Market Provision of Custom Software: Learning Effect and Low-Balling

Market Provision of Custom Software: Learning Effect and Low-Balling

Management Science. August
1995, Vol. 41, Issue 8, Pages 1343-1352

Due to reusability of program code and learning effects in software development, development cost of custom software typically decreases in time and experience. This creates a first-mover advantage to software developers. The paper studies whether the benefits of declining development costs are passed on to buyers in the form of lower prices when developers bid strategically. By using a model of bidding auctions we characterize equilibrium bidding strategies of two software developers. In order to become the first mover and attain future market dominance, developers find it optimal to forgo profits from the first projects. As a result, bid prices (= development cost plus a profit margin to the developer) to the buyers may not necessarily decrease over time, and even if so, not as fast as development cost drops. We also show that bidders expect a higher profit margin from a high-variance project. Thus, if there exist high-variance projects in the future, developers are more likely to submit below-cost bid prices or “low ball.”