Switching Costs and Network Externalities in the Production of Payment Services

Working Papers 166 Eero Lehto

This study considers the retail banking duopoly in the production of payment services. Switching costs make the old clients locked-in. Network externalities are exhibited ude to high transaction costs in making a transfer to another bank´s customer, and due to low marginal costs in processing an intrabank transfer. This makes the discounted marginal profits from the old clientele increase in the number of old clients that favours a larger bank. This can encourage the larger bank to capture the new clients which are free of scitching costs, even if price discrimination between old and young clients in not allowed. To obtain this result, requires, however, that a maximal price premium extracted from a payment transfer to another bank´s customer is small enough. Thus the ordinary result according to which, it is too big sacrifice for a larger bank to lower also the prices of the old clients in order to capture the new clients, can be reserved.

Keywords: Retail banking, switching costs, network externality
ISBN: 952-5071-49-9
ISSN: 1457-2923
JEL: G21, L11, L12
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