Habit Forming Consumers and Firm Dynamics

Abstract

In many markets consumers form long-term relationships with firms. In such settings, a firm's existing customers are valuable assets whose 'loyalty' must be maintained through continued investment. In this paper we assume that consumer loyalty is strengthened by repeated buying but may erode if the relationship is interrupted. In this context we show how a firm's history of costs and sales and the size of its customer base determine the extent to which it invests in maintaining its long term customer relationships by satisfying demand even when this involves a short-term loss. We show that for appropriate parameters, firms whose customer base is still small, and its customers' loyalty tenuous, invest to establish and reinforce customer loyalty and grow its customer base. However, once a firm is sufficiently large and its customers' habit sufficiently entrenched, its incentive to invest in customer retention declines and it stocks the product only when this is profitable in terms of current profit.

Keywords: firm dynamics, firm growth, habit formation, consumer dynamics