Monday, December 14, 2009
Posted by D. Daniel Sokol
Jiawei Chen (Department of Economics, University of California-Irvine) explains Switching Costs in Network Industries.
ABSTRACT: In network industries, switching costs have two opposite effects on the tendency towards market tipping. First, the fat-cat effect makes the larger firm price less aggressively and lose consumers to the smaller firm. This effect tends to prevent tipping. Second, the network-solidifying effect reinforces network effects by making a network size advantage longer-lasting and hence more valuable, thus intensifying price competition when networks are of comparable size. This effect tends to cause tipping. I find that when switching costs are high, the fat-cat effect dominates and an increase in switching costs can change the market from a tipping equilibrium to a sharing equilibrium. When switching costs are low, the network-solidifying effect dominates and an increase in switching costs can change the market from a sharing equilibrium to a tipping equilibrium. Policy intervention to remove switching costs in network industri! es may substantially reduce the likelihood of market tipping.