LockIn effect

1
Lock-In effect Networks externality

• Seungkyoon Shin

2
Recognizing Lock-In

• Cost of switching
• Compare
• Ford v. GM
• Mac v. PC

3
Whats 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 ATT
• 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, Profitswitching 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
• Borlands 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. BN'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
• Metcalfes 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
Dont Get Carried Away

• Network externalities dont 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 ATT, 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