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Co-ordination and Lock-in: Competition with Switching Costs and Network Effects

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  • Joseph Farrell

    ()
    (University of California)

  • Paul Klemperer

    ()
    (Nuffield College, University of Oxford)

Abstract

Switching 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 effciency, 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 effects. Firms compete ex ante for this ex post power, using penetration pricing, introductory offers, and price wars. Such "competition for the market" or "life-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 effciency losses but also softens competition and magnifies incumbency advantages. With network effects, established firms have little incentive to offer better deals when buyers’ and complementors’ expectations hinge on non-effciency 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 "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 s also discourage more aggressive entry. Because of these competitive effects, even ineffcient incompatible competition is often more profitable than compatible competition, especially for dominant rms 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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File URL: http://www.nuffield.ox.ac.uk/economics/papers/2006/w7/Farrell_KlempererWP.pdf
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Bibliographic Info

Paper provided by Economics Group, Nuffield College, University of Oxford in its series Economics Papers with number 2006-W07.

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Length: 129 pages
Date of creation: 01 Jul 2006
Date of revision:
Handle: RePEc:nuf:econwp:0607

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Web page: http://www.nuff.ox.ac.uk/economics/

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