Software Upgrades with Price Competition

In this paper, we model competition between two software product vendors, an incumbent and entrant, with specific focus on the role of switching costs. Contrary to conventional wisdom, we find that under certain conditions the switching costs imposed by the incumbent's product could actually hurt the incumbent's profit and help the entrant's profit. Additionally, we find that higher switching costs could actually result in higher consumer-surplus and social surplus. In our model, in a two period setting, the incumbent and entrant compete to sell to a mass of customers located on a Hotelling line. In the first period, the incumbent offers an initial version of the software product. In the second period, both incumbent and entrant offer improved versions of the software, with upgrade discounts to customers who have already purchased the incumbent's product in the first period. Our analysis reveals that the incumbent's profit is maximized when the entrant poaches some of the incumbent's first period customers through upgrade pricing - i.e. the incumbent would rather that some of her customers switch to the entrant than not. This is consistent with several instances of industry practice. The existence of this equilibrium requires sufficiently high switching costs. However, the profit of the incumbent in this equilibrium reduces with switching costs. This implies that to the extent the incumbent can endogenize switching costs; it prefers the switching costs to be just large enough to satisfy the existence criterion. Our model extends prior literature on duopolistic competition to the context of competition marked by price discrimination where such pricing is enabled through digital information exchange mechanisms such as e-mails and firm web-sites etc.