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: Akerlofs market for lemons
3. Some possible solutions
A.
B.
C.
D.
E.
F.
G.
H.

Reputation?
Advertising?
Guarantees?
Certification?
Samples?
Sell services, not software? (Software as services)
Rental?
(ideas?)

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.

Akerlofs 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

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 Akerlofs prediction, markets for
information goods do exist. How is that?
A.
B.
C.
D.
E.
F.

Reputation done already

Signaling through advertising another time!
Guarantees
Certification
Samples.

GUARANTEES

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

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.

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."

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 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 qiqJ, or it can choose to say nothing.

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 dont.

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 dont.

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).

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)

INTERMEDIATION AND SAMPLING

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.
2.
3.

Well known, basic quality sell as usual

Less well known, high quality offer a sample
Less well known, medium quality sell via repository

SOFTWARE DEVELOPMENT
1.
1.
2.

2.
1.
2.

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

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

Open Source Software: Private Provision of a Public Good

Justin Pappas Johnson, Journal of Economics & Management Strategy
Volume 11, Issue 4, pages 637662, Winter 2002
http://dx.doi.org/10.1111/j.1430-9134.2002.00637.x

SOFTWARE DEVELOPMENT

1. Open source development: A and B decide to work

together on the program.
1.
2.
3.
4.
5.
6.
7.

A maximizes A*v(eA+eB)-eA and thus makes effort s.t. A*v(eA+eB)=1.

B maximizes B*v(eA+eB)-eB and thus makes effort s.t. B*v(eA+eB)=1.
Both cannot be true at the same time if AB!
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
There is under-provision of effort vs. the optimum (which was
reached with a proprietary monopoly). (we assume convex costs)
On the other hand, B is better off ;)
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.

SOFTWARE DEVELOPMENT

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

1. An issue with proprietary software is that

developers care too much about ease of use!
1.
2.
3.

The monopolist cares about the marginal consumer, not the

average consumer.
Therefore he will develop too many features and will focus too
much on making the software easy to learn vs. easy to operate.
This is the curse of Microsoft users: every new version has more
features, no effort is made to improve existing features.

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

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.
2.
3.

4.

Incompatibility between different versions of the same original software

(forking).
Favouring the interests of existing users of the software vs. potential
new ones.
Lack of long-term involvement by developers, although open source
foundations help.
Note how some of those issues are the opposite of the issues with
proprietary software.

INTELLECTUAL PROPERTY RIGHTS

AND 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-andinnovation

HAPPY FURTHER READING!