Functional Quality Degradation of Software with Network Externalities

This paper considers a functional quality degradation of software with twoway features (such as reading and writing in word-processors). A software monopolist differentiates products by introducing a functionally down-graded version (e.g. the read-only version) by eliminating some functions of the full version. A simple two-type model is presented to explain the firm’s incentive to introduce a functionally down-graded version. It is shown that the functional quality degradation is an effective consumer screening device, especially when consumers’ valuation for each function is negatively correlated. With network externalities, the firm may wish to offer the down-graded good below cost or even free of charge in many cases (including the case where introducing the quality-degraded version does not involve a market expansion). The welfare consequence of this kind of quality degradation is generally ambiguous, and critically depends on how the total market size changes by the introduction of the quality-degraded version.