Information Rules:
A Strategic Guide to the Network Economy
Lock-In effect
&
Networks externality
Seungkyoon Shin
Recognizing Lock-In
• Cost of switching
• Compare
– Ford v. GM
– Mac v. PC
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
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 Rules
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Spring 2000
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
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
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”
Information Rules
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Spring 2000
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?
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
Follow the Lock-in cycle
Brand Selection
Sampling
Lock-In
Entrenchment
Information Rules
16
Spring 2000
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
Information Rules
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Spring 2000
Important Ideas
• Positive feedback
• Network effects
• Returns to scale
– Demand side
– Supply side
Information Rules
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Spring 2000
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”
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
Likelihood of Tipping
Low Scale High Scale
Economies Economies
Low Demand
For Variety
Unlikely
High
High Demand
For Variety
Low
Depends
Information Rules
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Spring 2000
Chicken & Eggs
• Fax and fax machines
• VCRs and tapes
• Internet browsers and Java
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
Legal Obstacles
• Need IP licensing
• Example:
– Sony and Philips CDs
– Amazon.com’ banner ad
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
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
Information Rules
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Spring 2000
Generic Strategies
Compatible
Control
Open
Controlled
Migration
Open
Migration
Incompatible Performance Discontinuity
Play
Information Rules
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Spring 2000
Performance Play
• Introduce new, incompatible technology
• Examples
– Palm Pilot
– Iomega Zip
• Attractive if
– Great technology
– Outsider with no installed base
Information Rules
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Spring 2000
Controlled Migration
• Compatible, but proprietary
• Examples
– Windows 98
– Pentium chips
– Upgrades and update of S/W programs
Information Rules
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Spring 2000
Open Migration
• Many vendors, compatible technology
• Little switching cost for customers
• Examples
– Fax machines
– Modems
Information Rules
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Spring 2000
Discontinuity
• New technology, but incompatible with
existing technology
• Supplied by many vendors
• Examples
– CD audio
– 3 1/2” disks
Information Rules
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Spring 2000
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
Information Rules
41
Spring 2000
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
Information Rules
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Spring 2000
Lessons, continued
• Fundamental tradeoff: openness and control
• Generic strategies
–
–
–
–
Performance play
Controlled Migration
Open Migration
Discontinuity
• Lessons of history
Information Rules
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Spring 2000