rules

Lock-In effect & Networks externality: 

Lock-In effect & Networks externality Seungkyoon Shin

Recognizing Lock-In: 

Recognizing Lock-In Cost of switching Compare Ford v. GM Mac v. PC

What’s the Difference?: 

What’s the Difference? Durable investments in complementary assets Hardware Software Netware Switching cost and lock-in are ubiquitous in information systems Supplier wants to lock-in customer Customer wants to avoid lock-in Basic principle: Look ahead and reason back

Examples of lock-in: 

Examples of lock-in Bell Atlantic and AT&T 5ESS digital switch used proprietary operating system Large switching costs to change switches Computer Associates Vender Level Locking System Level Locking

Small Switching Costs Matter: 

Small Switching Costs Matter Look at lock-in costs on a per customer basis Phone number portability Email addresses (Mail Forwarding issue) Hotmail (advertising, portability) $400 mil for 9.5 mil subscribers ACM, CalTech Provide forwarding service to approach possible donors

Valuing an Installed Base: 

Valuing an Installed Base Customer C switches from A to "same position" w/ B Total switching costs = customer costs + B's costs Example Switching ISPs costs customer $50 new ISP $25 New ISP make $100 on customer, switch New ISP makes $70 on customer, no switch In a competitive market, Profit=switching costs

Profits & Switching CostsIn General:: 

Profits & 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 How much to invest to get locked-in base Evaluate a target acquisition (e.g., Hotmail) Product and design decisions that affect switching costs

Classification of Lock-In: 

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

Durable Purchases: 

Durable Purchases Telephone switches, Mainframe, OS After-market sales (supplies, maintenance) Depends on (true) depreciation Usually fall with time due to depreciation Watch out for multiple pieces of hardware Supplier will want to stagger vintages Contract renewal Technology lock-in vs. vendor lock-in

Brand-specific Training: 

Brand-specific Training When personnel are trained General training/brand specific training How much is transferable? Software, an obvious example Competitors want to lower switching costs Borland’s Quattro Pro help for Lotus 123 users MS Word and WordPerfect help

Information & Databases: 

Information & Databases Data files Insist on standard formats S/W and database Whether information can be easily ported over to another system Zip - CD - DVD Transition

Specialized Suppliers: 

Specialized Suppliers If durable equipment or S/W is highly specialized, it will be hard to find alternatives Pentagon: Joint strike fighter project Structuring competition among suppliers Boeing, Lockheed Martin, McDonald IBM Dual sourcing Intel and AMD

Search Costs: 

Search Costs Consumers’ Search Cost Psychological costs of change Time and efforts Risk to customers Suppliers’ Search Cost Promotional cost Cost of actually closing the deal Cost of setting up a new account Risk to suppliers Example of Risk: Credit Cards $100 million in receivables is worth about $120 million Market valuation of “loyalty”

Loyalty Programs: 

Loyalty Programs Constructed by firm (artificial lock-in) Frequent flyer programs Getting more popular in E-Commerce Keep track of history sales: consumer information Personalized Pricing Gold status Example: Amazon and Barnes and Noble Amazon Associates Program v. B&N's Affiliates program Add nonlinearity?

Suppliers and partners: 

Suppliers and partners Bilateral, or two-sided lock-in Railroad spur lines Customized software Game for the Nintendo 64 platform S/W for Apple computer

Follow the Lock-in cycle: 

Follow the Lock-in cycle Brand Selection Sampling Lock-In Entrenchment

Networks and Positive Feedback: 

Networks and Positive Feedback

Old and New: 

Old and New Industrial Economy Populated with oligopolies Economies of Scale Information Economy Temporary monopolies Economies of Networks

Important Ideas: 

Important Ideas Positive feedback Network effects Returns to scale Demand side Supply side

Positive Feedback: 

Positive Feedback Strong get stronger, weak get weaker Negative feedback: stabilizing Makes a market “tippy” Examples: VHS v. Beta, Wintel v. Apple “Winner take all markets”

