Research by Pradeep K. Chintagunta and Jean-Pierre Dubé
Brand managers of high-tech hardware have become increasingly aware that the availability of compatible third-party software strongly influences sales of their products. However, the availability of this software depends on the number of people who have adopted the hardware, since these consumers constitute the consumer base for the software. Recent research gauges the extent of this "indirect network effect," and helps managers determine whether their resources are best invested in hardware improvements or in encouraging additional software creation.
When consumers contemplate purchasing high-technology products,
they take into account the price, quality, and features of
the brands they are considering. For some high-tech purchases,
consumers may also consider how many other people possess
the same technology.
The value and appeal of owning a fax machine, for example,
depends on a consumer's ability to use it for communicating
with other consumers. Hence, the total potential value that
consumers gain from owning a fax machine depends on the number
of people who have already adopted the technology, which is
referred to as the "installed base." This relationship
between value creation and the installed base is often referred
to as the "network effect."
In the case of hardware devices that use software as drivers
of their operating systems (O/S), the purchasing decision
also depends on how many software titles exist for the particular
operating system. The greater the variety of software, the
more appealing the hardware will be.
As a format of hardware becomes more popular, consumers will
demand more software to run it. This demand motivates software
producers to enter the market and develop more software for
that operating system, which leads to yet more sales of the
hardware. Hence, in an indirect way, the total potential value
that the hardware offers to consumers depends on the installed
base. Increasing the installed base leads to higher software
demand. This stimulates the greater production of software,
and ultimately raises the attractiveness of purchasing hardware.
The circular relationship between hardware value creation
and the installed base is often referred to as the "indirect
network effect"-how the availability and variety of software
influences hardware sales.
This circular effect has led to a growing belief among hardware
manufacturers that they can boost sales not only by improving
product quality, but also by encouraging compatible software
creation. More importantly, ignoring the indirect network
effect may cause managers to underestimate the total impact
of value-enhancing investments in their hardware on total
long-term sales.
In their recent study, "Empirical Analysis of Indirect
Network Effects in the Market for Personal Digital Assistants,"
University of Chicago Graduate School of Business professors
Pradeep K. Chintagunta and Jean-Pierre Dubé, and University
of Chicago Graduate School of Business doctoral student Harikesh
Nair examine this circular relationship in the context of
the growing market for personal digital assistants (PDAs).
"Firms should evaluate the cost of investing in improving
their product or encouraging software creation," says
Chintagunta. "If a company has limited resources, it
needs to choose between the approaches, but if it has greater
resources, it may choose a combination of the two. There are
likely to be synergistic benefits from simultaneously improving
your product and encouraging software development."
Prompting Purchasing
In order to track the market for PDAs, Chintagunta, Dubé,
and Nair used data from the market research firm NPD Techworld
on the retail sales of all PDA models from early 1999 to mid-2002.
The PDA market is dominated by two standard operating systems:
1) Palm O/S, which is run on Palm, Handspring and Sony models;
and 2) Microsoft O/S, which is run on Casio, Compaq, and HP
models.
The authors find that purchasing decisions were influenced
by a number of advanced product features, and that consumers
were predisposed to PDAs with greater random access memory
and clock speed, larger face areas, lighter weights, color
displays, built-in modems, lithium batteries, and multiple
expansion slots. In addition, PDA consumers preferred tablet-shaped
rather than clamshell-shaped units.
In making their purchasing decision, buyers strongly preferred
PDAs with operating systems that were compatible with a larger
number of software products.
The authors find that having a greater variety of software
led to higher PDA hardware sales, which in turn stimulated
the creation of additional complementary software.
Features vs. Software
Should PDA product managers invest company resources in hardware
improvement or encourage the development of additional complementary
software?
In most high-technology categories, such as PDAs, where prices
are falling and sales are rising, it is difficult to determine
whether higher sales figures reflect lower prices or a growing
acceptance of the product.
To resolve this issue, the authors analyzed data on software
variety and availability for each operating system, as supplied
by the Web site Download.com. They found that the availability
of software is becoming increasingly important as a sales
driver for PDAs.
