Strategic Invasion in Markets with Switching Costs

We investigate the role of consumer switching costs in a three-stage model in which the entrant and the incumbent firm set prices sequentially and then the consumers decide from which firm to buy. We characterize the unique subgame perfect equilibrium and find that even an entrant with a higher marginal cost may profitably invade part of the market due to the existence of switching costs. Switching costs benefit both firms but harm consumers. This model is used to understand pricing behavior in the US telecommunications industry.