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Lock-In effect & Networks externality. Seungkyoon Shin. Recognizing Lock-In. Cost of switching Compare Ford v. GM Mac v. PC. What’s the Difference?. Durable investments in complementary assets Hardware Software Netware

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Lock in effect networks externality l.jpg

Lock-In effect & Networks externality

Seungkyoon Shin


Recognizing lock in l.jpg
Recognizing Lock-In

  • Cost of switching

  • Compare

    • Ford v. GM

    • Mac v. PC


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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


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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”


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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?


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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


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Follow the Lock-in cycle

Brand Selection

Sampling

Lock-In

Entrenchment



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Old and New

  • Industrial Economy

    • Populated with oligopolies

    • Economies of Scale

  • Information Economy

    • Temporary monopolies

    • Economies of Networks


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Important Ideas

  • Positive feedback

  • Network effects

  • Returns to scale

    • Demand side

    • Supply side


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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”


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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


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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


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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


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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



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Chicken & Eggs

  • Fax and fax machines

  • VCRs and tapes

  • Internet browsers and Java


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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


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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


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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


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Legal Obstacles

  • Need IP licensing

  • Example:

    • Sony and Philips CDs

    • Amazon.com’ banner ad


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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


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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


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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


Openness l.jpg
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


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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



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Performance Play

  • Introduce new, incompatible technology

  • Examples

    • Palm Pilot

    • Iomega Zip

  • Attractive if

    • Great technology

    • Outsider with no installed base


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Controlled Migration

  • Compatible, but proprietary

  • Examples

    • Windows 98

    • Pentium chips

    • Upgrades and update of S/W programs


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Open Migration

  • Many vendors, compatible technology

  • Little switching cost for customers

  • Examples

    • Fax machines

    • Modems


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Discontinuity

  • New technology, but incompatible with existing technology

  • Supplied by many vendors

  • Examples

    • CD audio

    • 3 1/2” disks


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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


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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


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Lessons, continued

  • Fundamental tradeoff: openness and control

  • Generic strategies

    • Performance play

    • Controlled Migration

    • Open Migration

    • Discontinuity

  • Lessons of history


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