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

Joseph Farrell () and Paul Klemperer

No 2006-W07, Economics Papers from Economics Group, 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.

Pages: 129 pages
Date: 2006-07-01
New Economics Papers: this item is included in nep-com, nep-cse, nep-ict, nep-mic, nep-net and nep-tid
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Related works:
Chapter: Coordination and Lock-In: Competition with Switching Costs and Network Effects (2007)
Working Paper: Coordination and Lock-In: Competition with Switching Costs and Network Effects (2006)
Working Paper: Coordination and Lock-In: Competition with Switching Costs and Network Effects (2006)
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