1. Information Rules: A Strategic Guide to the Network Economy Lock-In effect & Networks externality Seungkyoon Shin

2. Information Rules Spring 2000 2 Recognizing Lock-In Cost of switching Compare – Ford v. GM – Mac v. PC

3. Information Rules Spring 2000 3 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

4. Information Rules Spring 2000 4 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

5. Information Rules Spring 2000 5 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

6. Information Rules Spring 2000 6 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

7. Information Rules Spring 2000 7 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

8. Information Rules Spring 2000 8 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

9. Information Rules Spring 2000 9 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

10. Information Rules Spring 2000 10 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

11. Information Rules Spring 2000 11 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

12. Information Rules Spring 2000 12 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

13. Information Rules Spring 2000 13 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”

14. Information Rules Spring 2000 14 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?

15. Information Rules Spring 2000 15 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

16. Information Rules Spring 2000 16 Follow the Lock-in cycle Brand Selection Sampling Lock-In Entrenchment

17. Information Rules: A Strategic Guide to the Network Economy Networks and Positive Feedback

18. Information Rules Spring 2000 18 Old and New Industrial Economy –Populated with oligopolies –Economies of Scale Information Economy –Temporary monopolies –Economies of Networks

19. Information Rules Spring 2000 19 Important Ideas Positive feedback Network effects Returns to scale –Demand side –Supply side

20. Information Rules Spring 2000 20 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”

21. Information Rules Spring 2000 21 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

22. Information Rules Spring 2000 22 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 n 2 Importance of expectations

23. Information Rules Spring 2000 23 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

24. Information Rules Spring 2000 24 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

25. Information Rules Spring 2000 25 Likelihood of Tipping

26. Information Rules Spring 2000 26 Chicken & Eggs Fax and fax machines VCRs and tapes Internet browsers and Java

27. Information Rules Spring 2000 27 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

28. Information Rules Spring 2000 28 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

29. Information Rules Spring 2000 29 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

30. Information Rules Spring 2000 30 Legal Obstacles Need IP licensing Example: –Sony and Philips CDs –Amazon.com’ banner ad

31. Information Rules Spring 2000 31 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

32. Information Rules Spring 2000 32 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

33. Information Rules Spring 2000 33 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

34. Information Rules Spring 2000 34 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

35. Information Rules Spring 2000 35 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

36. Information Rules Spring 2000 36 Generic Strategies

37. Information Rules Spring 2000 37 Performance Play Introduce new, incompatible technology Examples –Palm Pilot –Iomega Zip Attractive if –Great technology –Outsider with no installed base

38. Information Rules Spring 2000 38 Controlled Migration Compatible, but proprietary Examples –Windows 98 –Pentium chips –Upgrades and update of S/W programs

39. Information Rules Spring 2000 39 Open Migration Many vendors, compatible technology Little switching cost for customers Examples –Fax machines –Modems

40. Information Rules Spring 2000 40 Discontinuity New technology, but incompatible with existing technology Supplied by many vendors Examples –CD audio –3 1/2” disks

41. Information Rules Spring 2000 41 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

42. Information Rules Spring 2000 42 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

43. Information Rules Spring 2000 43 Lessons, continued Fundamental tradeoff: openness and control Generic strategies –Performance play –Controlled Migration –Open Migration –Discontinuity Lessons of history