Customer Capital and Dynamic Barriers to Entry

Many industries are dominated by large and very profitable firms. We develop a theory of firm dynamics, where competing firms operate a fixed-cost technology but due to customer inertia can only slowly build up a customer base. We show how the interaction between scale economies and customer inertia creates dynamic entry barriers and persistent performance differences. Our model also resolves the ‘paradox of entry barriers’: markets with higher fixed operating costs have higher long-run profits, but are unambiguously less attractive to enter, except when firms can also invest in product quality. In the latter case, early entrants can create persistent performance differences through upgrading and may want to enter high-cost markets.