Recognizing LockIn Hal R Varian SIMS Recognizing LockIn

Recognizing Lock-In Hal R. Varian SIMS

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

What’s the Difference? • Durable investments in complementary assets – – – Hardware Software Wetware • 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 – 5 ESS digital switch used proprietary operating system – Large switching costs to change programming • Computer Associates – Legacy software for IBM mainframes SIMS

More examples • Windows and Office – Individual switching costs: learning new software – Collective switching costs: exchanging file formats • Others? SIMS

Small Switching Costs Matter • Phone number portability – Landlines – Cellphones: history • Email addresses – Hotmail portability – Forwarding services: ACM, alumni, etc. • Lock-in costs on a per customer basis SIMS

Valuing an Installed Base • Customer C switches from A to "same position" w/ 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, switch – New ISP makes $70 on customer, no switch • Special case – Competitive market for commodity product – PV of profit=switching costs – ILEC profits=customer + CLEC switching costs SIMS

Profits and Switching Costs In 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 to. . – 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. ” • Mc. Kinsey Quarterly, March 2002 – Estimates sensitivity of checking account customers to bank charges SIMS

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 SIMS

Durable Purchases • After purchase supplies, maintenance • Watch out for multiple pieces of hardware – Supplier will want to stagger vintages – Contract renewal • 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 Word. Perfect users – MSNT and AOL SIMS

Information & Databases • Datafiles – Insist on standard formats • Control of data can be valuable – Ameriserve example in fastfood industry – high-labor turnover – supplier manages inventory information – big costs to switching to alternative supplier! SIMS

Specialized Suppliers • Advertising, legal, accounting firms • Pentagon – Dual sourcing • Infotech examples – Intel and AMD – Adobe PDF 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 “loyalty” SIMS

Loyalty Programs • Constructed by firm – Frequent flyer programs – Frequent coffee programs • 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 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