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."
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.
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 Chicagio Graduate School of Business.