Coordination and Lock-In: Competition with Switching Costs and Network Effects

Abstract

PRELIMINARY DRAFT: PLEASE SEND COMMENTSKEYWORDS: switching costs, network e ects, lock-in, network externalities, co-ordination, indirect network e ects JEL CLASSIFICATIONS: L130 market structure, rm strategy and market performance: oligopoly and other imperfect markets; monopolistic competition; contestable markets L150 information and product quality; standardization and compatibility L120 market structure, rm strategy and market performance: monopoly L140 transactional relationships: contracts and reputation: networks D430 market structure and pricing: oligopoly and other forms of market imperfection D420 market structure and pricing: monopoly. ACKNOWLEDGMENTS: We're grateful to many friends and colleagues for numerous helpful suggestions and comments over several substantial rewrites of this paper since our rst 1997 draft. Special thanks are due to Alan Beggs, Simon AbstractSwitching costs and network e ects bind customers to vendors if products are incompatible, locking customers or even markets in to early choices. Lock-in hinders customers from changing suppliers in response to (predictable or unpredictable) changes in e ciency, and gives vendors lucrative ex post market power|over the same buyer in the case of switching costs (or brand loyalty), or over others with network e ects.Firms compete ex ante for this ex post power, using penetration pricing, introductory o ers, and price wars. Such \competition for the market" or \life-cycle competition" can adequately replace ordinary compatible competition, and can even be ercer than compatible competition by weakening di erentiation. More often, however, incompatible competition not only involves direct e ciency losses but also softens competition and magni es incumbency advantages. With network e ects, established rms have little incentive to o er better deals when buyers' and complementors' expectations hinge on non-e ciency factors (especially history such as past market shares), and although competition between incompatible networks is initially unstable and sensitive to competitive o ers and random events, it later \tips" to monopoly, after which entry is hard, often even too hard given incompatibility. And while switching costs can encourage small-scale entry, they discourage sellers from raiding one another's existing customers, and so also discourage more aggressive entry.Because of these competitive e ects, even ine cient incompatible competition is often more pro table than compatible competition, especially for dominant rms with installed-base or expectational advantages. Thus rms probably seek incompatibility too often. We therefore favor thoughtfully pro-compatibility public policy.

Why Do Firms Switch Banks? Evidence from China

“…Large banks that are usually considered as nonaggressive to poach new customer, (known as the 'fat cat' effect of Farrell and Klemperer, 2007), tend to have a lower probability to lend. While small banks or banks with low profitability have higher likelihood to lend, even to 'risky' borrowers, as part of a strategy of increasing market share and improving future profitability.…”

Entrepreneurial Innovations in Network Industries

“…Second, it is common that economists support public policy in favor of increasing compatibility, see e.g. Farrell and Klemperer (2007), because competition between incompatible networks is usually found to be more profitable. As we point out, however, innovation incentives may be reduced if compatibility reduces incumbents willingness to pay for entrepreneurial innovations.…”

“…Liebowitz and Margolis (2001) also argue that quality largely explains success in software markets, which suggests that higher quality attracts more users and that the effect on market share and profits is then larger the stronger the network effects are. 7 See for instance Katz and Shapiro (1985a), Malueg and Schwartz (2006) or Farrell and Klemperer (2007). 8 Some empirical evidence that compatibility affects rivals of the owner of the innovation differently than the strength of network effects is given in Liu, Kremerer and Smith (2007).…”

A Short Survey of Network Economics

“…Although network effects and switching costs are related, this survey does not discuss switching costs and instead focuses more directly on network effects. Farrell and Klemperer (2007) provide a recent comprehensive literature survey of switching costs.…”