Perpetual Versus Subscription Licensing Under Quality Uncertainty and Network Externality Effects JIE (

We discuss the optimal way for a software vendor to license software: a perpetual license at a posted price, a subscription contract that subscribers receive automatic updates for periodic payment, or a hybrid approach that involves both. by addressing specific issues in the software market such as network effects, quality uncertainty, upgrade compatibility, and the vendor’s ability to commit to future prices in a dynamic environment, we demonstrate how a software vendor can manage the trade-offs of perpetual licensing and subscription to optimize profit, as well as the corresponding welfare effect on consumers. although the subscription model helps the vendor lock in consumers so as to increase profit when there is great uncertainty 40 ZhaNg aND SEIDMaNN associated with the next version software, it destroys the path dependence in creating network externalities. Therefore, when the network effect is sufficiently large, it is more profitable for a software vendor to provide both perpetual licensing and subscription. Key wordS and phraSeS: compatibility, network externality, price discrimination, quality uncertainty, software licensing, upgrades. Software productS traditionally have been Sold aS a property via a perpetual ownership licensing model. Customers acquire the permanent right to use and own the version of the software by paying up front. Software publishers have adjusted their licensing models from the traditional perpetual licensing model in favor of software subscription models. They deliver application software and services (software maintenance, upgrades, staff training, etc.) over the Web on a lease or subscription basis. for example, Microsoft bundled its Enterprise Subscription agreement for business users with Software assurance at an annual rate on a three-year term; vendors such as Sun, Oracle, SaS Institute, Computer associates, and bMC Software have also offered their own subscription licenses on their major products. Despite the various forms of licensing models, the vendors all aim at generating perpetual revenue streams by transforming software into a subscription-based service. Industry practitioners claim that the subscription model can lower the cost of ownership and grant users access to up-to-date software at a predictable cost without a large up-front investment. They have even claimed that “traditional software is already dead” [25]. International Data Corporation (IDC) has also predicted that the software industry will experience “a transition to subscription licensing” [24]. Software can be used for a period of time without replacement, though its value may depreciate. In this sense, it is a kind of durable good. Yet software as a commodity has some special characteristics that differentiate it from other durable goods: (1) in general, software cannot be resold or appropriated due to license restrictions, so a secondhand market such as that for used cars does not exist; therefore, we can ignore the resell problem in selling other durable goods; (2) the production of software that is an information good has cost-side economy of scale—it is costly to create the first copy but has negligible marginal production cost for additional copies; (3) with the development of information technology (IT), it is relatively easy to improve the value of installed software through upgrades; and (4) the use of software has a strong network externality; that is, the value of using any particular software increases with the number of its adopters. This network externality, therefore, is like the “chicken and egg” problem [15]. as a result, we cannot apply the established theories about selling or leasing durable goods directly to the licensing models of software. This paper addresses these issues by studying the optimal licensing policy of a monopolist software vendor who provides packaged off-the-shelf products through a perpetual licensing or subscription model exclusively, or through a mixed strategy of both. In order to provide strategic suggestions to software vendors as well as recomPErPETUal VErSUS SUbSCrIPTION lICENSINg 41 mendations to users, we address the following research questions by incorporating the special characteristics of software products: RQ1: What are the benefits and costs of perpetual and subscription licensing models for a vendor? RQ2: Trading off those benefits and costs, what is the optimal way for vendors to license software? Should they use subscription licensing to completely replace the traditional perpetual licensing? RQ3: How are consumers’ purchasing behaviors influenced by different licensing models? by addressing the specific issues related to licensing models, such as compatibility, network externalities, quality uncertainty, and commitment, our paper fills a gap in the literature by examining the impact of quality uncertainty and network externalities on a monopoly seller’s licensing models. With our more generalized new findings, our paper extends the previous results of selling and leasing durable goods [4, 7, 8, 16] to a broader scope, and it provides key insights to software vendors as well. literature review many economicS and marKeting reSearcherS have examined the ways of selling durable goods. Coase [7] conjectured that a monopolist seller of such goods could not sell them at the monopoly price because rational and patient consumers would anticipate a future price drop and delay their purchase. Coase suggested that leasing durable goods would solve this time-inconsistency problem. bulow [4] formally proved the Coase conjecture and further affirmed that leasing can achieve the optimal profit for a monopolist seller of nondurable goods; other studies verifying the conjecture followed, including, for example, gul et al. [12]. Some works, however, have challenged the assumptions of the Coase model and have proposed conditions under which leasing can coexist with selling as the optimal strategy for a monopolist seller of durable goods. bucovetsky and Chilton [3], for example, suggested threat of entry as a reason for the monopolist to mix selling and leasing. Desai and Purohit [8] found that leasing does not dominate selling in all cases if depreciation of the durable goods is taken into account and that a mixed strategy is optimal when the depreciation rates differ between selling and leasing. We investigate a monopolist software vendor who sells or leases his or her product to the market, which is similar to this stream of research. In order to examine the impact of the network externality effect and uncertainty regarding quality on the vendor’s strategy, we exclude from consideration the potential effects of competition and product depreciation. We deal here with intertemporal product quality improvement, which differs from vertical product differentiation in a static state, as studied by bhargava and Choudhary [1], Moorthy [18], and Mussa and rosen [19], among others. a related stream of literature concerns product upgrades in selling durable goods. levinthal and Purohit [17] considered the pricing of two generations of a durable good but do 42 ZhaNg aND SEIDMaNN not allow for an upgrade price. Dhebar [9] discussed the existence of pure strategy subgame-perfect equilibria in two-period models of overlapping generations of products with and without upgrades. Padmanabhan et al. [20] show that firms may issue upgrades as a signal of potential product acceptance when consumers face uncertainty about the degree of network effects for the product. fudenberg and Tirole [11] discussed how a monopolist prices the new generation of durable goods based on the information he or she has about past customers. Viard [26] studied a monopolist’s upgrade strategy in an infinite-period setting and empirically verifies the results with data from the PC software industry. Sankaranarayanan [22] found that a monopolist software vendor will have an incentive to release new updates without cannibalizing his or her existing customers when the fixed cost of developing software is relatively high. among the research on selling and leasing packaged software products, Choudhary et al. [6] suggested that renting software in the first period to those who otherwise would adopt later can increase the seller’s profit; Choudhary [5] considered the effect of the selling and leasing schemes on the publisher’s incentive to invest in software quality. harmon et al. [13] provided a thorough review of the literature on IT services pricing and presented a value-based approach. Our work also draws on the literature about markets that involve direct or indirect network effects. Katz and Shapiro [15] categorized such markets and identify the issues firms and consumers face in them. brynjolfsson and Kemerer [2] constructed a hedonic model and empirically report that the network externalities significantly contribute to the success of spreadsheet products: a 1 percent increase in a product’s installed base was associated with a 0.75 percent increase in its price. Network externalities endogenize a user’s decision on the other users’ utilities and decisions. Combined with compatibility, versioning, and upgrades, they significantly complicate a software vendor’s strategic decisions. The most current attempt to address these issues is by Ellison and fudenberg [10], who examined software upgrades with network externalities under the pure selling policy. They found that the network effect causes upgrades beyond the socially optimal level. Our paper uses a similar setting, but we instead look at the seller’s licensing and pricing strategies. building on prior literature, we consider software upgrades, quality uncertainty, compatibility, the network effect, and the ability to commit in our model of a monopoly software vendor’s optimal licensing policy, taking into account users’ responses. We provide vendors with important insights on licensing policies and improve our understanding of the implications of