Information Rules:
A Strategic Guide to the Network Economy
Recognizing Lock-In
Carl Shapiro
Hal R. Varian
The “friction-free” economy
delivered by the Internet?
• The Year 2000 Problem: a testament to the
enormous rigidities that plague the info
economy.
• Your choice for the future will still be hemmed
in by the selections you made in the past.
• Understanding the costs of switching(tech or
brand) is fundamental to success in today’s
economy.
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Recognizing Lock-In
• Cost of switching: new girl friend?
Headaches. Ex is better?
• Compare
– Hyundai vs. KIA : not much
– iPhone vs. Gallexy : can be significant
• Definition : Inability to switch from one
brand to another due to high switching cost
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What’s the Difference?
• Durable investments in complementary assets
–
–
Hardware (ex: Mac users switching to PC)
Software (ex: Mac users switching to PC)
• Supplier wants to lock-in customer
• Customer wants to avoid lock-in
• Basic principle: Look ahead and reason back
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Examples
• Bell Atlantic and AT&T
5ESS AT&T
– Bell purchased 5ESS digital switch ($3 bil), which
used proprietary operating system of AT&T
– AT&T charged a lot for upgrade and stuff
($10mil/upgrade)
– Large switching costs to change switches
• Computer Associates: supplier of IBM
compatible mainframe computer software, $3.5
billion in revenue in 1996 ($4.3 bill, 2008), 3rd
largest software company
• Aircraft repair and cargo conversion
Information Rules
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Charles Wang founder of CA
Small Switching Costs MatterMass Market Lock-in
• Maybe small for individuals, but big for large
organizations
• Phone number portability (Bell vs. AT&T,MCI,
Sprint; interim # portability  call forwarding)
• Email addresses (America Online vs. other ISP)
• Hotmail (advertising, portability)
• Look at lock-in costs on a per customer basis:
more customers, higher lock-in cost collectively
Installed base(기존 고객기반) is a measure of the number of units of a particular type of system (usually a
computing platform) actually in use, as opposed to market share, which only reflects sales over a particular
period. Information
Because installed
base includes machines that
may have been in use for many years, it is usually a
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higher figure than market share. Many people see it as a more reliable indicator of a platform's popularity.
Valuing an Installed Base
• Customer switches from KT to "same position" w/ SK
– Total switching costs = customer costs + SK's costs
– If $25 given by SK to C, total switching costs don’t
change
– What if 100 minutes free calls($15 value to C, $5 cost
to SK)? Total switching cost falls by $10.
• How much should you spend? Example
– Switching ISPs costs customer $50 + new ISP $25 =
$75 (new ISP pays this, including customer’s $50)
– If new ISP make $100 on customer, then encourage to
switch
– If new ISP makes $70 on customer, then do not
encourage to switch
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Profits & Switching Costs
In General: Profit=Switching Cost
• Possible Profits from a customer = total switching
costs + quality/cost advantages of the service
supplier
• In commodity market like telephony, profit per
customer = total switching costs per customer b/c
each company provides the same service, thus no
distinct advantage
Information Rules
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Profits & Switching Costs
In General:
•Use of this rule of thumb
– Can anticipate how much to invest to get locked-in
base (by discounting, advertising etc)
– Can evaluate a target acquisition (e.g., Hotmail),
instead of figuring out the revenue and costs
– Can help inform decisions affecting your
customers’ switching cost (product design and
compatibility decision if it is too low, make the
product incompatible so that switching cost goes up
 higher switching cost  charge more  higher
profit)
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Classification of Lock-In:
ways to lock-in
• Durable purchases and replacement: (lock-in) declines
with time Ex) Vacuum Tube TV
• Brand-specific training: rises with time Ex) MS Excel
• Information and data: rises with time Ex) Data format
• Specialized suppliers: may rise with time Ex) Legal
Consulting
• Search costs: learn about alternatives Ex) Insurance
• Loyalty programs: rebuild cumulative usage Ex) Sky
Team
• Contractual commitments: by contract Ex) Free
Mobile Phones (약정기간 동안 no switching)
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Locked-in by Durable Purchases
•
•
•
•
•
ex) Bell Atlantic and AT&T
Aftermarket sales (supplies, maintenance)
Depends on depreciation
Usually fall with time
Watch out for multiple pieces of hardware
– Supplier will want to stagger vintages
– Contract renewal
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10
20
30
40
roof
roof
roof
roof
Staggered
vintages
boiler
boiler
pipes
50
roof
boiler
roof
boiler
pipes
paint paint paint paint paint paint paint
paint
Roof: fix every
10 years
painting:
every 7 years
boiler:
replace
every 15
years
Information Rules
60
pipes: replace
every 25 years
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Locked-in by
Brand-specific Training
• Standardization by a single vendor
ex) Hangul vs. MS Word
• How much is transferable?
• Competitors want to lower switching costs
– Borland and Quattro Pro help
– Word and WordPerfect help
– Conversion from HANGUL to Word. Why not
work so good? To prevent migration.
Information Rules
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Lock-in
for Information & Databases
• Data files
– Insist on standard formats
– Hard to import Hangul format into MS Word
• Backward Compatibility: Current DVD
player can read old formats such as music
CDs and video CDs to reduce switching
cost to DVD players
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Locked-in for
Specialized Suppliers
• Not just hardware, software too;
Advertising, legal, accounting firms are
examples of specialized suppliers
• ex) of avoidance strategy
– Pentagon from Lockheed AND Boeing
– IBM from Intel AND AMD
Information Rules
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Search Costs
• Transactions cost in finding new supplier:
Insurance agent, travel agent, etc.
• Also costs to be found are borne by new supplier
ex) Promotion, closing deal, setting up account,
credit risks
• Example: Credit Cards companies searching for
customers + customer searching for companies
– $100 million in receivables is worth about $120
million when sold b/c of market valuation of “loyalty”
정보비대칭성이 거래 이전에 발생
Moral hazard: 도덕적 해이, 정보비대칭성이 거래 이후 발생
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Loyalty Programs
- Artificial lock-in, a synthetic friction
• Constructed by firm
– Frequent flyer programs
– Frequent coffee programs
• Personalized Pricing
– Gold status offered to who has gold status
The Green Stamps
– Example: More than 10,000 miles/year to sustain
the ‘Elite’ status.
– If less than 10,000 miles/year, the privilege (20kg
vs. 40kg, checking/boarding in with business class)
is deprived  want to use Korean Air for sure next
time.
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Contractual Commitments
• “Requirements contract”: Purchase supplies from
one supplier consider not just price, degraded
quality as well.
• Need to think about compensatory(to break the
contract, you compensate your existing supplier if
your new supplier offers a big discount) or
liquidated damages (new supplier buys you out of
your current contract)
• Beware of “evergreen contracts” that renew
automatically
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Suppliers and partners face
lock-in too
• Railroad spur lines (coal mine and coalfired power plant)
• Customized software (Apple computer,
Playstation, Nitendo 64)
spur line: very short branch line may be called a spur line
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Follow the Lock-in cycle
and Anticipate!
Changes
-Higher or lower
switching costs
-New techs.
1. Brand
Selection
2. Sampling
4. Lock-In
Switching cost
becomes
prohibitively
expensive
 Loyalty program
Information Rules
Use new brand
Take advantage
Get used to the
new brand
3. Entrenchment
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Ask for sweetener
- 8 books for $1
Lessons
• Switching costs are ubiquitous (some small,
some big but they DO exist)
• Customers may be vulnerable
• Value your installed base (locked-in
customers) to see how much to invest
• Watch for durable purchases
• Be able to identify 7-types of lock-in
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