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Coordination and Lock-In: Competition with Switching Costs and Network Effects


Joseph Farrell


University of California, Berkeley - Department of Economics

Paul Klemperer


University of Oxford - Department of Economics; Centre for Economic Policy Research (CEPR)

May 2006


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 favor thoughtfully pro-compatibility public policy.

Number of Pages in PDF File: 129

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

JEL Classification: L13, L15, L12, L14, D43, D42

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Date posted: October 17, 2006  

Suggested Citation

Farrell, Joseph and Klemperer, Paul, Coordination and Lock-In: Competition with Switching Costs and Network Effects (May 2006). Available at SSRN: http://ssrn.com/abstract=917785 or http://dx.doi.org/10.2139/ssrn.917785

Contact Information

Joseph Farrell
University of California, Berkeley - Department of Economics ( email )
549 Evans Hall #3880
Berkeley, CA 94720-3880
United States
510-642-9854 (Phone)
510-642-6615 (Fax)
Paul Klemperer (Contact Author)
University of Oxford - Department of Economics ( email )
Manor Road Building
Manor Road
Oxford, OX1 3BJ
United Kingdom
+44 1865 278 588 (Phone)
+44 1865 278 557 (Fax)
Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
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