Lock-In effect & Networks externality

1. Lock-In effect & Networks externality Seungkyoon Shin

2. Recognizing Lock-In • Cost of switching • Compare • Ford v. GM • Mac v. PC

3. What’s the Difference? • Durable investments in complementary assets • Hardware • Software • Netware • Switching cost and lock-in are ubiquitous in information systems • Supplier wants to lock-in customer • Customer wants to avoid lock-in • Basic principle: Look ahead and reason back

4. Examples of lock-in • Bell Atlantic and AT&T • 5ESS digital switch used proprietary operating system • Large switching costs to change switches • Computer Associates • Vender Level Locking • System Level Locking

5. Small Switching Costs Matter • Look at lock-in costs on a per customer basis • Phone number portability • Email addresses (Mail Forwarding issue) • Hotmail (advertising, portability) • $400 mil for 9.5 mil subscribers • ACM, CalTech • Provide forwarding service to approach possible donors

6. Valuing an Installed Base • Customer C switches from A to "same position" w/ B • Total switching costs = customer costs + B's costs • Example • Switching ISPs costs customer $50 new ISP $25 • New ISP make $100 on customer, switch • New ISP makes $70 on customer, no switch • In a competitive market, Profit=switching costs

7. Profits & Switching CostsIn General: • Profits from a customer = total switching costs + quality/cost advantages • In commodity market like telephony, profit per customer = total switching costs per customer • Use of this rule of thumb • How much to invest to get locked-in base • Evaluate a target acquisition (e.g., Hotmail) • Product and design decisions that affect switching costs

8. Classification of Lock-In • Durable purchases and replacement: declines with time • Brand-specific training: rises with time • Information and data: rises with time • Specialized suppliers: may rise • Search costs: learn about alternatives • Loyalty programs: rebuild cumulative usage • Contractual commitments: damages

9. Durable Purchases • Telephone switches, Mainframe, OS • After-market sales (supplies, maintenance) • Depends on (true) depreciation • Usually fall with time due to depreciation • Watch out for multiple pieces of hardware • Supplier will want to stagger vintages • Contract renewal • Technology lock-in vs. vendor lock-in

10. Brand-specific Training • When personnel are trained • General training/brand specific training • How much is transferable? • Software, an obvious example • Competitors want to lower switching costs • Borland’s Quattro Pro help for Lotus 123 users • MS Word and WordPerfect help

11. Information & Databases • Data files • Insist on standard formats • S/W and database • Whether information can be easily ported over to another system • Zip - CD - DVD Transition

12. Specialized Suppliers • If durable equipment or S/W is highly specialized, it will be hard to find alternatives • Pentagon: Joint strike fighter project • Structuring competition among suppliers • Boeing, Lockheed Martin, McDonald • IBM • Dual sourcing • Intel and AMD

13. Search Costs • Consumers’ Search Cost • Psychological costs of change • Time and efforts • Risk to customers • Suppliers’ Search Cost • Promotional cost • Cost of actually closing the deal • Cost of setting up a new account • Risk to suppliers • Example of Risk: Credit Cards • $100 million in receivables is worth about $120 million • Market valuation of “loyalty”

14. Loyalty Programs • Constructed by firm (artificial lock-in) • Frequent flyer programs • Getting more popular in E-Commerce • Keep track of history sales: consumer information • Personalized Pricing • Gold status • Example: Amazon and Barnes and Noble • Amazon Associates Program v. B&N's Affiliates program • Add nonlinearity?

