SOME INDUSTRIAL ECONOMICS OF SOFTWARE MARKETING

AND DEVELOPMENT

Alexia Gaudeul

Guest lecture

MW24.5 Economic Aspects of E-Commerce

Winter 2014-2015

FSU Jena

DEFINITION OF SOFTWARE AS AN INFORMATION GOOD

1. Software is an information good: its value resides in the instructions it gives to a computer.

2. From an economic point of view, three main issues

1. You have to consume it before you can evaluate it.

2. High production costs, low reproduction and diffusion costs

3. Non-rival and non-excludable public good, i.e. me using it does not diminish your own enjoyment of it, and it is difficult for me to prevent you having access to it.

DEFINITION OF SOFTWARE AS AN INFORMATION GOOD

1. Those three issues lead to the three main parts of this lecture:

1. Marketing main focus

2. Development a little bit

3. Intellectual property protection no time!

MARKETING OF SOFTWARE

1. How do you get people to pay for something that can be evaluated only by using it?

2. The problem: Akerlof’s market for lemons

3. Some possible solutions…A. Reputation?

B. Advertising?

C. Guarantees?

D. Certification?

E. Samples?

F. Sell services, not software? (Software as services)

G. Rental?

H. … (ideas?)

THE MARKET FOR LEMONS

1. Akerlof’s “market for lemons” (1970) or “the strange case of the disappearing market”...

2. Consider a buyer faced with many sellers i={1,…,N}, each with a good of quality qi, qi distributed over [0,1] according to the uniform distribution function.

3. qi is known to the seller i only and not to others.

4. The buyer is a price taker: she buys as long as her expected payoff is more than 0.

The Market for "Lemons": Quality Uncertainty and the Market Mechanism

George A. Akerlof, The Quarterly Journal of Economics,

Vol. 84, No. 3, (Aug., 1970), pp. 488-500.

http://www.jstor.org/stable/1879431

THE MARKET FOR LEMONS

1. The buyer derives utility qi from buying a good of quality qi.

2. The seller faces average per-unit costs c*qi to produce a good of quality qi (c<1, otherwise what is the point!)

3. Suppose the buyer is offered a price pi by seller i.

4. The quality qi must therefore be s.t. pi-c*qi>0 (profits).

5. She therefore knows that quality qi is between 0 and pi /c

6. Therefore, the expected value of the good is pi/2c.

7. Therefore, if she accepts, she gets expected utility pi/2c-pi which is positive only if c<1/2.

THE MARKET FOR LEMONS

1. The buyer therefore rejects any price pi>0 if c>1/2.

2. Therefore, only the seller with a good of quality qi=0 will sell.

3. Only lemons sell, while all other goods stay on the market.

4. The process above is called ‘unraveling’.

5. There is no point for the seller to produce a good of better than lowest quality.

Or is there?...

HOW TO GUARANTEE THE EXISTENCE OF MARKETS FOR EXPERIENCE GOODS?

1. Despite Akerlof’s prediction, markets for information goods do exist. How is that?

A. Reputation done already

B. Signaling through advertising another time!

C. Guarantees

D. Certification

E. Samples.

F. …

GUARANTEES

1. Suppose the seller can offer a guarantee g*pi such that g*pi is given to the consumer if she returns the good.

2. For example, g=1 corresponds to a full refund.

3. Suppose seller i with a good of quality qi who asserts his good is of quality qi can sell it at price pi.

4. If seller i deviates and asserts his good of quality qi is actually of quality qJ then the consumer returns the good, and the profit of the deviator is pJ-g*pJ-c*qi. (!!! Here c is marginal costs!)

5. This must be no more than the profit from telling the truth, which is pi-c*qi.

9

Guarantees and Risk-Sharing

Geoffrey Heal, The Review of Economic Studies,

Vol. 44, No. 3 (Oct., 1977), pp. 549-560

http://www.jstor.org/stable/2296907

GUARANTEES

1. I must therefore have pJ-g*pJ<pi for the guarantee to be believable.

2. If this is so, then p(q)=q for any q (assuming for simplicity that the buyer is a price taker).

3. Suppose q can be at most 1. Any supplier could say q=1 (if you lie, lie boldly!) so I must have 1-g<q for any q for this to be avoided.

