Week 7: Clear

Software as Money Making Machine

Today’s Software Business is a very lucrative business. Not for nothing do so many different companies engage in this industry. So what are aspects which make this business so attractive and why do these companies earn so much money with it?

There are three general concepts which make the Software business so profitable and popular, namely marginal costs, network effects and switching costs.

Let us have a look at all three of them:

Marginal Costs

Marginal costs with respect to software are effectively zero. Once a software is developed and all development expenditures are paid, each additional copy of it is easy to manufacture. Just another hard drive is needed (e.g. a CD) and the code can be copied without any effort. Hence, the marginal costs is so low that it can be neglected.

Network Effects

Graphic 1: Network Effect of the Telephone

Another reason why software is considered as “money making machine” are the network effects. The network effects describe the phenomena that as more and more people are using a software, the value of the program grows. So the larger the user base the larger the value. Professor Olsen  compared it to an avalanche coming down a mountain. It starts small but get bigger and bigger quite soon.

A simple example for this is the telephone (see Graphic 1). When only two people own a telephone the value they can gain is limited as they can only call each other. However, if five people own a telephone each, the value they can gain is much larger, as each of them can not only call one other person but 4 other people. So the more people are using a telephone, the higher is the value one can gain by being connected to this community.

Switching Costs

The last concept being explained is the concept of switching costs. Switching costs are high with respect to software. Once a company has engaged in expenditures for a certain software, has installed this program on all technical devices and has for example provided training for employees to work with this software, the company is less likely to switch to another software or software vendor. The switching costs are high as significant effort, time and money has to be spend on the software itself and on the activities making the software usable.

So keeping in mind that once all accrued costs due to development are paid, the marginal costs are zero, that the more people use a software, the more valuable it gets and that once a customer has spend money, time and effort on a program, he or she is unlikely to switch, it gets clear why the Software industry is such a profitable and popular business. However, one should not forget, that it might also be hard to survive in this industry as it is very dynamic and risky.

Graphic 1 by Fernando S. Aldado on Wikimedia Commons:

http://commons.wikimedia.org/wiki/File:Network_effect.png