Product Innovation with Industry Leaders and Consumer Switching Costs

Abstract

We analyze firms’ investment in product innovation when there are heterogeneous consumer switching costs in markets with an industry leader. We show that higher switching costs require a successful entrant to charge a higher price and increase investment in product innovation to remain competitive, while an industry leader’s best strategy is to increase R&D, ensuring greater market share and profit. Alternatively, with relatively low switching costs, entry reduces an industry leader’s R&D investment. Our results provide evidence of a co-existence between “Arrowian” and “Schumpeterian” investment theories, which hinges on the magnitude of consumer switching costs. Overall, entry in an innovative industry may be socially undesirable due to switching costs. Our analysis suggests that an industrial policy designed to lower switching costs (such as product standardization) unambiguously increases consumer surplus and overall welfare but may affect product innovation negatively.