Review of Industrial Organization 12: 79–94, 1997.
1997 Kluwer Academic Publishers. Printed in the Netherlands.
The Effect of Consumer Switching Costs on Prices:
A Theory and its Application to the Bank Deposit
STEVEN A. SHARPE
Board of Governors of the Federal Reserve System, Washington, D.C. 20551, U.S.A.
Abstract. As demonstrated by Klemperer (1987), if households face a cost of switching among
brands of a differentiated good, pricing is likely to be more competitive, the greater is the fraction
of customers that move into or around the market. I generalize this theory to a world with arbitrary
market structure and test it empirically using panel data on bank retail deposit interest rates. I ﬁnd
that the amount of household migration in a market has a signiﬁcant competitive inﬂuence on price
markups, that is, a positive effect on the level of deposit interest rates. Consistent with the model, the
magnitude of this effect depends in some cases upon the degree of market concentration.
Key words: Switching costs, market concentration, deposit rates.
As argued by Klemperer (1987), if households face costs of switching among
suppliers of a differentiated good, market prices may be far from competitive,
regardless of the number of suppliers. In particular, Klemperer’s theory charac-
terizes a relationship between the competitiveness of pricing and the degree of
turnover or growth in a market’s customer base. Even in the presence of small
switching costs, the theory generally predicts that the greater is the proportion of
customers that are “new” to the market, the more competitive prices will be.
Switching costs are potentially important in markets where signiﬁcant infor-
mation or transaction costs exist, but they are probably most inﬂuential where
such costs appear to give rise to long-term relationships and repeated transactions.
Such relationships–implicit or explicit–clearly abound, particularly among service
industries such as medical care, auto repair, life insurance, and banking services.
Despite this, there is little or no empirical work aimed at gauging the inﬂuence of
switching costs on pricing. One exception to this is provided by Ausubel (1991),
The views expressed herein are the author’s and do not necessarily reﬂect those of the Board of
Governors nor the staff of the Federal Reserve System. This research has beneﬁted in no small part
from many helpful discussions with Richard Rosen, as well as comments from Dean Amel, Bruce
Greenwald, Joel Lander and Alan Reichert, and research assistance provided by Gerhard Fries and