Anxiously awaiting the arrival of the "friction-free" economy? Don't. The most valuable asset in the new economy is not manufacturing prowess or raw materials. It's an installed base of customers, kept loyal by switching costs - friction - that deter them from changing brands.
Switching costs are more important than ever before, because information goods and services work in systems. Hardware requires software, videos require players, browsers require servers and new technology requires learning-time investment. Changing a single component often requires changing other components, which can impose large switching costs on users. Developers and vendors are acutely aware of these costs and are seeking ways to elevate consumers' switching costs and thus lock in current customers.
In the old days, the main cost associated with switching brands came with acquiring information about alternatives. Information technology has dramatically reduced this component of consumer search costs - price quotes and product specs are only a click away. But now there are other types of switching costs: Installing new software often means retraining employees, upgrading or converting historical data or maintaining incompatible systems.
We've identified seven categories that switching costs fall into. The most potent lock-in causes switching costs to rise over time. "Information and databases" and "loyalty programs" are two types of lock-in that are significant in the information economy.
Iomega (IOM) illustrates the "information-and- databases" category. Suppose you have a library of data on Zip disks. When you get your next computer, you'll be inclined to buy another Zip drive to avoid converting the existing data to a new format. Conversion takes time and requires the purchase of a new batch of disks. Anticipating this, Iomega discounts its drives, expecting to earn substantial profit margins on subsequent sales of its proprietary media.
This story is as old as giving away the razor to sell the blades, but it's cheaper to switch razors than disk formats. Lock-in is caused by "durable investments in complementary assets." Razors and blades are complements, but blades wear out and disks don't. Databases are not only durable, their size and value also tend to grow with time.
Amazon.com (AMZN) illustrates the "loyalty programs" category of lock-in. Loyalty programs are arrangements, like frequent-flyer programs, that reward repeat and intensive users. Amazon.com's Affiliates Program rewards referrals; Barnes & Noble (dossier) has countered with its Associates Program. We'll see more of these programs because it's easy to keep track of online customers. Smart cash registers let your local supermarket get into the act, with clubs that reward cumulative purchases. From 1993 to 1996, supermarkets' net profit margin rose from 0.49 percent of sales to 1.2 percent of sales, a new high in the $400-billion-a-year business. Much of this increase was due to "shoppers' clubs" that rewarded loyalty.
A recurring drama in the information economy is the struggle between incumbent vendors seeking to profit from their installed bases and rivals hoping to steal away those same customers. In the 1980s, Borland designed its QuattroPro spreadsheet program to make it easy for Lotus 1-2-3 customers to switch. Lotus claimed intellectual property rights on the names of menu commands and sued Borland for copyright infringement. Lotus counted on lock-in from brand-specific training, which Borland was trying to counteract. The dispute went all the way to the Supreme Court and ended with a deadlocked court - a victory for Borland in the courtroom, but not in the marketplace.
Another info age drama involves companies with shaky claims to installed customer bases. Some Internet companies, such as portals, are overvalued because investors see an installed base of users and conclude that these customers are locked in. While an installed base has value based on consumer inertia, the switching costs of changing the default Web site on a browser will decline as consumers grow more sophisticated. Investors may be in for a rude surprise.
Whether you supply information technology, or merely use it, you will benefit from understanding, classifying and measuring switching costs. The "friction-free" economy is a fiction; look for more lock-in, not less, as the information age progresses.
Carl Shapiro is a professor at the Haas School of Business at UC Berkeley. Hal R. Varian is the dean of UC Berkeley's School of Information Management. Their book Information Rules: A Strategic Guide to the Network Economy (Harvard Business School Press) will be published Nov. 10.
Contractual Commitments: Breaking contracts can lead to compensatory damages
Durable Purchases: Replacing existing equipment can be expensive
Brand-specific Training: Switching programs means your team has to learn a new interface
Information and Databases: New systems are needed when companies change formats
Search Costs: Finding and evaluating a new supplier costs time and money
Specialized Suppliers: Sometimes a critical component is supplied by a single supplier
Loyalty Programs: Switching can cause customers to lose out on program benefits
