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Switching costs and innovation are two major issues in economics. Prior research demonstrates the effects of switching costs on competition, but ignores the influence of switching costs to firm innovation. So the purpose of this study is to reveal the relationships between switching costs and cost-reducing innovation by considering brand loyalty. All our theoretical conclusions are captured by game theory based on a two-stage duopoly model. The conclusions of this study show that under moderate conditions, switching costs improve competition. Strong firms implement lower price when switching costs are present than when they are not present. Second, at the asymmetric equilibrium, lower-efficiency firms with switching costs launch less innovative investments than do those without switching costs, while higher-efficiency firms with switching costs launch more innovation. But under symmetric equilibrium, switching costs have no effect on innovative investment. The novel contributions of this paper are that we find switching costs and loyalty have vertical impacts on firms’ cost-reducing innovation, which extends the theory of switching costs.

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