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Selling and Leasing Software with Network Externalities

Explore the benefits and costs of subscription licensing for software vendors and users, and the impact of network externality on licensing policies. Dive into literature on selling durable goods, software upgrades, and network externality to understand the dynamics of the software industry.

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Selling and Leasing Software with Network Externalities

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  1. Selling and LeasingSoftware with Network Externalities

  2. Perpetual vs. Subscription Licensing • Software has been traditionally sold as a property — Perpetual proprietary license • A new trend of software delivery — Software as a service (SaaS)/Utility computing — the purchase of software as a subscription to the service • On-Demand Service Providers: • SalesForce.com provides On-Demand CRM software to its users from $65/user/month • Independent Software Vendors: • Oracle on Demand: subscription-based applications at a per user per month fee • Microsoft: offered Enterprise Subscription Agreement since 2001, “live” online services show progress, however, it insists on hybrid web-PC apps

  3. Speculations about the SaaS Model • Gartner: 30% of all software sales will be delivered on-demand by 2010; • The Economist 2006: traditional (way of delivering) software is already dead; • IDC (2007): SaaS model will help drive a transition to subscription licensing in its top ten predictions for the software industry.

  4. To the users Technology protection: install any new release of the upgrades timely; Predictable budgeting: smoothen the license payment stream; Cost savings: reduce total cost of ownership (?) To the vendors More reliable and stable revenue stream Better understanding of user’s needs A preferable way of locking in users Increasing profits (?) Benefits of Subscription Licensing Proposed by SaaS Proponents

  5. Research questions • What are the benefits and costs of the subscription licensing to the vendors and to the users? • What is the optimal software distribution for vendors to license software? • When should they use it? • When should they avoid using it? • How does network externality affect the vendors’ licensing policy? • Will subscription licensing completely replace the traditional perpetual licensing? • How are the users influenced by this trend of subscription licensing?

  6. Literature • Selling Durable Goods • Coase conjecture (1972): Time-inconsistent problem in selling durable goods; The firm is about to exploit residual demand in future periods; Consumers are rational and patient • Stokey (1981) and Gul (1986): Formalized Coase Conjecture • Bulow (1982): Selling is inferior to leasing strategy • Desai and Purohit (1998): Selling can co-exist with leasing • Software upgrades: • Choudhary, Tomak, and Chaturvedi (1998) • Fudenberg and Tirole (1998) • Viard (2007) • Network externality: • Katz and Shapiro (1986) • Brynjolfsson and Kemerer (1996) • Ellison and Fudenberg (2000)

  7. Software — Special Durable Goods • No second-hand market. Cannot resell or appropriate. • Easy to improve the value of already installed software through upgrades without interfering with the original customization • Economy of scale in production, sales and installment • Strong positive network externality

  8. Period 1 SV provides Version 1 with qualityq1 Period 2 SV provides Version 2 with qualityq2 Upgrade to version 2 Retain version 1 Buy version 1 Auto upgrade to version 2 Buy version 2 Lease version 1 Inactive Inactive Model Users

  9. The Software Vendor • Choose the optimal licensing policy • Pure selling • Pure leasing • Hybrid (selling + leasing) • Determine the optimal pricing under the selected policy • p1: selling price of version 1 in period 1 • p2: selling price of version 2 in period 2 • pu: upgrade price in period 2 • pr: per-period leasing price

  10. The Users • Net utility assumed to be linear • : the quality preference • q: the quality of the software product (speed, features, functionalities, user interface, ease of learning, etc. ) • e:the intensity of the network externality • x:the mass of the adopters of this and previous versions of software (backward compatibility). • p: price • Users are indexed by their quality preference which is uniformly distributed in the support of [0,1]. • Vertical Product quality at the two periods are q1 and q2 respectively, and q2 > q1 > 0.

