Pricing and Market Segmentation for Software Upgrades

Upgrades are endemic in the software industry and create the possibility that customers might either postpone purchase or buy early on and never upgrade: When will a customer upgrade? Is it better to upgrade now or to wait for an improved version? When should we release an improved product? How much should we charge for each version? Should we give discounts on upgrades to existing customers? Will today’s sales be cannibalized by the anticipated improved version? We focus on pricing and how it is affected by the degree to which a product is improved between versions. In particular, we are interested how the firm should price different versions of its product and whether it should offer “upgrade discounts” to existing customers. To address these issues, we analyze a two-period model in which a firm sells an initial version of its product in the first period and an improved version the second. In each period, the firm (i.e., the software supplier) selects the selling prices, and customers decide whether to purchase. Customers may purchase the product in either or both periods and, at the firm’s discretion, are given a discounted price if they repurchase/upgrade in the second period. We solve this model for subgame perfect equilibrium prices and purchasing decisions and investigate how equilibrium prices, profits, and cash flows are influenced by the degree of product improvement. We also uncover a number of managerial insights; for example, equilibrium pricing induces all of the first period purchasers to upgrade to the improved product in the second period. ∗UCLA Anderson School of Management, Los Angeles, CA Pricing for Software Upgrades Bala and Carr