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Edited by Michael Dietrich and Jackie Krafft
Chapter 31: Product Innovation when Consumers have Switching Costs
Evens Salies 31.1 INTRODUCTION A primary weapon of a capitalist society is the development of new products that firms race to introduce before a competitor comes out with a model that consumers will like much better (Baumol, 2006). Economists have long recognized, however, that in free markets, incentives to innovate will be diluted unless some factors grant innovators a temporary monopoly (Tirole, 1988). Patenting is the most cited factor in the economic literature. This survey concentrates on another factor that confers innovators with firstmover advantage over their competitors, namely consumer switching costs, whereby ‘a consumer makes an investment specific to her current seller, that must be duplicated for any new seller’ (Klemperer, 2008, p. 9). This concept that has been formally introduced in theoretical economics in the seminal journal articles of Von Weizsäcker (1984) and Klemperer (1987),1 can be dated back to Schumpeter ( 1962) who suggested a role of long-period contracts as devices for tying prospective customers to investing firms. Unlike patenting or other price or non-price strategic instruments, temporary monopoly power can arise as a purely demand-side phenomenon when, for example, consumers want to avoid transaction costs (the cost of using the market in the sense of Coase, 1937) or learning how to use another firm’s technology. The effect of consumer switching costs on innovation is controversial, however, and has been largely neglected in the economics of the firm literature, in which the focus on demand inertia is for the case of businessto-business relationships, where buyers...
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