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Competition with Switching Costs and Network Effects Coordination and Lock-In: Competition with Switching Costs and Network E ects May 2006 the latest version of this paper, and related material, will be at www.paulklemperer.org Joseph Farrell University of California, Berkeley, 549 Evans Hall # 3880 Berkeley, CA 94720-3880, USA email: [email protected] and Paul Klemperer Nueld College, Oxford University, Oxford OX1 1NF, England Int Tel: +44 1865 278588 Int Fax: +44 1865 278557 email: [email protected] First draft: 1997 This draft: 2006 PRELIMINARY DRAFT: PLEASE SEND COMMENTS KEYWORDS: 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 im- perfection 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 Board, Tim Bresnahan, Yongmin Chen, Matthew Clements, David Gill, Jonathan Good, Moshe Kim, Catherine McNeill, Markus Mobius, Meg Meyer, Tore Nilssen, Hiroshi Ohashi, Pierre Regibeau, Garth Saloner, Marius Schwartz, Oz Shy, Re- becca Stone, John Vickers, Matthew White, Miguel Villas-Boas, and the Editors of this Volume. Joe Farrell was chief economist at the Federal Communications Commission 1996-7 and at the Antitrust Division of the Department of Justice 2000-1, and Paul Klemperer served as a Member of the UK Competition Commis- sion 2001-5, but all the views expressed are personal ones. c Joseph Farrell and Paul Klemperer, 2006 1 Abstract Switching costs and network e ects bind customers to vendors if prod- ucts 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 eciency, 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 pric- ing, introductory o ers, and price wars. Such \competition for the market" or \life-cycle competition" can adequately replace ordinary compatible com- petition, and can even be ercer than compatible competition by weaken- ing di erentiation. More often, however, incompatible competition not only involves direct eciency 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-eciency factors (especially history such as past market shares), and although competition between incompatible networks is initially unsta- ble and sensitive to competitive o ers and random events, it later \tips" to monopoly, after which entry is hard, often even too hard given incom- patibility. 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 inecient incompatible com- petition 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. c Joseph Farrell and Paul Klemperer 2 Coordination and Lock-In: Competition with Switching Costs and Network E ects CONTENTS 1. INTRODUCTION 2. SWITCHING COSTS AND COMPETITION 2.1 Introduction 2.2 Empirical Evidence 2.3 Firms who Cannot Commit to Future Prices 2.3.1 Bargains Followed by Ripo s 2.3.2 Ineciency of the Price-Path 2.4 Firms who Cannot Discriminate Between Cohorts of Consumers 2.4.1 Free-Entry Model 2.4.2 Do Oligopolists Hold Simultaneous Sales?, or Staggered Sales?, or No Sales? 2.4.3 Oligopoly Dynamics 2.4.4 The Level of Pro ts 2.4.5 The E ect of Consumers' Expectations on Prices (i) Consumers who Assume any Price Cut below their Expected Price will be Maintained in the Future (ii) Consumers whose Expectations about Future Prices are Una ected by Current Prices (iii) Consumers with Rational Expectations 2.4.6 Collusive Behavior 2.5 Consumers Who Use Multiple Suppliers 2.5.1 Paying Consumers to Switch 2.5.2 Is There Too Much Switching? (i) Price Di erences Don't Re ect Cost Di erences (ii) Consumers Switch In Order To A ect Prices (iii) Switching Costs Are Not Real Social Costs 2.5.3 Multiproduct Firms 2.6 Battles for Market Share 2.6.1 The Value of Market Share 2.6.2 Penetration Pricing 2.6.3 Harvesting vs Investing: Macroeconomic and International Trade Applications 3 2.7 Entry 2.7.1 Small Scale Entry is (Too) Easy 2.7.2 Large Scale Entry is (Too) Hard 2.7.3 Single-Product Entry May Be (Too) Hard 2.7.4 Arti cial Switching Costs Make Entry (Too) Hard 2.8 Endogenous Switching Costs: Choosing How to Compete 2.8.1 Reducing Switching Costs to Enhance Eciency 2.8.2 Increasing Switching Costs to Enhance Eciency 2.8.3 Increasing Switching Costs to Enhance Oligopoly Power 2.8.4 Reducing Switching Costs to Enhance Oligopoly Power 2.8.5 Increasing Switching Costs to Prevent or Exploit Entry 2.9 Switching Costs and Policy 3. NETWORK EFFECTS AND COMPETITION 3.1 Introduction 3.2 Empirical Evidence 3.2.1 Case Studies (i) Ex ante: did QWERTY pass a good market test when the market tipped to it? (ii) Ex post: As of now, would a switch be socially ecient? 