Software industry landscape
The software industry is highly concentrated. A small number of players dominate the industry holding relatively high market shares. For example, Microsoft (MSFT) dominates the personal computer market, SAP AG (SAP) is the leader in the enterprise application software segment, and Salesforce.com (CRM) dominates customer relationship management.
The confluence of network effects, law of increasing returns, and switching costs associated within the industry can explain its concentration.
The previous chart shows the market share enjoyed by different desktop operating systems. Windows tops the list commanding 91% of the market.
Organizations prefer to develop and deploy application and information systems in an environment that has a strong network of supporting infrastructure and a large customer base. This minimizes compatibility issues and maximizes portability. Microsoft Windows operating system commands 90% of the personal computer (or PC) market. It’s an example of network effect in the software industry. Most of the employees are familiar with windows operating environment and its compatible applications. It has become the first choice of the corporate world. This is called the “network effect,” where current users of Microsoft Windows are benefiting as more people adopt it.
Standardization and customization
Every computer requires operating systems. They’re standardized across to appeal to the mass market. Computer manufacturers are the principal customers of “operating systems,” who prefer to maintain compatibility among various operating systems. Compatibility ensures ease of data exchange. As a result, few operating systems dominate the landscape, which gives them a considerable pricing power. It has limited variations to offer, which makes it unsuitable to different end users. Certain industries and organizations cater to customers with various requirements. The more the needs of the end-users are varied, the more likely the chances are of software being customized. Mass market products are standardized while products catering to a niche market are customized. Standardization is most likely to be pursued by a product organization to drive economies of scale. Customization will be preferred by services because it helps them in the value chain. With the rapid advancement in technology, licensed software are being customized to cater to huge organizations, which creates “mass customization.” Customer relationship management (CRM) and enterprise resource planning (ERP) fall under the “mass customization category.”
Also, because the installed base of Microsoft Windows is so large, independent software vendors chose or are forced to develop applications compatible with Windows. That explains why we see so many applications being developed for Windows and not Linux OS of Oracle (ORCL). In 1994, IBM released the OS/2 warp operating system. Despite a massive investment, it failed to achieve significant traction because of its inability to gain support from independent software vendors and third party developers.
Network effects tend to give the leading players a competitive edge and monopoly over pricing power, which imposes a significant barrier to competition. Microsoft harnessed its success and dominance in operating systems by selling its office software. Microsoft exploited network effects to the maximum.
However, when the differentiating feature of a product is stronger, then niche products can survive in spite of a weaker network. Apple (AAPL) is a classic example with its sticky market share.
Once customers adopt specific operating systems, it would be very difficult for them to even consider changing it. Organizations make huge investments in buying an operating system and training their employees. If it decides to switch, it would have to pay a large amount to integrate the new system with its existing systems and then train its employees. This explains the high “switching costs” associated with the software industry.
Law of increasing returns
At first, huge costs are incurred to develop proprietary software. Once it’s developed, it doesn’t cost much to duplicate or produce a thousand copies of the same software program. The packaging costs falls with volume. As a result, the cost of software per unit tends towards zero with volume.
Both network effects and increasing returns rules out or minimizes competition in the proprietary software market. Also, leading players apportion huge marketing expenditure. The marketing becomes more important than software features and its quality.