Coordination and Lock-In: Competition with Switching Costs and Network Effects
AbstractSwitching costs and network effects 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 efficiency, and gives vendors lucrative ex post market powerâ€”over the same buyer in the case of switching costs (or brand loyalty), or over others with network effects. Firms compete ex ante for this ex post power, using penetration pricing, introductory offers, and price wars. Such â€œcompetition for the market" or â€œlife-cycle competition" can adequately replace ordinary compatible competition, and can even be fiercer than compatible competition by weakening differentiation. More often, however, incompatible competition not only involves direct efficiency losses but also softens competition and magnifies incumbency advantages. With network effects, established firms have little incentive to offer better deals when buyersâ€™ and complementorsâ€™ expectations hinge on non-efficiency factors (especially history such as past market shares), and although competition between incompatible networks is initially unstable and sensitive to competitive offers and random events, it later â€œtips" 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 anotherâ€™s existing customers, and so also discourage more aggressive entry. Because of these competitive effects, even inefficient incompatible competition is often more profitable than compatible competition, especially for dominant firms with installed-base or expectational advantages. Thus firms probably seek incompatibility too often. We therefore favor thoughtfully pro-compatibility public policy.
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Bibliographic InfoPaper provided by Competition Policy Center, Institute for Business and Economic Research, UC Berkeley in its series Competition Policy Center, Working Paper Series with number qt9n26k7v1.
Date of creation: 01 May 2006
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switching costs; network effects; lock-in; network externalities; co-ordination; indirect network effects; market structure; firm strategy and market performance; oligopoly and other imperfect markets; monopolistic competition; contestable markets; information and product quality; standardization and compatibility; monopoly; transactional relationships; contracts and reputation; networks; market structure and pricing; oligopoly and other forms of market imperfection; market structure and pricing;
Other versions of this item:
- Farrell, Joseph & Klemperer, Paul, 2007. "Coordination and Lock-In: Competition with Switching Costs and Network Effects," Handbook of Industrial Organization, Elsevier.
- Farrell, Joseph & Klemperer, Paul, 2006. "Coordination and Lock-In: Competition with Switching Costs and Network Effects," CEPR Discussion Papers 5798, C.E.P.R. Discussion Papers.
- Joseph Farrell & Paul Klemperer, 2006. "Co-ordination and Lock-in: Competition with Switching Costs and Network Effects," Economics Papers 2006-W07, Economics Group, Nuffield College, University of Oxford.
- Paul Klemperer & Joseph Farrell, 2006. "Coordination and Lock-In: Competition with Switching Costs and Network Effects," Economics Series Working Papers 2006-W07, University of Oxford, Department of Economics.
- L13 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Oligopoly and Other Imperfect Markets
- L15 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Information and Product Quality
- L12 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Monopoly; Monopolization Strategies
- L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation
- D43 - Microeconomics - - Market Structure and Pricing - - - Oligopoly and Other Forms of Market Imperfection
- D42 - Microeconomics - - Market Structure and Pricing - - - Monopoly
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