Estimating switching costs: The case of banking

We present an empirical model of firm behavior in the presence of switching costs. Customers' transition probabilities, embedded in firms' value maximization, are used in a multiperiod model to derive estimable equations of a first-order condition, market share (demand), and supply equations. The novelty of the model is in its ability to extract information on both the magnitude and significance of switching costs, as well as on customers' transition probabilities, from conventionally available highly aggregated data which do not contain customer-specific information. As a matter of illustration, the model is applied to a panel data of banks, to assess the switching costs in the market for bank loans. The point estimate of the average switching cost is 4.1%, about one-third of the market average interest rate on loans. More than a quarter of the customer's added value is attributed to the lock-in phenomenon generated by these switching costs. About a third of the average bank's market share is due to its established bank-borrower relationship.