New Features Free of Charge? Using Price to Sort Consumers Among Legacy Software Versions

Abstract

In many durable good contexts, firms price discriminate by charging higher prices for the latest functionality. By contrast, the software market sees little such price discrimination, despite new versions being introduced over time. I propose that the software firm’s ability to price discriminate is restricted by (1) the extent to which consumers value the innovation and (2) the cost associated with legacy software maintenance. To analyze this question, I use a unique dataset of subscriptions to a Fortune 500 firm’s software products. In my data, consumers frequently choose to forgo the free upgrade, electing to renew legacy versions of the product instead. To distinguish among the different factors driving this pattern, I develop a dynamic model of consumer choice of product versions, renewal opportunities and upgrades. The model estimates reveal that although the majority of consumers value new versions, the high value, price insensitive consumers do not, causing it to be unprofitable for the firm to price latest functionality at a premium. Even so, I find that this preference heterogeneity favors a shift to a product with automatic upgrades to the latest functionality, thus providing both a cost and a demand justification for this observed industry trend.