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

Joseph Farrell, University of California, Berkeley

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 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-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 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.

Keywords: switching costs, network effects, lock-in, network externalities, co-ordination, indirect network effects.

JEL classification: L130, L150, L120, L140, D430, D420.