Vertically Differentiated Markets with Costly Under-Provisioning: The Case of Versioning in Software Industry

Abstract

Versioning literature recommends that a software firm should always sell only one version of a product with the highest quality unless other factors such as piracy, network externality, or concave cost of producing quality are present. However, software firms universally adopt versioning strategies that are invariant across different market settings. To bridge the gap between theory and practice, this research proposes a vertical differentiated consumer utility model that captures consumer heterogeneity in taste for functionality and preferred level of functionality. While consumers experience disutility if the level of functionality is lower than their preferred level, they do not derive any additional utility if the level of functionality is higher than their preferred level. To that extent, under-provisioning of functionality is costly. This article shows that in a monopolistic market, versioning strategy is always optimal compared with strategies to sell one version to all consumers or only to high type users. Counterintuitively, an increase in the high (low) type users’ preferred level of functionality negatively (positively) impacts high type users’ surplus. As the preferred level of functionality of high type users increases, functionality level of the high version increases, and the impact on functionality level of the low version depends on the proportion of high type users in the market. On the other hand, as the preferred level of functionality of low type users increases, functionality level of high version remains the same and the impact on functionality level of low version is ambiguous.

Keywords: Vertical differentiation, utility function, versioning, costly under-provisioning, preferred level of functionality