3.2.2 Econometric Approaches 3.3 Under-Adoption and Network Externalities 3.3.1 Formalities 3.3.2 What are the Groups? 3.3.3 Total and Marginal E ects 3.3.4 Under-Adoption of Single Network 3.3.5 Are Network E ects Externalities? 3.4 The Coordination Problem 3.4.1 Coordination Breakdowns: Mistakes, Splintering, Wait-and-See 3.4.2 Coordinating on the Wrong Equilibrium (i) Single network (ii) Competing networks 3.4.3 Cheap Talk and Consensus Standards 3.4.4 Coordination through Sequential Choice 3.5 Inertia in Adoption 3.5.1 Ex Post Inertia 3.5.2 Early Power 3.5.3 Positive Feedback and Tipping 3.5.4 Option Value of Waiting 3.6 Sponsored Price and Strategy for a Single Network 3.6.1 Pricing to Di erent Groups: Penetration Pricing 3.6.2 Single Monopoly Price 3.6.3 Commitment Strategies 3.6.4 Contingent Contracts 4 3.7 Sponsored Pricing of Competing Networks 3.7.1 Competition With Cost/Quality Di erences 3.7.2 Competition With Cost/Quality Di erences that Vary Over Time 3.7.3 Static Competition When Consumers' Preferences Di er 3.7.4 Dynamic Competition When Consumers' Preferences Di er 3.8 Endogenous Network E ects: Choosing How to Compete 3.8.1 Eciency E ects 3.8.2 Competitive E ects 3.8.3 Institutions and Rules: Who chooses? (i) Horizontal competitors (ii) Vertical locus of compatibility choice (iii) Means to network bene ts (iv) International trade 3.9 Network E ects and Policy 4. CONCLUSION References 5 1 Introduction The economics of switching costs and network e ects have received a great deal of popular, as well as professional, attention in the last two decades. They are central to the \new economy" information technology industries. But these new topics are closely linked to traditional concepts of contract incompleteness, complementarity, and economies of scale and scope. Both switching costs and proprietary network e ects arise when con- sumers value forms of compatibility that require otherwise separate purchases to be made from the same rm. Switching costs arise if a consumer wants a group, or especially a series, of his own purchases to be compatible with one another: this creates economies of scope among his purchases from a single rm. Network e ects arise when a user wants compatibility with other users so that he can interact or trade with them, or use the same complements; this creates economies of scope between di erent users' purchases. These economies of scope make a buyer's best action depend on other, complementary transactions. When those transactions are in the future, or made simultaneously by others, his expectations about them are crucial. When they are in the past, they are history that matters to him. History also matters to a rm because established market share is a valuable asset: in the case of switching costs, it represents a stock of individually locked-in buyers, while in the case of network e ects an installed base directly lets the rm o er more network bene ts and may also boost expectations about future sales. Vying for valuable share, rms may compete hard for early adoptions, notably with penetration pricing but perhaps also in less ecient ways. Early sales induce lucrative follow-on sales, which we often call locked-in, although lock-in is seldom absolute. Both switching costs and proprietary network e ects thus shift the locus of competition from smaller to larger units of sales, as economies of scope, tying, and bundling do. When switching costs are high, buyers and sellers actually trade streams of products or services, but their contracts often cover only the present. Similarly, network e ects push large groups of users toward doing the same thing as one another, but contracts usually cover only a bilateral transaction between a seller and one user.
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