15. Suppliers and partners • Bilateral, or two-sided lock-in • Railroad spur lines • Customized software • Game for the Nintendo 64 platform • S/W for Apple computer

16. Follow the Lock-in cycle Brand Selection Sampling Lock-In Entrenchment

17. Networks and Positive Feedback

18. Old and New • Industrial Economy • Populated with oligopolies • Economies of Scale • Information Economy • Temporary monopolies • Economies of Networks

19. Important Ideas • Positive feedback • Network effects • Returns to scale • Demand side • Supply side

20. Positive Feedback • Strong get stronger, weak get weaker • Negative feedback: stabilizing • Makes a market “tippy” • Examples: VHS v. Beta, Wintel v. Apple • “Winner take all markets”

21. Sources of Positive Feedback • Supply side economies of scale • Declining average cost • Marginal cost less than average cost • Example: information goods, Automobile industry • Demand side economies of scale • Network effects • In general: fax, email, Web • In particular: Sony v. Beta, Wintel v. Apple

22. Network Effects • Real networks: • Fax machines, compatible modems, email • Virtual networks • Mac users, CD-ROM driver, Nintendo 64 • Computer (both S/W and H/W) buyers are picking a network, not simply a product. E.g. user group • Number of users • Metcalfe’s Law: Value of network of size n proportional to n2 • Importance of expectations

23. Lock-In and Switching Costs • Network effects lead to substantial collective switching costs • Even worse than individual lock-in • Due to coordination costs • Example: QWERTY

24. Don’t Get Carried Away • Network externalities don’t always apply • ISPs (but watch out for QoS) • PC production • Likelihood of tipping • See next slide

25. Likelihood of Tipping

26. Chicken & Eggs • Fax and fax machines • VCRs and tapes • Internet browsers and Java

27. Igniting Positive Feedback • Evolution • Give up some performance to ensure compatibility, thus easing consumer adoption • Revolution • Wipe the slate clean and come up with the best product possible

28. Evolution • Offer a migration path • Failure of CBS • Examples • Microsoft • Borland v Lotus • Build new network by links to old one • Problems: technical and legal

29. Technical Obstacles • Compatibility/Performance Trade-off • Use Creative design • Think in terms of system (NBC/CBS) • Converters and bridge technologies • One-way compatibility • Office 97/95 • Boland Q-pro/Lotus 1-2-3

30. Legal Obstacles • Need IP licensing • Example: • Sony and Philips CDs • Amazon.com’ banner ad

31. Revolution • Users will bear the switching cost when production is so much better than what people are currently using • Groves’ law: “10X rule” • But depends on switching costs • Example: Nintendo vs. Sega

32. Openness v. Control • “Open” approach: offering to make the necessary interfaces and specifications available to others • “Control” approach: keeping your system proprietary • The goal is to maximize the value of your technology, not control

33. To maximize the value… • Your reward = Total value added to industry x your share of industry value • Value added to industry • Depends on product and • Size of network • Your share • Depends on how open

34. Openness • More cautious strategy than control • Full openness • Anybody can make the product • Problem: no champion • Alliance • Only members of alliance can use • Problem: holding alliance together

35. Control • Control standard and go it alone • A strategy for Market leaders: AT&T, MS, and Intel • If several try this strategy, it may lead to standards wars

36. Generic Strategies

37. Performance Play • Introduce new, incompatible technology • Examples • Palm Pilot • Iomega Zip • Attractive if • Great technology • Outsider with no installed base

38. Controlled Migration • Compatible, but proprietary • Examples • Windows 98 • Pentium chips • Upgrades and update of S/W programs

39. Open Migration • Many vendors, compatible technology • Little switching cost for customers • Examples • Fax machines • Modems

40. Discontinuity • New technology, but incompatible with existing technology • Supplied by many vendors • Examples • CD audio • 3 1/2” disks

41. Lessons on Lock-in • Switching costs are ubiquitous • Customers may be vulnerable • Value your installed base • Watch for durable purchases • Be able to identify 7-types of lock-in

42. Lessons on Network and Positive feedback • Positive feedback means strong get stronger and weak get weaker • Consumers value size of network • Works for large networks, against small ones • Consumer expectations are critical • Fundamental tradeoff: performance and compatibility

43. Lessons, continued • Fundamental tradeoff: openness and control • Generic strategies • Performance play • Controlled Migration • Open Migration • Discontinuity • Lessons of history