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Recognizing Lock-In
Hal R. Varian
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Recognizing Lock-In
• User’s cost of switching products/suppliers in tech industries can be large
• Compare– Ford v. GM– Mac v. PC
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What’s 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 AT&T– 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
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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
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Competition for locked-in customers
• Competitors can compensate user for switching– Earthlink’s 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 competitor’s customer switching costs
• Customer C switches from A to "same position"
with supplier B: Total switching costs = C’s 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 = competitor’s 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
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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
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Suppliers and Partners
• Both sides may be locked in– Railroad spur lines– Customized software– IPOs
• Bilateral monopoly problem– Game of Chicken– @home and AT&T
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Follow the Lock-in cycle
Brand Selection
SamplingLock-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