Last modified on 17 May 2012, at 23:45

Strategy for Information Markets/Dynamic Competition

Technological innovation arises from companies trying to gain a competitive advantage either by reducing costs, or introducing a new technology. When a new product is introduced to the market, consumers are left with inferior products, and must decide whether or not it is worth it for them to buy into the new technology. This can create what are called switching costs.

Demand-driven dynamic competitionEdit

Switching costsEdit

Switching costs are the costs incurred by switching to a different company, format, platform etc. Though switching costs usually refer to upgrading to a newer and better technology, this is not always entirely the case and instances of changing to an entirely different system can occur. For example, the switching costs related to replacing an existing library of DVD movies to Blu-Rays would include the costs of buying a Blu-Ray player, the Blu-Ray discs themselves, and getting a High-Definition television. Included in the switching costs would also be the time and effort it takes to make the switch (driving to the store, waiting in line at the checkout, etc).
Note: Although the word "costs" is used, switching costs are not purely monetary, as shown in the example above.

Uncertainty can play a big role in switching as well. Blu-Ray originally had to compete with another standard known as HD-DVD in the high definition video disk market. In the beginning, it was uncertain which format would become the prominent standard. This uncertainty can affect switching costs, because consumers can see it as a risk to switch to a certain format, because they cannot possibly be sure if the format they chose will be the format that "wins". For those consumers that chose HD-DVD, they eventually have to decide whether to pay even more (now that Blu-Ray won) for High-Definition video discs, or stay within their limited options. This uncertainty plays an important role in determining switching costs.

Lock-InEdit

If the switching costs are higher than the potential benefits of switching, lock-in occurs. Lock-in implies that the consumer decided to stay with their current network/product/standard instead of switching to a product that might be better. For the consumer, switching is not worth the effort, due to the high switching costs. The lock-in that stems from these switching costs proves to be a huge competitive advantage for the firms, causing a dispute over "fair" and "unfair" competition tactics. Some firms are viewed as monopolistic because they are the sole supplier of certain locked-in users with a specific product. However, companies that are often not regarded as monopolistic can create lock-in by carrying high switching costs. This is often seen with contracts, a form of lock-in.

Information products working together in systems cause a switch from any single product to be very expensive on the consumer. This can mainly occur through products that have many compliments, such as the Apple iPad. The iPad's function is to run applications for the benefit of the user. While there are free applications, some apps cost the consumer in order to use. Often times, buying an app does not mean that it can be universally used. If an iPad user becomes tired of the iPad and prefers an Android tablet, they will have to incur the costs of the new tablet, and the cost of buying the apps again. Due to the incompatibility between products and the number of complements that information products can have, switching can become expensive, and may not be worthwhile.

Another example of information products having lock-in is a user switching from the Microsoft Windows platform to the Apple OS X platform. Along with monetary costs, time becomes a large portion of the cost as well. Learning to use a Microsoft operated PC and switching to a Macintosh can prove to be often confusing and aggravating, and vice versa. This can also be said about products like Microsoft Word or Microsoft Excel, these systems are often taught in schools and are the main product for Office type programs. It would be very tough for a competitor to be able to derail Microsoft from their top spot of Office programs because learning to use a different Word processor or spreadsheet processor would take lots of time, practice, and patience, which many people might find more of a detriment or hassle rather than beneficial. However, switching costs also allow firms to maintain long relationships and loyalty to their products and build a network of consumer support through the longevity of the products life. This acts as a guarantee to the firm that customers will stick around with a company because the threat of switching costs is too high.

Individual lock-InEdit

Individual lock-in is a situation that is realized when the consumer's individual switching costs are high enough to discourage an individual from changing product or service provider. That is, when it is significantly costly for a consumer to change vendors, that consumer is 'locked-in' to his or her original choice of consumption.

note: Switching costs do not have to be great to lead a Lock-in situation. Rather they need only be significant enough to prevent consumers from migrating to another vendor.

