Recognizing Lock-In

Recognizing Lock-In Hal R. Varian SIMS

Recognizing Lock-In • User’s cost of switching products/suppliers in tech industries can be large • Compare • Ford v. GM • Mac v. PC SIMS

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 SIMS

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 SIMS

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

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 SIMS

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 SIMS

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 SIMS

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 SIMS

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 SIMS

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 SIMS

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 SIMS

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 SIMS

Types of Switching Costs • Durable purchases and replacement • Brand-specific training • Information and data • Personalized suppliers • Search costs • Loyalty programs • Contractual commitments SIMS

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 SIMS

Ink Jet Printers SIMS

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 SIMS

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! SIMS

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 SIMS

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” SIMS

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 SIMS

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 SIMS

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 SIMS

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

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 SIMS

Recognizing Lock-In