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 Kierkegaaard: “it is perfectly true, as philosophers say, that life must be understood backwards. But they forget the other proposition, that it must be lived forwards.” SIMS

Examples Bell Atlantic and AT&T Computer Associates 5ESS digital switch used proprietary operating system Large switching costs to change programming Computer Associates Legacy software for IBM mainframes Bell Atlantic: 1995 suit for monopolization 15 year life of switch Computer Associates: $3.5 billion, behind Microsoft and Oracle Computer Associates: $432,000 per employee Microsoft: $422,000 per employee Oracle: $180,000 per employee Don’t want to switch OS or applications or vendors. Peru bought Soviet aircraft at deep discounts Didn’t buy manuals or spare parts! Most airlines avoided this mistake. SIMS

More examples Windows and Office Others? 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 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 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 McKinsey Quarterly, March 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 Wordperfect help in Microsoft World 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 Lock-In Sampling 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