Sequential Entry, Switching Costs and Strategic Pricing

Rahul Telang Carnegie Mellon UniversityUday RajanCarnegie Mellon University

Agenda

MotivationLiterature ReviewMyopic ModelResultsForward Looking ModelConclusions

Motivation

Product Positioning, pricing and switching costs have been a great area of Interest in Marketing.Much of the work in switching cost domain points to the firm strategies of penetration pricing followed by higher prices.The key question is how do firms act when they enter a differentiated market sequentially where consumers face switching costs?

Research Question

What is the role of first period pricing? We show that unlike penetration pricing, incumbent is better off offering high prices in the first period which can then sustain higher non-cooperative “collusive prices” in the second period when an entrant enters.Consider the entry of Xbox with PlayStation as an expensive incumbent. Unlike popular belief, Xbox was priced higher than PlayStation in almost all markets including Japan. Even now, both are high price products.

Literature Review

Hauser and Shugan (1983)’s defender model provides the outline the strategy of differentiation.Hauser(1988) and Kumar and Sudarshan (1988) show that maximal differentiation is optimalAnsari et al (1994) generalizes the model to non-uniform preference and shows that maximal differentiation may not be optimal.Klemperer (1987) shows that in duopolistic structure, firms first offer penetration prices and then milk the base later in presence of switching costs.Wernerfelt (1991) shows how brand loyalty leads to higher prices.

Literature Review

Tyagi (2000) shows how incumbent may occupy unattractive location if it expects a superior competitor later.Klemperer (1987) shows how low first period output may be optimal in the presence of switching costs if new customers enter the market.In our paper, we outline a pure strategy and mixed strategy equilibrium such that incumbent strategically overprices its product to accommodate the entrant.

Model (Myopic Customers)

It can be shown that entrant will always maximally differentiateWhat’s the optimal prices p1 and p2 given p0 and switching cost s?

0pR

Second Period EquilibriumR = 2.4, s = 0.5, p_monopoly = 1.6

Incumbent and Entrant Reaction Functions

Second Period Equilibrium

R = 2.4, s = 0.5, p_monopoly = 1.6

Incumbent and Entrant Reaction Functions

Results

Switching Cost s

Incumbent offers monopoly po = pm.

Competitive pure strategyequilibrium in second

period

Incumbent overprices in first period po > pm.Collusive mixed

strategy equilibrium in second period

Incumbent overprices in first period po > pm.

Collusive pure strategy equilibrium in

second period

Incu

mbe

nt’s

Str

ateg

y

Slow Shigh

Implications

Maximal differentiation is robust strategy even in the presence of switching costsDeliberate overpricing and leaving a share of market to the entrant is an optimal strategy if entry can not be avoided.Switching costs are critical for this strategy to be sustainable.Both firms end up offering high prices (“collusive” prices) even in the second period reducing consumer welfare.

Sophisticated Customer

0pR

A sophisticated Customer can force competition in the second period byBuying today even though it gets negative utility.

Incumbent then can price its product even higher to force “collusive” prices.

Sophisticated CustomerThe tension between incumbent’s desire for high prices and customer’s desire for competition leads to the equilibrium.

Switching Cost s

Incumbent offers Penetration pricing po < pm. Competitive pure strategy

equilibrium in second period

Incumbent overprices in first period po > pm.Collusive mixed

strategy equilibrium in second period

Incumbent overprices in first period po > pm.

Collusive pure strategy equilibrium in

second period

Incu

mbe

nt’s

Str

ateg

y

ShighSlow

Implications

For lower switching costs we observed “penetration” prices in first period and for higher switching costs we observe “high” prices in first period.Higher switching costs are needed for the incumbent to sustain “collusive” prices when customers are forward looking.Interestingly, forward looking customers could do worse if the “collusive” equilibrium is sustained.

Questions?