Consumers in information economies are especially vulnerable to lock-in. This is due to the nature of information goods and services. Information goods typically have high switching costs because of two factors:

  1. Time investment: Many information goods, such as Microsoft Excel, or Adobe PhotoShop require a significant investment of a consumer's time to learn to use effectively. This non-monetary investment in learning represents a large switching cost to consumers and tends to naturally lock consumers in. Furthermore, even information goods without high learning curves can require a significant time investment for the consumer to receive optimal utility.
  2. Limited resale value: This stems from the unrecoverable time investment involved with adopting many information goods. That is, a consumer often cannot recoup his or her investment through any means. Furthermore, many information goods are provided at no monetary cost to the consumer. Downloaded MP3 files cannot be resold to other consumers, and the time invested into learning to use a certain system or network cannot be recovered by resale.

Even goods that would have had a resale potential in the past are becoming increasingly precluded from resale. As more and more content moves away from tangible tape/cartridge/CD/DVD distribution, information goods lose resale potential. Take, for instance, a video game purchased and downloaded through the on-line gaming network, STEAM. This consumer good cannot be resold to recoup value. It cannot be traded for another game. The cost to switch to another game is the cost to buy a new game.

While lock-in is harmful to the consumer, it is greatly beneficial for vendors. Lock-in ensures continued revenue and discourages consumers from patronizing competitors. So while lock-in is the natural result of significantly high consumer switching costs, savvy vendors tend to cultivate lock-in situations by artificially increasing switching costs for their consumers.

Common ways that vendors raise switching costs to create artificial lock-in:

  • Contracts: Contracts are direct, formal, legal means for creating switching costs. They impose monetary penalties for changing vendors. Contracts are the most clear and straightforward method of lock-in. Nearly all consumers in the United States are contractually locked in with a vendor. Contractual Lock-in include mortgages, auto leases, mobile phone plans, internet agreements and cable/satellite television plans.
  • Two-part tariff pricing: Two-part tariffs set a base cost for consumers then provide the good or service at a per unit price. It is the base cost of the product that raises the consumer's switching cost. Examples of this include "membership discount retailers" such as shopping clubs that charge an annual fee for admission to the point of sale and also charge for your purchases, amusement parks where there are admission fees and also per-ride fees, cover charges for bars combined with per drink fees, and personal seat licenses in professional sports, in which fans of a team pay an up-front lump sum fee for the right to purchase tickets at face value.
  • Brand loyalty programs: Examples include family-plan mobile phone discounts and Southwest Airlines' Rapid Rewards Program effectively decrease the value of switching vendors. This adds to switching costs and thus increases the potential for lock-in.
  • Gift cards: These create lock-in by allowing the consumer to spend their money only on the vendor's goods. The switching cost involved with gift cards is the money that is forfeited by not using the gift card. For example, if a consumer is given a gift card, but has no intention of ever spending the money at the store to which the money is meant for, then the consumer ultimately is throwing away their cash. Gift cards lock the consumer in to spending money at a certain store.
  • Search costs: search costs create lock-in by making it inconvenient of finding another suitable vendor. If a consumer is unhappy with a product or service, but finding a replacement takes too much time or effort (or even money), customers may stick with their current product or service.

Additional information regarding lock-inEdit

Overcoming competitors' lock-in:Edit

When competitors in a market seem to be increasing market share through competitive lock-in, it is important to understand the power and use of compatibility in a product. This makes it easier for consumers to switch back and forth between companies supplying products and allowing the customer to get maximum use out of the product. This can be made easier with product standardization and product complements.

Anticipated lock-in:Edit

Anticipated Lock-in can also occur. This type of lock-in is associated with an individual's knowledge of the lock-in before they are actually taking part in the lock-in. An example of an anticipated lock-in would be a potential customer buying a cell phone when they have never previously purchased one. They will see that they are locked-in to a set contract by the service provider, and they can anticipate the lock-in. The response to an anticipated lock-in can often be a lower demand, since consumers generally do not like the idea of being "tied down" to a particular firm. Individuals tend to like choice, and they will often choose a firm that will give them the least amount of anticipated lock-in as possible. The most general example of anticipated lock-in is contracts (of cell phone/internet providers, etc).

