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Recognizing Lock-In

Recognizing Lock-In. Hal R. Varian. Recognizing Lock-In. User’s cost of switching in high-tech industries can be high Compare Ford v. GM Mac v. PC. What’s the Difference?. Durable investments in complementary assets Hardware Software Wetware

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Recognizing Lock-In

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  1. Recognizing Lock-In Hal R. Varian SIMS

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

  3. 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

  4. Examples • Bell Atlantic and AT&T • 5ESS digital switch used proprietary operating system • Large switching costs to change programming • Computer Associates • Legacy software for IBM mainframes SIMS

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

  6. 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

  7. 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

  8. Profits and 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 to.. • Decide how much to invest to get lock-in Evaluate a target acquisition • Make product and design decisions that affect switching costs SIMS

  9. Examples • NYTimes, June 11, 2002 • “Earthlink acquires PeoplePC 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

  10. 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

  11. 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

  12. Ink Jet Printers SIMS

  13. 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 • MSNT and AOL SIMS

  14. 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

  15. Specialized Suppliers • Advertising, legal, accounting firms • Pentagon • Dual sourcing • Infotech examples • Intel and AMD • Adobe PDF SIMS

  16. 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

  17. Loyalty Programs • Constructed by firm • Frequent flyer programs • Frequent coffee programs • Nonlinear reward structure is important to induce switching rather than diversification SIMS

  18. Contractual Commitments • “Requirements contract”: Purchase supplies from one supplier • Beware of “evergreen contracts” that renew automatically SIMS

  19. 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

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

  21. 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

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