  11. Users’ Decision • If the user buys in period 1, has the option of choosing to upgrade or keep using version 1 in period 2 • If she enters a lease contract, she agrees to pay the per period rent and uses the latest version in both periods • If the user chooses to be inactive in period 1, he/she obtains the option of buying version 2 in period 2 • : discount factor • x0: the mass of adopters of first version software • x1: the mass of users who do not upgrade in period 2 • x2: the mass of adopters of either version of the software

  12. Users’ Decision (cont.) • A consumer of type chooses a strategy that maximizes the expected total discounted value from using the software over the two periods

  13. Analytical Model Structure *Commitment: the ability of the vendor to credibly commit to selling or upgrade prices of version 2 announced in period 1.

  14. N L or BU 0 1 1/2 Case 1-the benchmark: with commitment and no network externality • Proposition 1: In equilibrium, the vendor achieves the same profit under any strategy. Users either use the latest version software in both periods or remain inactive in both periods. The total consumer surplus does not vary among the three licensing policies. • BU: Buying and upgrading; • L: leasing; • N: No action.

  15. Case 2: no commitment and no network externality • Incredible commitment: when the vendor cannot commit on second period prices, it is optimal to reduce price in period 2

  16. N NB BU 0 1 Case 2: no commitment and no network externality (cont.) • Proposition 2: In equilibrium, there exists “leapfrog” users in pure selling and hybrid markets. The seller’s profit ranking is The rankings of the consumer surplus and the social welfare are in the opposite order.

  17. The New Licensing Scheme • High-end users (high ) who always upgrade pay more after the vendor adopts the subscription licensing, but they pay less under the hybrid policy than pure leasing • We show analytically, behind the “reduced cost over life cycle” is the fact that the vendor increases the prices to better segment the market

  18. N BH L/BU 0 1 Case 3: with commitment and with network externality • Proposition 3: In equilibrium, a pure selling or hybrid policy weakly dominates a pure subscription strategy for the vendor: No users leapfrog, but some first-period adopters do not upgrade. The consumer surplus and the social welfare are also not higher when the vendor chooses to lease An interesting exception to the Coase Conjecture due to the network effect!

  19. Market Share and Profit Comparison between the Pure Selling/Hybrid and the Leasing Policies L/BU BH N Market Segmentations of Selling or the Hybrid Policy (in red) vs. Leasing (in blue) with Externalities. Profit from Selling or the Hybrid Policy (in red) vs. Leasing (in blue) with Externalities.

  20. Case 4: no commitment and with network externality When the intensity of network effect e is large enough, profits under the hybrid policy (in red) can be higher than that under the pure leasing policy (in blue).

  21. Comparisons of Consumer Surplus and Social Welfare Consumer Surplus of the Hybrid Policy (in red) vs. Pure Selling (in green) vs. Pure Leasing (in blue). Social Welfare of the Hybrid Policy (in red) vs. Pure Selling (in green) vs. Pure Leasing (in blue).

  22. Managerial insights • Software vendors should consider the following factors in choosing their optimal licensing strategy: • The anticipated degree of quality improvement • The intensity of the network externality effect • The ability to make a commitment

  23. Conclusion • With the network externality effect, pure leasing policy is preferred due to the intertemporal substitution; • With the increase of network effect, the vendor has greater incentive to increase market share and can subtract more surplus from social welfare; • When the effect of network externalities is large enough, the standard Coase Conjecture that “leasing creates the same profit to a monopolist durable good seller as that to a monopolist nondurable good seller” is violated; • The subscription policy helps the vendor better segment the users according to their quality preference. Adding it to the traditional pure selling licensing policy increases vendor profit, but it reduces consumer surplus and social welfare

  24. Limitation and future work • We only considered the case when quality improvement is moderate. Future work to generalize the results in more cases; • Consider controlling product quality through investment in innovation; • Discuss the impact of uncertainty of product quality on the consumers and software vendor’s strategies; • Explore the two-part tariff pricing and generalize the results to other pure on-demand software service providers.

  25. Questions and Answers

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