Lock-in as a negative for sellersEdit

Lock-in can also have a negative impact for sellers. If consumers know about an anticipated lock-in, they might not even try the product at all. They will bypass it completely, having a negative result for the seller (because they do not get the product sold). As a result, sellers often have promotional deals in order to entice consumers. An example of this is when dealerships offer to pay off the remainder of your lease or trade-in if you buy one of their cars. Sellers can also offer a brief no lock-in period, such as a 90 day money back guarantee.

Examples of individual lock-inEdit

Cell phone contractsEdit

John Consumer currently has a 2-year mobile phone contract with T-Mobile. John is dissatisfied with his current phone service. His text message plan results in increased monthly charges, and he frequently encounters limited signal dead-zones. John would like to change to a more reliable and text message friendly mobile carrier, like Verizon. Unfortunately, it would cost him $150 to terminate his current contract with T-mobile. The cost to break his contract is John's switching cost. Because this high switching cost is not worth improved service to John, he faces what is called Individual lock-in.

Software useEdit

Companies often chose software based on the needs of a company. When an initial decision is made on what software to use, it usually become the software that they continually use for years if not permanently, as the cost of switching would be expensive and potentially not worth the company's time. For example, if they are using the software service ADP for payroll and other human resource needs, the company will continue using ADP instead of switching to SAP (another software) because they already have purchased and know how to use ADP. The company could potentially "stuck" with ADP indefinitely until a situation arises where they would switch (i.e. corporate buyout, retiring personnel who use the old software, etc).

Systemic (collective) lock-inEdit

Systemic lock-in tends to arise naturally in markets, like individual lock-in. Unlike individual lock-in however, systemic lock-in is not the result of effectively high consumer switching costs. Rather, systemic lock-in is the market situation in which it is unprofitable for one consumer or firm to switch products unless all(or most) other firms or consumers also adopt the same product. Even though switching would benefit all firms, the benefit depends on all firms switching. Thus, systemic lock-in is the result of consumers' collective inability to coordinate switching vendors. This is the a huge factor in firms generating critical mass; which helps build, define, and expand their market share. If a firm can obtain critical mass in their selective market, then they have a proportionately large share of the market and will cause disincentives for customers to switch firms.

Systematic lock-in can be easily found today in online social networking sites, like Facebook and Google+, and does not always have to result from monetary effects. While Google+ has millions of users (62 million as of Dec. 2011 [1]), it barely has 10% of the numbers of Facebook, which was reported to have surpassed 750 million users in the middle of 2011.[2] While Google+ may be better than Facebook in some aspects of social networking, its late entry into the market has proven a difficult climb for Google to conquer. Most of the people on Facebook are content with using just Facebook, and the large drawback to adopting Google+ is the idea that you have to build your social network repertoire all over again on a website with less users. Facebook users may not want the hassle of learning a new social networking site, and they may not want to use it because friends and family are not on the site, which devalues Google+ for them. As a result, Google+ is suffering non-monetary effects of systemic lock-in.

Systemic lock-in often comes from a coordination game, most notably the Stag Hunt Coordination Game. [3]Both parties would be better off hunting a stag, but opt to hunt for the hare because they cannot be sure that the partner will also hunt for a stag (thus, possibly sticking with an inferior decision) (See risky coordination). Systemic lock-in can been seen as being in one Nash (or consumer demand) Equilibrium, and the "players" are having a hard time collectively switching to a different equilibrium.

Although individual lock-in may be more prevalent and often purposeful than systemic lock-in, systemic lock-in is perhaps a more common aspect of modern information economies which mostly exist online. The usefulness of an online site or network to an individual consumer is based largely on the number of other consumers that utilize the network.

Examples in an information economy:Edit

Phone plans:Edit

There are two friends who currently keep in contact via text messages. They each currently pay $10 per month for their text messaging plan. Player 1 wants to switch to a new text service that will let him send messages for free to any other phone with the same service. Player 2 also wants to switch. However, they know each other well enough to know that they are each unlikely to do what they say they are going to do. The cost to switch to the new service is $10.

