Entry Deterrence in Markets with Consumer Switching Costs

Attention is focused on how the threat of new entry affects an incumbent's behavior in a market with switching costs and thus provides a simple explanation of limit pricing behavior. A firm may cut price before the date in which new entry is threatened to build up its customer base and thus deny customers to, and so reduce the profits of, any potential entrants. Unlike several others models, this form of limit pricing deters rational potential entrants, and a firm in the model does not directly dissipate first-period profits to signal information. If signaling the information is important, it is likely that there are far cheaper ways to do this. In other models, however, rational limit pricing actually may be followed by new entry because having a larger number of customers "buy in" to its product may help an incumbent even if entry does occur. First, the model is set out in a general framework. Then, the results are presented for the case of linear demand and costs, and it is shown that they do not depend on unusual assumptions.