Switching Costs and Resale at a Loss in the Internet Industry

Abstract

This paper studies the optimal pricing strategies of two horizontally-differentiated Internet Service Providers (ISPS) through a dynamic game. Each ISP discriminates between locked-in and new end-users. These are assumed to incur not only transportation costs, but also switching costs if they will change supplier. In fact, we intend examine the conditions under which end-users are locked-in and the ones under which the ISPS sell at a loss.

In the Internet industry, end-users incur switching costs when they change access supplier. Each ISP faces then two types of end-users: locked-in and new end-users. When ISPS are able to discriminate between them, they can charge new end-users a below-cost access price over the current period with the aim to lock them in the future. This pricing strategy is a Resale at a Loss (hereafter R2aL) because the access to the Internet is sold by a backbone to an ISP who in turn sells it to the end-users. For example, in order to improve sales, some ISPS offer a free subscription over a given period.

Klemperer (1995) has simply mentioned in no-discrimination context that, when switching costs are sufficiently high, firms can lower their prices below marginal cost. Since, several studies have analyzed the price discrimination between locked-in and new consumers, like Chen (1997), Shaffer and Zhang (2000), Taylor (2003) and Cabral (2012). Only Taylor (2003) has showed that the R2aL is adopted when at least three firms act in the market. In contradiction with Taylor (2003), we show that the R2aL holds even if the market is a duopoly.

Our paper’s model assumes a two-period dynamic game between two horizontally-differentiated ISPS where end-users’ switching and transportation costs are distinguished from each other. In the first period, we consider three market structures: two cases where an ISP is active alone and one case where both ISPS share the market. In the three scenarios, each ISP seeks determining the optimal price. In the second period, end-users have the choice between whether to stay with the current supplier or to switch. In this period, the ISPS discriminate between the locked-in and the new end-users by charging them different prices.

Relative to the existing literature, we obtain, in our paper, the following three interesting results:

i) The switching costs level end-users incur in the second period affect the market structure. There exists a threshold of these costs, depending on the transportation costs, above which entry is blocked. Actually, if only one ISP is active over the first period, it can keep its monopoly power at the second period when the switching costs are sufficiently high. In this case, no end-user is incited to switch to the other ISP. In contrast, when switching costs are sufficiently low, the competitor becomes able to enter the market and captures a certain market share;

ii) In the second period and in the case where the two ISPS are active, end-users are locked-in even if the switching costs they bear are low. This result differs from that obtained in the literature on switching costs, with or without discrimination, according to which consumers are locked-in only if such costs are so high;

iii) There exists another threshold of the switching costs, depending also on the transportation costs, from which the two ISPS practice during the first period the R2aL strategy in order to attract further consumers to locked-in over the second period. This result differs from that found by Taylor (2003).

Keywords: Switching costs, Resale at a loss, Price discrimination, Horizontal differentiation, Internet industry

JEL Classification: L96, L110, L42