Possibilities:

The Game Matrix (below) helps visualize the potential payoffs that each friend has when deciding ultimately to switch or stay with the same text messaging plan.

Switch Messaging Plans? Player 2
Switch Stay
Player 1 Switch 10, 10 -10, 0
Stay 0, -10 0, 0
  1. If they both switch to the new text-phone service, they will obviously both enjoy the benefit of free messages to each other. In the long run the free messages will save each of them $10 per month.
  2. If only Player 1 switches, but Player 2 does not, Player will have simply spent $10, and will realize no savings (and therefore, a worse payoff for having spent the $10 to switch)
  3. Vice versa, if Player 2 Switches, but Player 1 does not, then Player 2 will have simply spent $10, and will realize no savings (and again, a worse payoff for having spent the $10)
  4. Both player opt not to switch. Neither friend incurs the $10 switch fee, but doesn't getting the full benefit of the cheaper plan.

In this example, each friend gets a greater payoff if they both decide to switch, and get a worse payoff if one of them switches (albiet one friend gets an even worse payoff). Since they cannot count on each other to follow through with their plans, each friend is likely to simply lose $10 should they switch to the text plan individually. Therefore, both friends are systemically locked in to their current phone plans by the uncertainty of what the other will do.

The Qwerty keyboard:Edit

A potential example of lock-in is the QWERTY keyboard. Studies have shown that the QWERTY keyboard may not be the most efficient keyboard in the market. But the QWERTY keyboard has become the standard in the computing world. But, there is another little known type of keyboard available, known as the Dvorak keyboard. Some have claimed that the Dvorak keyboard is easier to type on. However, there are a potential number of switching costs associated with moving from QWERTY to Dvorak including the following: the price of purchasing the new Dvorak keyboard, retraining oneself to learn how to type on such a keyboard, the scarcity of the keyboard itself and finally being able to type on both the Dvorak keyboard and the standard QWERTY keyboards on a regular basis.

A brief history of the Dvorak keyboard:

Originally, the Qwerty keyboard was designed to place the most common two-letter combinations on opposite sides of the keyboard in order to prevent jams in typewriters. Now that typewriters are obsolete, and the original purpose for the QWERTY keyboard is no longer necessary. The Dvoark keyboard was invented by Dr. William Dealey and Dr. August Dvoark to increase typing efficiency and accuracy. The Dvorak keyboard received a U.S. patent in 1932.[4]

Locked in to QWERTY:

Because the QWERTY keyboard is such a standard and the numerous switching costs that come along with the DVORAK keyboard, consumers are essentially locked into the QWERTY version. While the Dvorak keyboard may be more efficient, its just not a realistic possibility of consumers. So this is the main reason why the Dvorak keyboard has yet to really catch on in the information technology world. In addition, there has been conflicting support on the efficiency of the Dvoark keyboard in comparison to QWERTY. One advantage that the Dvorak keyboard does have over its QWERTY counterpart is comfort level. According to users it is more comfortable to type on the Dvorak keyboard. Despite this claim, consumers are still essentiall locked into QWERTY becasue computers come stanard with this version today.

Social networking sites:Edit

Social networking cites provide for the largest example of systemic lock-in in an information economy. For example, it often takes new Facebook users months to build a substantial network of on-line friends. This time investment discourages consumers from switching to competing social networks like Google+ or Myspace.

Companies often chose software based on the needs of a company. When an initial decision is made on what software to use, it usually become the software that they continually use for years if not permanently, as the cost of switching would be expensive and potentially not worth the company's time. For example, if they are using the software service ADP for payroll and other human resource needs, the company will continue using ADP instead of switching to SAP (another software) because they already have purchased and know how to use ADP. The company could potentially "stuck" with ADP indefinitely until a situation arises where they would switch (i.e. corporate buyout, retiring personnel who use the old software, etc).