Sales of Palm O/S models led sales of Microsoft O/S models
by a significant amount. By the concluding months of the study,
price and model features accounted for 78 percent of Palm's
lead in sales. Greater software availability for the Palm
O/S models accounted for the remaining 22 percent of the sales
gap.
In studying sales of PDAs and compatible software, the authors
found Palm O/S enjoys a significant advantage over Microsoft
O/S in the number of compatible third-party software titles
available. That availability has helped Palm O/S sell nearly
twice as many PDAs as its closest rival.
The overall trajectory of the two shares over time implies
that the availability of compatible software will be an ever
bigger trigger for hardware sales in the future.
"Software is becoming increasingly important,"
says Dubé. "The industry isn't just focused on
increasing megahertz anymore. With a large base of users,
it's possible to justify the development costs for more software
applications by third-party producers."
The authors analyzed the degree to which each hardware platform
would be better off if there was more software available for
that platform. They then looked at how the lack of availability
of one platform's software actually helped sales of software
for the rival's product. They find that Microsoft benefits
more when there is less software available for Palm than Palm
would if there was less software available for Microsoft.
This finding has significant implications for brand managers
employed by manufacturers of Microsoft O/S platform PDAs.
According to the authors, if brand managers were to identify
small but promising software companies, they might strongly
consider signing exclusive agreements with those firms to
supply Microsoft while shutting out Palm.
Product Improvements
The authors next approached the issue from the perspective
of a Palm manager deciding whether to improve specific product
features of Palm PDAs. The sales gains from making such improvements
would have to be balanced against the costs of implementing
the changes.
Improving product quality by enhancing features has two effects.
The first, a direct effect, would flow from the addition of
a feature valued by customers, resulting in greater sales
for Palm.
The additional sales volume would probably come at the expense
of other Palm O/S-compatible PDAs. However, if the sales gains
to Palm were greater than the decreases experienced by other
Palm O/S-compatible PDAs, the number of people using PDAs
with the Palm operating system would increase.
The second effect is an indirect effect: the increase in
the number of Palm O/S users would encourage the creation
of more Palm O/S-compatible software by third-party providers.
That increase in software would further boost sales of all
Palm O/S compatible PDAs.
For Palm PDAs, a stronger direct effect will yield a stronger
indirect effect. This is due to the positive feedback from
the increase in the number of Palm O/S users, which will result
in the creation of more software compatible with that system.
"Improving hardware attributes has two effects,"
says Chintagunta. "The direct effect is that adding a
color screen, for example, will lead to higher hardware sales.
The indirect effect is that by virtue of the increasing hardware
sales, more software will be created, and that will further
increase hardware sales. It's important to take both these
effects into account."
To evaluate the trade-offs between the investment in hardware
improvements and the sales gains resulting from those improvements,
the authors calculated the number of new software titles required
to achieve the same level of sales growth.
The authors find that 224 more third-party software titles
would have to be added to the market to attain the same unit
sales gains Palm enjoyed as a result of upgrading its Palm
V device to a color display. One hundred sixty-one titles
would have to be added to match gains resulting from the increase
in screen size, 83 titles to equal gains from the increase
in clock speed, and 19 to match gains from adding a second
expansion slot.
If brand managers know the costs involved in encouraging
the development of more software, they can better evaluate
the trade-offs between improving the hardware and encouraging
the creation of software.
Chintagunta, Dubé, and Nair conclude that an undersupply
of third-party software hurts sales of both Palm and Microsoft
O/S-compatible PDAs.
PDA manufacturers would benefit from investing resources
to increase the supply of software compatible with their products.
"There is a sizable indirect network effect," says
Dubé. "Given this effect, it's not surprising
that hardware manufacturers are starting to divert sizable
resources away from hardware research and development to both
in-house and third-party software development."
Pradeep K. Chintagunta is Robert Law Professor of Marketing at the University of Chicago Graduate School of Business. Jean-Pierre Dubé is assistant professor of marketing at the University of Chicago Graduate School of Business.
