information rules: a strategic guide to the network economy lock-in effect & networks...

Information Rules:

A Strategic Guide to the Network Economy

Lock-In effect &

Networks externality

Seungkyoon Shin

Information Rules Spring 20002

Recognizing Lock-In

• Cost of switching

• Compare– Ford v. GM– Mac v. PC


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

• 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• 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

• 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 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

• 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

• 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

• 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

• 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

• 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• 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• 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

• 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

Brand Selection

SamplingLock-In

Entrenchment

Information Rules:

A Strategic Guide to the Network Economy

Networks and Positive Feedback


Old and New

• Industrial Economy– Populated with oligopolies– Economies of Scale

• Information Economy– Temporary monopolies– Economies of Networks


Important Ideas

• Positive feedback

• Network effects

• Returns to scale– Demand side– Supply side


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

• 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

• 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

• 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

• Network externalities don’t always apply– ISPs (but watch out for QoS)– PC production

• Likelihood of tipping– See next slide


Likelihood of Tipping

Low ScaleEconomies

High ScaleEconomies

Low DemandFor Variety

Unlikely High

High DemandFor Variety

Low Depends


Chicken & Eggs

• Fax and fax machines

• VCRs and tapes

• Internet browsers and Java


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

• 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

• 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

• Need IP licensing

• Example: – Sony and Philips CDs– Amazon.com’ banner ad


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

• “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…

• 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

• 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 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

Control Open

Compatible ControlledMigration

OpenMigration

Incompatible PerformancePlay

Discontinuity


Performance Play

• Introduce new, incompatible technology

• Examples– Palm Pilot– Iomega Zip

• Attractive if– Great technology– Outsider with no installed base


Controlled Migration

• Compatible, but proprietary

• Examples– Windows 98– Pentium chips– Upgrades and update of S/W programs


Open Migration

• Many vendors, compatible technology

• Little switching cost for customers

• Examples– Fax machines– Modems


Discontinuity

• New technology, but incompatible with existing technology

• Supplied by many vendors

• Examples– CD audio– 3 1/2” disks


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

• 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

• Fundamental tradeoff: openness and control

• Generic strategies– Performance play– Controlled Migration– Open Migration– Discontinuity

• Lessons of history

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