Information networks with systemic lock-in:Edit

Path dependenceEdit

Path dependence is the process that how things happen can often determine what happens. Path dependence often occurs in markets with strong network externalities where there are multiple stable equilibria. We don't have a prediction from the model what equilibrium will eventually be reached (compared to a single stable equilibrium market - often identified with a simply supply-demand curve). So what happens over time can determine what occurs and which equilibrium is reached. Path dependence is also similar to a "Bandwagon Effect", where the larger network is more appealing to consumers after many have joined it and thus creating a snowball effect of expansion.[5]

Path dependence is used in analysis of a standards battle. In the beginning of a standards battle, both standards may seem similar, and people buy into each of them. Eventually, one standard is adopted due to the large network externalities associated with having a particular standard. The other standard not universally adopted is then eventually rejected.

Path dependency was originally developed to explain the technology adoption process and industry evolution. Since the decision one faces for any specific instance is limited by past decisions; the nature of any achieved state depends heavily on the process of getting there. It can be considered the road map or process of evolution for a market, detailing the history of technological advances a firm has made to reach optimum market share.

Examples of path dependenceEdit

Path dependence is also well demonstrated in the fight between Blu-Ray and HD-DVD to dominate the high-definition DVD market. Both products were very similar with their capabilities and advantages and neither of them offered much of variety from the other. However, once movie studios, such as Disney and Paramount, moved to using Blu-Ray technology as their main movie standard, the market shifted in Blu-Ray's favor, giving it the advantage over HD-DVD. This decision by these major movie studios created a path dependence throughout the market by making the HD-DVD technology less sought after and inferior to Blu-Rays, regardless of the fact that it started on par with Blu-Ray. Now that these movie studios are producing their movies on the higher standard Blu-ray, the only advantage of purchasing a HD-DVD player over a Blu-ray player would be the slightly less cost, and this is the outcome of the path dependence that has been created. Eventually, this path dependence is what lead to the fall of HD-DVD.[6]

Another example of how path dependence can work highly in a businesses favor is by encouraging a market to move in a particular direction. In highly competitive markets like the example shown above, large market share holders in one market can greatly affect the overall outcome and consequently the success or failure of other affiliated markets. This is one reason that path dependency can such a strong economic affect. Large market share holders have something of a closed network when introducing new technologies that do not offer any standardization along with improved advantages. Once again, referring to the example above, it can be seen that without the cooperation of the large movie studios, such as Disney and Paramount, Blu-ray and HD-DVD would not have been able to enter the DVD market at all on any real level.

Supply-driven dynamic competitionEdit

First-mover advantageEdit

Throughout the business world, many subjects use the term first-mover advantage. It is important to recognize which one is being referenced. Often times, a first-mover advantage can actually refer to a "last-mover disadvantage", which implies different strategies.

In information economics, first-mover advantage explains the idea that a supplier is rewarded for bringing a new good or service to the market. There are many advantages that come from being a first-mover in a market:[7]

  • First-movers can often establish brand recognition, making it a long lasting household name. Examples include "You owe me a coke." "Take an Aspirin." "Hand me some Kleenex." "Let's jump in the Jacuzzi." and others.
  • First-movers often help establish the market, and generally are not easily swayed into exiting the market. This is the result of heavy sunk costs that they company incurs, often forcing the company to be economically committed to staying in the market. This is an advantage because it can often deter other firms from entering the market at all. If the new firm is successful, it is still unlikely that they can remove the first-mover from the market. Even a small revenue by the first-mover will be better than simply accepting its sunk costs as loss and exiting the market. This is similar to the military strategy Hernando Cortes[[1]]employed, scuttling his fleet after he landed in Vera Cruz. There is no going back. The only options are victory or death (failure).
  • First movers gain the advantage of being further along the learning curve in the manufacturing and development of the product. They can learn from their mistakes, and easily find areas to improve efficiency and ultimately reducing costs.
  • First-movers can often gain significant market share that competitors have a hard time reducing. The strongest example in today's world is Apple's iPad. Apple developed the first tablet computer that people actually wanted, giving Apple significant market share that other companies have tried (and some failed) to reduce. Market share can often help achieve

