Price Effects of Entries

Traditional oligopoly theories of markets where products are differentiated predict that entry of new firm enhances competition and thereby brings down the equilibrium market price. These theoretical predictions are, however, often challenged by contrasting empirical evidence suggesting that price increases with actual entries (Perloff, Suslow, Sequin ('96); Thomadsen ('05)). We provide a theoretical model in support of such empirical evidence by incorporating switching costs. Intuitively, if consumers have to incur costs when they switch products, a monopolist facing potential entry has incentives to price below the monopoly level and expand its consumer base pre-entry. By doing so, the incumbent firm can take full advantage of the lock-in effect post-entry by charging higher prices only to those consumers facing switching costs instead of directly competing with the entrant.