Pricing Software Upgrades: The Role of Product Improvement and User Costs

The computer software industry is an extreme example of rapid new product introduction. However, many consumers are sophisticated enough to anticipate the availability of upgrades in the future. This creates the possibility that consumers might either postpone purchase or buy early on and never upgrade. In response, many software producers offer special upgrade pricing to old customers in order to mitigate the effects of strategic consumer behavior. We analyze the optimality of upgrade pricing by characterizing the relationship between magnitude of product improvement and the equilibrium pricing structure, particularly in the context of user upgrade costs. This upgrade cost (such as the cost of upgrading complementary hardware or drivers) is incurred by the user when she buys the new version but is not captured by the upgrade price for the software. Our approach is to formulate a game theoretic model where consumers can look ahead and anticipate prices and product qualities while the firm can offer special upgrade pricing. We classify upgrades as minor, moderate or large based on the primitive parameters. We find that at sufficiently large user costs, upgrade pricing is an effective tool for minor and large upgrades but not moderate upgrades. Thus, upgrade pricing is suboptimal for the firm for a middle range of product improvement. User upgrade costs have both direct and indirect effects on the pricing decision. The indirect effect arises because the upgrade cost is a critical factor in determining whether all old consumers would upgrade to a new product or not, and this further alters the product improvement threshold at which special upgrade pricing becomes optimal. Finally, we also analyze the impact of upgrade pricing on the total coverage of the market.