Sources of Positive Feedback: 

Sources of Positive Feedback Supply side economies of scale Declining average cost Marginal cost less than average cost Example: information goods, Automobile industry Demand side economies of scale Network effects In general: fax, email, Web In particular: Sony v. Beta, Wintel v. Apple

Network Effects: 

Network Effects Real networks: Fax machines, compatible modems, email Virtual networks Mac users, CD-ROM driver, Nintendo 64 Computer (both S/W and H/W) buyers are picking a network, not simply a product. E.g. user group Number of users Metcalfe’s Law: Value of network of size n proportional to n2 Importance of expectations

Lock-In and Switching Costs: 

Lock-In and Switching Costs Network effects lead to substantial collective switching costs Even worse than individual lock-in Due to coordination costs Example: QWERTY

Don’t Get Carried Away: 

Don’t Get Carried Away Network externalities don’t always apply ISPs (but watch out for QoS) PC production Likelihood of tipping See next slide

Likelihood of Tipping: 

Likelihood of Tipping

Chicken & Eggs: 

Chicken & Eggs Fax and fax machines VCRs and tapes Internet browsers and Java

Igniting Positive Feedback: 

Igniting Positive Feedback Evolution Give up some performance to ensure compatibility, thus easing consumer adoption Revolution Wipe the slate clean and come up with the best product possible

Evolution: 

Evolution Offer a migration path Failure of CBS Examples Microsoft Borland v Lotus Build new network by links to old one Problems: technical and legal

Technical Obstacles: 

Technical Obstacles Compatibility/Performance Trade-off Use Creative design Think in terms of system (NBC/CBS) Converters and bridge technologies One-way compatibility Office 97/95 Boland Q-pro/Lotus 1-2-3

Legal Obstacles: 

Legal Obstacles Need IP licensing Example: Sony and Philips CDs Amazon.com’ banner ad

Revolution: 

Revolution Users will bear the switching cost when production is so much better than what people are currently using Groves’ law: “10X rule” But depends on switching costs Example: Nintendo vs. Sega

Openness v. Control: 

Openness v. Control “Open” approach: offering to make the necessary interfaces and specifications available to others “Control” approach: keeping your system proprietary The goal is to maximize the value of your technology, not control

To maximize the value…: 

To maximize the value… Your reward = Total value added to industry x your share of industry value Value added to industry Depends on product and Size of network Your share Depends on how open

Openness: 

Openness More cautious strategy than control Full openness Anybody can make the product Problem: no champion Alliance Only members of alliance can use Problem: holding alliance together

Control: 

Control Control standard and go it alone A strategy for Market leaders: AT&T, MS, and Intel If several try this strategy, it may lead to standards wars

Generic Strategies: 

Generic Strategies

Performance Play: 

Performance Play Introduce new, incompatible technology Examples Palm Pilot Iomega Zip Attractive if Great technology Outsider with no installed base

Controlled Migration: 

Controlled Migration Compatible, but proprietary Examples Windows 98 Pentium chips Upgrades and update of S/W programs

Open Migration: 

Open Migration Many vendors, compatible technology Little switching cost for customers Examples Fax machines Modems

Discontinuity: 

Discontinuity New technology, but incompatible with existing technology Supplied by many vendors Examples CD audio 3 1/2” disks

Lessons on Lock-in: 

Lessons on Lock-in Switching costs are ubiquitous Customers may be vulnerable Value your installed base Watch for durable purchases Be able to identify 7-types of lock-in

Lessons on Network and Positive feedback: 

Lessons on Network and Positive feedback Positive feedback means strong get stronger and weak get weaker Consumers value size of network Works for large networks, against small ones Consumer expectations are critical Fundamental tradeoff: performance and compatibility

Lessons, continued: 

Lessons, continued Fundamental tradeoff: openness and control Generic strategies Performance play Controlled Migration Open Migration Discontinuity Lessons of history