Working Paper: CEPR ID: DP5798
Authors: Joseph Farrell; Paul Klemperer
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 efficiency, 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 efficiency 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-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 '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 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 favour thoughtfully pro-compatibility public policy.
Keywords: coordination; indirect network effects; lock-in; network effects; network externalities; switching costs
JEL Codes: D420; D430; L120; L130; L140; L150
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Switching costs (D23) | Lock-in effects (E43) |
| Lock-in effects (E43) | Reduced competition (L49) |
| Reduced competition (L49) | Increased market power for incumbent (D43) |
| Initial purchase (Y20) | Switching costs incurred (D23) |
| Switching costs incurred (D23) | Lock-in to incumbent supplier (L14) |
| Lock-in to incumbent supplier (L14) | Increased market power for incumbent (D43) |
| Penetration pricing (D49) | Increased market share (D49) |
| Increased market share (D49) | Lock-in effect (E43) |
| Lock-in effect (E43) | Higher post-lock-in prices (P22) |
| Early adoption (Y20) | Network effects (D85) |
| Network effects (D85) | Market tipping towards monopoly (D42) |
| High switching costs (L15) | Reduced competition (L49) |
| Reduced competition (L49) | Increased prices (D49) |