Recognizing Lock-In Hal R Varian SIMS Recognizing

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 – 5 ESS 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 Easy. Switch – 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. ” • Mc. Kinsey 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 Word. Perfect 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