Regulating Endogenous Customer Switching Costs

Customer switching costs can limit the opportunities for new entry in some markets. Incumbent firms may be able to reduce these switching costs, but have no incentive to do so without regulatory intervention. For example, in telecommunications, incumbent firms can provide customers with number portability, reducing the cost customers face when moving to a new carrier. This paper considers alternative regulatory policies to deal with these endogenous switching costs. We find that rules requiring an incumbent firm to ameliorate customer switching costs lead to lower pricing by the incumbent but higher pricing by the entrant. These rules can reduce social surplus, particularly if average customer switching costs are relatively low compared to amelioration costs. Regulatory rules also affect the efficiency of the decision to reduce customers' switching costs and the technological choice of the incumbent firm. For example 'customer pays' regulation encourages an efficient amelioration choice but provides poor incentives for the incumbent to choose a least cost amelioration technology. We consider the addition of a 'buy back' rule to standard incumbent-firm-pays regulation and show that this is always preferred to standard firms-pay regulation. Buy-back rules dominate other standard regulatory rules when firms can price discriminate on the basis of customers' switching costs. Further, buy-back rules lead to more efficient technological choices by the incumbent firm