Competition in mature software markets

European Journal of Management, Summer, 2008 by Luba Torlina, Gennadi Kazakevitch

ABSTRACT

A theoretical framework is built for capturing properties of competition in mature monopolistic digital product markets. Based on an empirical study of the market of accounting software for small and medium enterprises, a consumer choice model is suggested, where a rational consumer is already using a particular version of a software package and is considering to chose from the following three options: either to continue using it, or to upgrade to a newer version of the product, or to switch to a competitive product. Consumer decision is justified by software quality, and network effects, under the price and switching costs constrains. A modified consumer demand function is used for the model, and theoretical conditions are analysed for choosing from one of the three above-mentioned options. The results are applicable to a wide range of digital products.

Key words: Mature markets; Product Quality; Consumer Choice; Monopolistic Competition.

1. INTRODUCTION

How do software users decide on purchasing or replacing a software package? Software vendors, who want to increase their market share in a particular product niche, are interested in an answer. In this paper we explore the major factors of decision making, in regard to buying or upgrading software. A conceptual framework suggested here reflects the decision making process. The dimensions, identified as strategically important include price, software quality, switching costs and network effects. An example of accounting software for small and medium enterprises (SMEs) was used for this study.

Factors and conditions of commercial success affecting software acquisition, acceptance, and continuity of use have been of wide interest to the academic and industry communities. Software markets fall in the category of digital product markets with quite distinctive characteristics (Shapiro and Varian, 1999). Switching costs, network effects, and customer lock-in mechanisms, in addition to price incentives, product utility and quality appear to be the factors influencing both consumer choice and firms' competitive strategies in high technology markets, including, such as markets of software products.

Consumer switching costs (CSCs) may include transaction, learning, artificial and contractual costs (Klemperer, 1989),. Transaction costs are incurred by a consumer when ceasing a relationship with one supplier and switching to a rival brand. Learning costs occur when the learning undertaken by a consumer to use one brand is not applicable to other brands. The costs of switching, both in terms of lost productivity and money spent, may outweigh any perceived benefits. Artificial costs are created by firms in order to increase customer loyalty. Contractual CSCs are induced by contracts that commit consumers to buy a product or to use a service from a firm for a particular period of time or for a particular number of purchases.

The concept of the network effect has been established in the literature on infrastructure and utility sectors (Economides, 1996). The network effect is a positive externality that depends on how many others use the product. This concept has been applied to information and high-technology products in tandem with CSC (Farrell and Shapiro, 1988). In particular, Shapiro & Varian (1999) believe, that the challenge for firms seeking to introduce new technology, that is not compatible with existing technology, is to build network size and thus overcome the combined CSC of all consumers. This is particularly applicable to software product markets.

Consumer lock-in is induced by a seller of good or service, and occurs where CSC are higher than the perceived benefit from using an alternate product (Van Hoose, 2003). Consumer lock-in tends to decrease consumers' propensity to search and switch and occurs due to a consumer's preference to minimise immediate costs and an underestimation of the impact of future CSC (Zauberman, 2003).

As long as market structures and competition are concerned, the majority of literature devoted to switching costs and network effects has been dealing with oligopolistic markets that answer particular conditions. Market power is exercised by competitors acquiring their market shares and affecting market prices, while innovations, product variety or quality are not predominant competitive tools. Goods are assumed to be homogenous and each firm is assumed to possess some market power (e.g. Chen & Hitt, 2002, Elzinga & Mills, 1998, Farrell & Shapiro, 1988, Klemperer, 1995, Valletti, 2000), allowing them to price at above marginal cost and obtain monopoly profits. While these conditions are adequate for many markets, they do not include essential properties required for realistic analysis of digital product markets.

The rest of the paper is structured as following. Firstly, we suggest a conceptual model of digital product markets that incorporates essential properties for further analysis:

* The market is monopolistically competitive and mature. Non-price tools are broadly used, and can be seen as prevailing in rivalry between competitors;