Product innovation with industry leaders and consumer switching costs

Innovation enhances product functionality but may require consumer learning for consumers to realize the product's full value. Familiarity with a product facilitates adoption of updated products, whereas rival products require additional learning, effectively imposing a switching cost (SC) on consumers. We examine sequential R&D competition followed by simultaneous Bertrand price competition to explore how product innovation and SC impact competition in markets with heterogeneous consumer learning. Our analysis focuses on markets dominated by an incumbent firm and consumers with varying levels of technology comprehension. Our findings indicate that greater SC necessitate greater product appeal from an entrant to challenge an incumbent firm’s product. When SC are sufficiently high, industry leaders reduce their R&D investment, as their captive consumer base diminishes the competitive pressure to innovate. In turn, market entry may be socially undesirable, given the learning-related SC that consumers must incur when adopting a competitor's product. Our analysis suggests that policies designed to lower SC, such as product standardization, unambiguously increase consumer surplus and overall welfare but can negatively affect product innovation. Conversely, the acquisition of an entrant firm by the industry leader can increase social welfare without reducing innovation.