The Optimal Software Licensing Policy under Quality Uncertainty

The rapid rate of standard software development, and the need of users to stay current, has unleashed unprecedented levels of process and product innovations in the software industry. A new service model has emerged which delivers application software and services over the Web on a lease or subscription basis. Software vendors such as Sun, Oracle, and Microsoft have already adopted this innovative business model. They have expanded their sales offerings with lease contracts that augment their traditional one-time purchase transactions. Our paper studies the optimal licensing policy of a software vendor that uses that business model. We look at software vendors that are both selling (at a posted price) or leasing their products where as lessor they guarantee that the lessee will always have the latest version of the software on their desktop. We address some of the specific issues of implementing this policy at the packaged software market, including the impact of network externality, negligible marginal production costs, and upgrade compatibility. We show that by properly defining their pricing structure, software vendors can segment the market and realize effective second- degree price discrimination and show how and when software vendors can maximize their profits through the use of this new licensing policy