The impact of switching costs on behavior-based price discrimination with multiple consumer types

Abstract

Behavior-based price discrimination is a pricing strategy frequently observed in membership-based services and it has been studied widely in the literature. This paper considers a two-period behavior-based price discrimination model in which there are two distinct types of consumers with different demands, and a common switching cost is incurred for all customers who switch firms in the second period, regardless of customer type. We assume that firms accepting the switching customers bear the switching cost because they aim to attract customers from rival firms. As switching costs increase, competition for higher-demand customers intensifies. Eventually, in the second period, firms stop poaching these customers due to the heavy burden of switching costs. This leads to a situation where only consumers with low demand switch. The equilibrium price in the first period remains positive as long as both types of customers switch in the second period, but it continues to decline and eventually reaches zero after higher-demand customers stop switching. This means that sales promotions such as “first-time free” and “30-day free”offers are justifiable as long as higher-demand customers remain with the same firm in the second period. Once the price in the first period reaches zero, firms’ profits increase with the switching cost. We also find that higher switching costs are beneficial from a social welfare perspective, although they are detrimental to consumers.