Recognizing Lock-In

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Recognizing Lock-In

• Hal R. Varian

2
Recognizing Lock-In

• Users cost of switching products/suppliers in
  tech industries can be large
• Compare
• Ford v. GM
• Mac v. PC

3
Whats the difference?

• Durable investments in complementary assets
• Hardware
• Software
• Wetware
• Switching one component may involve switching all
• Supplier wants to lock-in customer
• Customer wants to avoid lock-in
• Basic principle Look ahead and reason back

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Examples

• Bell Atlantic and ATT
• 5ESS digital switch used proprietary operating
  system
• Large costs to change programming
• But even larger costs to change HW
• Computer Associates
• Legacy software for IBM mainframes

5
More examples

• Windows and Office
• Individual switching costs learning new software
• Collective switching costs file formats for
  exchanging work
• Online bill payments
• Other examples

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Small Switching Costs Matter

• Phone number portability
• Landlines
• Cellphones history of portability
• Email addresses
• All providers make it hard to switch
• Forwarding services ACM, alumni, etc.
• Lock-in costs on a per customer basis

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Pricing and switching costs

• With no switching cost
• Highest price you can charge user cost of next
  best alternative
• Alternative could be go without or buy from a
  competitor
• With switching cost
• Highest price you can charge user cost of next
  best alternative user switching cost
• Examples
• Automobile parts
• Cell phone additional services
• Printer ink

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Impact of competition

• Before choice is made environment may be very
  competitive (cell phones)
• Competition leads to low prices
• After choice is made you may have few
  alternatives
• Lack of competition leads to high prices
• Smart buyer looks at both the before choice and
  after-choice situation
• Smart seller looks at user switching costs as an
  asset

9
Competition for locked-in customers

• Competitors can compensate user for switching
• Earthlinks EasySwitch
• Word for Wordperfect users
• But competitors may have cost of acquiring new
  customers as well
• What matters is user alternative supplier
  switching costs

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Impact of competitors customer switching costs

• Customer C switches from A to "same position"
  with supplier B Total switching costs Cs
  costs B's costs of new customer
• Example
• Switching ISPs costs customer 50, new ISP 25
• New ISP make 100 on customer, worth
  compensating usr
• New ISP makes 70 on customer, not worth
  compensating user

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Profits and Switching Costs

• Profits from a customer total switching costs
  quality advantages
• Why? Because price can exceed supply cost by
  amount of user switching costs
• Profit my price my supply cost
• Profit competitors price quality advantage
  switching cost supply cost

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Commodity market

• All products are same (e.g., local phone service)
• Profit per customer total switching costs per
  customer
• Use of this rule of thumb to value your installed
  base of customers
• Decide how much to invest to get lock-in
• Evaluate a target acquisition
• Make product and design decisions that affect
  switching costs

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Examples

• NYTimes, June 11, 2002
• Earthlink acquires People PC customers for 80
  apiece, half of what the company pays to acquire
  dialup customers.
• McKinsey Quarterly, March 2002
• Estimates sensitivity of checking account
  customers to bank charges

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Types of Switching Costs

• Durable purchases and replacement
• Brand-specific training
• Information and data
• Personalized suppliers
• Search costs
• Loyalty programs
• Contractual commitments

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Durable Purchases

• After purchase supplies, maintenance
• Photocopying machines
• Watch out for multiple pieces of hardware
• Supplier will want to stagger vintages
• Contract renewal is sensitive time
• Technology lock-in v. vendor lock-in

16
Ink Jet Printers
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Brand-specific Training

• How much is transferable?
• Software
• Wetware and retraining costs can be huge
• Berkeley Financial System, Izio v Catalyst v
  Sakai
• Competitors want to lower switching costs
• Quattro Pro help for Lotus users
• MS Word help for WordPerfect users
• Earthlink Easy Switch

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Information and Databases

• Datafiles
• Insist on standard formats
• Control of data can be valuable
• Ameriserve example in fast food industry
• high-labor turnover
• supplier manages inventory information
• big costs to switching to alternative supplier!

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Personalized Suppliers

• Advertising, legal, accounting firms
• Pentagon
• Dual sourcing for tech and strategy reasons
• Infotech examples
• Intel and AMD chip socket design
• Xerox Interleaf and Adobe

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Search Costs

• Customer cost in finding new supplier
• Supplier costs in finding and servicing new
  customer
• promotion, closing deal, setting up account,
  credit risks
• Example Credit Cards
• 100 million in receivables sells or about 120
  million
• Market valuation of credit card loyalty

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Loyalty Programs

• Constructed by firm
• Frequent flyer programs
• Frequent coffee programs
• Much easier to do now that most transactions are
  computer mediated
• Nonlinear reward structure is important to induce
  switching rather than diversification

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Contractual Commitments

• Requirements contract Purchase supplies from
  one supplier
• Beware of evergreen contracts that renew
  automatically
• Magazine subscriptions
• Cell phone renewals retention specialists
• AOL contract cancelation

23
Suppliers and Partners

• Both sides may be locked in
• Railroad spur lines
• Customized software
• IPOs
• Bilateral monopoly problem
• Game of Chicken
• _at_home and ATT

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Follow the Lock-in cycle
Brand Selection
Sampling
Lock-In
Entrenchment
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Lessons

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