Hedonic Model of Network Externalities

From Information Systems at Pitt Business

Software applications are a multi-billion dollar industry. However, unlike other products the pricing of software is difficult to determine and predict. Software vendors spend thousands or millions of dollars to develop the initial software application, with each subsequent copy costing relatively nothing. As a result, the pricing of a software application package is very strategic and not driven by direct costs like manufactured products.

This paper creates a hedonic model to predict the price of spreadsheet applications. The model was verified with data from the spreadsheet industry from 1987-1992. The model finds that consumers are willing to pay more for the spreadsheet application when more individuals use the given application, and when the application follows industry standards. Additionally, the price of the application dropped with each year of the analysis.

[edit] Abstract

Because of network externalities, the success of a software product may depend in part on stalled base and its conformance to industry standards. This research builds a hedonic model to determine the effects of network externalities, standards, intrinsic features and a time trend on microcomputer spreadsheet software prices.

When data for a sample of products during the 1987-1992 time period were analyzed using this model, four main results emerged: 1) Network externalities, as measured by the size of a product's installed base, significantly increased the price of spreadsheet products: a one percent increase in a product's installed base was associated with a 0.75% increase in its price. 2) Products which adhered to the dominant standard, the Lotus menu tree interface, commanded prices which were higher by an average of 46%. 3) Although nominal prices increased slightly during this time period, quality-adjusted prices declined by an average of 16%. per year. 4) The hedonic model was found to be a good predictor of actual market prices, despite the fact that it was originally estimated using list prices.

Several variations of the model were examined, and, while the qualitative findings were robust, the precise estimates of the coefficients varied somewhat depending on the sample of products examined, the weighting of the observations and the functional form used in estimation, suggesting that the use of hedonic methods in this domain is subject to a number of limitations due, inter alia, to the potential for strategic pricing by vendors.

[edit] Paper Information

Authors: Erik Brynjolfsson, Chris Kemerer

Check out this paper at Network Externalities in Microcomputer Software: An Econometric Analysis of the Spreadsheet Market

This paper was originally published in Management Science, Vol 42, Num 12, 1996.

[edit] Keywords

Network externalities, standards, pricing, software, hedonic regression, information technology