Product Innovation with Industry Leaders and Consumer Switching Costs*

Abstract

Innovation enhances product functionality but may require consumer learning for full product utilization. Familiarity with a product facilitates adoption of updated products, whereas rival products require additional learning, effectively imposing a switching cost on consumers. We use a Stackelberg leadership model to explore how product innovation and switching costs impact competition in markets with heterogenous consumers learning. Our analysis focuses on markets typically dominated by an incumbent firm and consumers with varying levels of technology comprehension. Our findings indicate that greater switching costs necessitate greater product appeal from an entrant to challenge an incumbent firm’s product. When switching costs are sufficiently high, industry leaders are disincentivized from innovating due to captive their captive consumer base, which could render market entry socially undesirable due to the learning-related switching costs associated with a competitor’s product. Our analysis suggests that policies designed to lower switching costs, such as product standardization, unambiguously increase consumer surplus and overall welfare but can negatively affect product innovation. Conversely, the acquisition of an entrant firm by the industry leader can increase social welfare without reducing innovation.

Keywords: switching costs; industry leader; learning; R&D investment; product appeal

JEL Classification: D43, L15, C72, O32, L2