SIMS

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– 5ESS 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 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

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

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 WordPerfect 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

SamplingLock-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