4. This must be true even if q=0, so I need g=1.

5. This means a full guarantee is necessary to deter deviation by the worst sellers.

GUARANTEES FOR INFORMATIONAL GOODS

1. Consider now a modified situation where the good has to be consumed for its quality to be known: ice cream, software, book, etc…

2. I cannot wipe out your experience of a book when you come back for a refund.

3. Therefore, whether you liked the book or not, you ask for a refund.

4. To avoid this, samples may be given to you (one spoon, one month, one page...)

5. But how do you know if the sample is representative of your future experience?

INTERLUDE… (HTTP://WWW.READERSDIGEST.COM.AU/FALSE-ADVERTISING)

A computer salesman dies and meets St. Peter at the Pearly Gates. St. Peter tells the salesman that he can choose between heaven and hell.

First he shows the man heaven, where people in white robes play harps and float around. "Dull," says the salesman.

Next, St. Peter shows him hell: toga parties, excellent food and wine, and everyone looking as though he's having a wonderful time.

"I'll take hell," he says.

He enters the gates of hell and is immediately set upon by a dozen demons who poke him with pitchforks.

"Hey," the salesman demands as Satan walks past, "what happened to the party I saw going on?" "Ah," Satan replies. "You must have seen our demo."

CERTIFICATION

1. Suppose an intermediary comes in and offers to certify the goods.

2. The intermediary knows the quality of the goods and cannot lie, but it can be vague.

3. For example, instead of saying: “this good is of quality qi ”, it can say, “this good is of quality between [a,b]”, which is true as long as qi∈[a,b], or ‘this good is not of quality qJ’, which is true as long as qi≠qJ, or it can choose to say nothing.

Information Revelation and Certification Intermediaries

Alessandro Lizzeri, The RAND Journal of Economics

Vol. 30, No. 2 (Summer, 1999), pp. 214-231

http://www.jstor.org/stable/2556078

CERTIFICATION

1. Suppose the certification intermediary offers to sells its services at price t to each sellers who comes to get certified.

2. Suppose it offers to tell the consumers the quality of the good.

3. Then, a seller with a good of quality q can choose to get certified, sell at price p(q)=q and make profit of p(q)-t.

4. Otherwise, it can choose to not get certified, sell at market price P and make profit P.

CERTIFICATION

1. Then, all sellers with a good with quality q s.t. q-t>P will get certified.

2. That means that any seller with good of quality q<P+t will not get certified.

3. Therefore, the expected value of a good that is not certified is (P+t)/2 (remember we still assume uniform distribution).

4. Therefore, P= (P+t)/2, so P=t.

5. This means that all sellers with quality more than 2t get certified, and others don’t.

CERTIFICATION

1. Profit for the intermediary is then (1-2t)t.

2. This is maximized for 1-4t=0 t=1/4.

3. This means half get certified, half don’t.

4. Is there no way to do better, by for example NOT saying the whole truth?

5. YES. The best for the certifier is to say “this good is not of quality 0” as long as this is indeed true, and say “this good is of quality 0” if this is indeed true.

6. Suppose all those with quality more than 0 get certified.

CERTIFICATION

1. In that case, getting certified allows you to sell at price 1/2 (expected value if certified) and make profit 1/2-t. Not getting certified gets you identified as a 0, with 0 profit.

2. This means the intermediary can set t=1/2 and make corresponding profit 1/2 which is more than 1/8 if it just told the whole truth.

3. This depends of course on the belief by consumers that anybody not getting certified is of quality 0.

4. This belief is then confirmed in equilibrium.

5. The certifier is thus able to acquire the whole producer surplus (profits).

INTERMEDIATION AND SAMPLING

Software marketing on the Internet: the use of samples and repositories,

Alexia Gaudeul, Economics of Innovation and New Technology

Volume 19, Issue 3, 2010

(download from http://ssrn.com/abstract=1140674)

1. Software companies face a choice between selling as usual (relying on reputation, guarantees) or offering a sample or listing the software on a repository (needs a sample).

