Price competition in markets with customer testing: the captive customer effect (Q926224)

The paper introduces product differentiation into the analysis of price competition in markets where suppliers face uncertainty about the profitability of serving a customer and conduct tests in order to reduce this uncertainty. The main goal of the paper is to examine how the presence of captive customers (who pass only one supplier's test) affects price competition in a duopoly model with differentiated products. The authors' analysis reveals that for a sufficiently high degree of differentiation the presence of such customers implies that suppliers can improve the composition of their clientele by charging higher prices. Moreover, endogenizing the suppliers' location decisions in product space, the authors demonstrate for a subset of parameters that both a high degree of product differentiation and a high level of prices are implemented in a pure-strategy subgame-perfect equilibrium of the two-stage extension of their model. The obtained results differ sharply from the results of the original Hotelling model with linear travel costs, where a pure-strategy subgame-perfect equilibrium fails to exist. Since, similarly as for the Hotelling model, it is apparently impossible to analytically derive the mixed-strategy equilibrium profits for every subgame, the authors tackled the study of subgame-perfect equilibria by applying the technique of iterated elimination of strictly dominated strategies, which might be of independent interest for the analysis of other multi-stage games that do not allow for an analytical solution of some subgames.