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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