We study a duopoly model of history-based price competition with switching costs and demonstrate how strategic history-based pricing induces the owners of the firms to implement managerial short-termism by delegating the pricing decisions to managers with a discount factor lower than that of the owners. Managerial short-termism is a strategic device whereby owners can soften price competition at the stage when customer relationships are established. The degree of short short-termism is shown to depend on the market structure, the intensity of competition and the magnitude of switching costs.

Introduction

During the past decades the marketing literature has highlighted the importance of strategies focusing on the acquisition and management of customer relationships (see for example, Dwyer et al., 1987). As exemplified by Venkatesan and Kumar (2004), Blattberg et al. (2009) or Stahl et al. (2012), this approach has emphasized the application of customer lifetime value (CLV) with associated business strategies to maximize the long-term profitability of customer relationships. As Reinartz et al. (2005) emphasize, this typically involves the balancing of resources between acquisition and retention of customers. It seems intuitive that managers operating with a short-term objective would pay insufficient attention to the long-term implications of customer policy and that managerial short-termism therefore would imply reduced profit margins and suboptimal customer lifetime value for the firms. In this study we show analytically that quite the opposite holds true: managerial short-termism promotes profit margins in oligopoly markets with switching costs. We characterize how delegation of pricing decisions to short-sighted managers serves as a strategic instrument to soften competition between firms in oligopoly markets. In general, short-termism refers to the phenomenon of excessive discounting of future outcomes. In this study we consider the delegation of pricing decisions to short-sighted managers as a strategic instrument. The analysis is conducted within the framework of history-based (or behavior-based) price discrimination with switching costs. Due to the switching costs, firms have strong static and dynamic incentives to acquire customers because established customer relationships are a valuable asset generating benefits not only at present but also in the future. Firms can achieve higher market shares by targeting very competitive prices to consumers with whom they have not yet established a customer relationship. The implied tougher competition reduces current profits. To avoid such intensified competition, each firm can commit not to compete as fiercely by delegating the pricing decision to a manager who is more short-sighted than the owner, i.e., a manager with a discount factor lower than that of the owners of the firm. Our analysis establishes analytically that for arbitrary exogenously given initial market shares, the subgame perfect equilibrium configuration is characterized by strategic delegation to myopic agents, i.e., price-setting managers paying less attention to the future than the firm owners. Myopia turns out to be optimal both with a two-period and an infinite horizon. Thus, strategic history-based pricing competition induces the owners of the firms to implement managerial short-termism. We also extend our analysis to an environment where we endogenize the initial market shares and for that purpose we focus on price competition with differentiated products and a two-period horizon. Our main qualitative result is robust to such considerations: in equilibrium, pricing decisions are again delegated to managers operating with discount factors lower than those of the owners. The equilibrium managerial discount factor crucially depends on the parameters of the model – the magnitude of the switching costs, the market power in the initial period, and the discount factor of the owners. Overall, we establish that the degree of short-termism is determined by balancing the incentives to exploit market power in the initial period against the incentives to benefit from switching costs in the second period.