First-mover advantage with informationEdit

In an information market, the first-mover advantage is much often larger than in it would be in a conventional market. This is because network effects can make such markets tippy, meaning that whichever firm has an early advantage is likely to beat out all competitors (again, think of Apple's iPad). Conversely, in information markets, the first-mover advantage can be more treacherous. Due to the nature of information goods, suppliers have very high fixed costs and minimal variable production costs. If a second-mover is able to forgo the high sunk costs of entering the market by emulating the first-mover, then the second firm is left with only minimal variable production costs--a significant advantage. In situations like this, "the second mouse gets the cheese."

In addition, IP laws can often help with first mover advantage. If a company is the first to file a patent, no other company can copy what the first mover is doing until the patent expires. So while competitors may have a lower investment, they cannot copy exactly what the firm does without violating laws. By the time the patent runs out, the R&D used to develop the patent could be considered a sunk cost, and the investment could actually be considered "lower" than the competing firms "lower" investment. This is one way to protect valuable R&D information that a company might have and still retain first mover advantage. Another could actually be trade secrets. [7] The reason Coca-Cola has never filed a patent on its recipe is they do not want competitors to know it. They keep it a secret, giving them an advantage over other firms.[8]

Disadvantage of being a first-moverEdit

There is one distinct disadvantage from being the first to enter the market. Research and Development (R&D) is usually costly in order to create a new market for a product, and all that R&D won't guarantee success of the product. If the first mover fails to capitalize off of the first-mover advantage, then the competitors that follow can learn from the first-mover's mistakes and avoid some of the pitfalls and sunk costs of entering the market earlier, perhaps beating out the first mover. This is widely known as the bleeding edge.

Example of the advantages and disadvantages of being a first moverEdit

Let's say small bandages have yet to be introduced to the consumer market. If your company wants to create a new product that people can use to cover their minor wounds. Since this product has yet to invented, you have the opportunity to choose the name. If this product is successful, people may start referring to your product by your name rather than the what it actually is. Your company is Band-Aid. The bandage that you introduce to consumers takes off. Now other companies begin introducing a similar product. Since you were the first mover in the market though, the know all bandages as Band-Aid. Your company has and advantage here. On the other hand, there are some disadvantages to being a first mover in a particular market. This can include, but is not limited to, advances in technology. In the case of this particular example, competing bandage companies can build on the product that you introduced first. They can then make the product better and sell it at a cheaper price.

ReferencesEdit

  1. Constine, Josh (27 December 2011). "For Google+, User Count Is a Journey, Not a Race". http://techcrunch.com/2011/12/27/google-user-count/. Retrieved 23 April 2012. 
  2. unknown (27 June 2011). "Facebook user count reaches an astounding 750 million". http://ssdigitalmedia.com/2011/06/27/facebook-user-count-reaches-an-astounding-750-million/. Retrieved 23 April 2012. 
  3. Shor, Mike (2006). "Stag Hunt". http://www.gametheory.net/Dictionary/Games/StagHunt.html. Retrieved 23 April 2012. 
  4. Bigler, Jeff (7 March 2003). "The Dvorak Keyboard". http://www.mit.edu/~jcb/Dvorak/. Retrieved 2 November 2010. 
  5. Puffert, Douglas (2009). "Path Dependence in Economic History". Economic History Association. http://eh.net/encyclopedia/article/puffert.path.dependence. Retrieved 24 April 2012. 
  6. unknown (21 February 2008). "Toshiba quits HD DVD 'format war'". http://www.cnn.com/2008/BUSINESS/02/19/toshiba.hdd/index.html. Retrieved 3 May 2012. 
  7. a b Lieberman, M.; Montgomery, D. (1998). "First-mover advantages". Strategic Management Journal 9. 
  8. Judge, Walter (12 January 2012). "Protecting Trade Secrets". Downs Rachlin Martin PLLC. http://theipstone.com/2012/01/12/protecting-trade-secrets-eight-questions-businesses-need-to-ask-and-answer/. Retrieved 3 May 2012.