SIMS 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 –5ESS 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 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 EasySwitch –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.” McKinsey 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 WordPerfect 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 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