect on the demand of the firm with a weak market share but benefit its profit by leading a high price. We implement a simulation study to validate our theoretical results on market dynamics.