Review of Industrial Organization 17: 395–409, 2000.
© 2000 Kluwer Academic Publishers. Printed in the Netherlands.
Switching Costs in Vertically Related Markets
TOMMASO M. VALLETTI
London School of Economics, Politecnico di Torino and Centre for Economic Policy Research
Department of Economics, LSE, Houghton Street, London WC2A 2AE, UK
Abstract. In the presence of switching costs, ﬁrms are often interested in expanding current market
shares to exploit their customer base in the future. However, if the product is sold by retailers, manu-
facturers may face the problem of extracting too much surplus from the retailer. If this happens, then
the latter has not an incentive to build a subscriber base. This paper would like to connect two streams
in the literature, on switching costs and vertical restraints respectively. An upstream–downstream
duopoly model is presented to analyse the mutual incentive for ﬁrms to enter into particular trading
relationships. When switching costs are high, then integrated structures are predicted. On the other
hand, when lock in effects are not too relevant, mixed structures with independent and integrated
ﬁrms emerge as an equilibrium in growing industries. The results are discussed with reference to the
UK mobile telecommunications industry.
Key words: Foreclosure, integration, switching costs, telecommunications, vertical restraints.
Consumer switching costs make changing suppliers expensive and tend to lock
consumers into the ﬁrms they were previously patronising. If those who buy from
a ﬁrm now have a desire to buy from the same ﬁrm next period, then it is natural that
increasing market share is in the ﬁrm’s interest. In a stylised two-period model of
switching costs, a ﬁrm is usually willing to serve a larger set of customers in the ﬁrst
period than in traditional models because this enlarges its ‘captive’ segment of the
market in the following period. This theory of heightened competition for market
shares in the initial phase justiﬁes strategies like giving cheap introductory offers to
new customers, even if such behaviour involves some sacriﬁce of short-run proﬁt.
Switching costs lead to rents, but in turn these rents induce greater competition in
the early stages of the market’s development. Thus ﬁrms face a trade-off between
future proﬁts and present losses caused by the aggressive ﬁrst-period behaviour.
I am grateful to Pedro Pita Barros, David Salant, John Sutton and seminar participants at LSE,
Lisbon, Madrid, Stockholm, and various conferences for useful discussions and comments. I also
acknowledge the very constructive comments provided by General Editor William Shepherd and by
an anonymous referee.