2. The issue with selling on the repository is one is faced with more competition.

3. I show that firms’ choice will depend on the quality of their product and on how well known they are.

4. Three main types:1. Well known, basic quality sell as usual

2. Less well known, high quality offer a sample

3. Less well known, medium quality sell via repository

SOFTWARE DEVELOPMENT

1. Consider two people A and B who wish to develop software. They can both contribute effort e for its development. The value of the software is

1. A*v(eA+eB)-eA for A and

2. B*v(eA+eB)-eB for B. (v concave).

2. Proprietary development: Suppose A decides to develop the software, then he maximizes (A+B)v(eA)-eA (assuming B is a price taker and will thus pay full price).

1. eA is set such that (A+B)*v’(eA)=1. Social welfare is maximized and A acquires the whole surplus.

2. Note however that A must be able to make B pay for the software. Easy in this case, but what if there are two potential customers, B and C? What prevents B from selling the software to C once he bought it from A?

SOFTWARE DEVELOPMENT

1. Open source development: A and B decide to work together on the program.

1. A maximizes A*v(eA+eB)-eA and thus makes effort s.t. A*v’(eA+eB)=1.

2. B maximizes B*v(eA+eB)-eB and thus makes effort s.t. B*v’(eA+eB)=1.

3. Both cannot be true at the same time if A≠B!

4. Nash equilibrium: The one with the highest value for the software does all the effort. Suppose A>B, then eA s.t. A*v’(eA)=1 while eB=0

5. There is under-provision of effort vs. the optimum (which was reached with a proprietary monopoly). (we assume convex costs)

6. On the other hand, B is better off ;)

7. Furthermore, A does not have to incur the additional costs of commercialization and intellectual property protection + he does not have to think about B when developing his product.

Open Source Software: Private Provision of a Public Good

Justin Pappas Johnson, Journal of Economics & Management Strategy

Volume 11, Issue 4, pages 637–662, Winter 2002

http://dx.doi.org/10.1111/j.1430-9134.2002.00637.x

SOFTWARE DEVELOPMENT

1. An issue with proprietary software is that developers care too much about ease of use!

1. The monopolist cares about the marginal consumer, not the average consumer.

2. Therefore he will develop too many features and will focus too much on making the software easy to learn vs. easy to operate.

3. This is the curse of Microsoft users: every new version has more features, no effort is made to improve existing features.

“Economic incentives in software design”,

Hal R. Varian, Computational Economics,

Volume 6, Issue 3-4 , pp 201-217,

http://dx.doi.org/10.1007/BF01299175

SOFTWARE DEVELOPMENT

1. An issue with open-source software is that developers care too little about ease of use for others.

1. Usually a steep learning curve, although forums help.

2. Other issues include:1. Incompatibility between different versions of the same original software

(forking).

2. Favouring the interests of existing users of the software vs. potential new ones.

3. Lack of long-term involvement by developers, although open source foundations help.

4. Note how some of those issues are the opposite of the issues with proprietary software.

“Do Open Source Developers Respond to Competition?: The LaTeX Case Study”

Alexia Gaudeul, Review of Network Economics, 6(2), pp. 239-263,

http://dx.doi.org/10.2202/1446-9022.1119

INTELLECTUAL PROPERTY RIGHTSAND INNOVATION

1. What is the appropriate level of protection for intellectual property rights

1. Patents or copyright? see http://en.wikipedia.org/wiki/Software_patent_debate for some issues related to this debate.

2. Balance between being easy to copy and build upon vs. incentives to innovate. See “Patent Life and R&D Rivalry” by Morton I. Kamien and Nancy L. Schwartz, The American Economic Review, Vol. 64, No. 1 (Mar., 1974), pp. 183-187, http://www.jstor.org/stable/1814893

2. Is the software industry sufficiently innovative?1. How can one know?!

2. For more on this, see my presentation on open source software and innovation at http://www.scribd.com/doc/18245353/Open-source-software-and-innovation

HAPPY FURTHER READING!