The Software Industry: When personal computers first came onto the scene, the task of writing software was considerably more difficult than it is today. Over the following decades, consumer demand for software has increased as personal computers became prevalent in more and more homes and businesses at the same time as it has become easier to write software. Thus, the industry has been one of expanding demand and decreasing fixed entry costs.
A: In this part of the exercise, analyze the evolution of the software industry using both the monopolistic competition model from Section 26A.4 as well as insights from our earlier oligopoly models.
(a) Begin with the case where the first firm enters as a monopoly — i.e. the case where it has just become barely profitable to produce software. Illustrate this in a graph with a linear downward sloping demand curve, a constant MC curve and a fixed entry cost.
(b) Suppose that marginal costs remain constant throughout the problem. In a separate graph, illustrate how an increase in demand impacts the profits of the monopoly and how a simultaneous decrease in fixed entry costs alters the potential profit from entering the industry.
(c) Given the possibility of strategic entry deterrence, what might the monopolist do to forestall entry of new firms?
(d) Suppose the time comes when a strategic entry deterrence is no longer profitable and a second firm enters. Would you expect the entering firm to produce the same software as the existing firm? Would you expect both firms to make a profit at this point?
(e) As the industry expands, would you expect strategic entry deterrence to play a larger or smaller role? In what sense is the industry never in equilibrium?
(f) What happens to profit for firms in the software market as the industry expands? What would the graph look like for each firm in the industry if the industry reaches equilibrium?
(g) If you were an antitrust regulator charged with either looking out for consumers or maximizing efficiency, why might you not want to interfere in this industry despite the presence of market power? What dangers would you worry about if policy-makers suggested price regulation to mute market power?
(h) In what sense does the emergence of open-source software further weaken the case for regulation of the software industry? In what sense does this undermine the case for long-lasting copyrights on software?
B: In this part of the exercise, use the model of monopolistic competition from Section 26A.4. Let disposable income I be $100 billion, ρ = −0.5 and marginal cost c = 10.
(a) What is the assumed elasticity of substitution between software products?
(b) Explain how increasing demand in the model can be viewed as either increasing I or decreasing α. Will either of this change the price that is charged in the market? Explain.
(c) We noted in part A of the exercise that fixed entry costs in the software industry have been declining. Can that explain falling software prices within this model?
(d) True or False: As long as the elasticity of substitution between software products remains unchanged, the only factor that could explain declining software prices in this model is declining marginal cost. (Can you think of real world changes in the software industry that might be consistent with this?)
(e) Now consider how increases in demand and decreases in costs translate to the equilibrium number of software firms. Suppose α = 0.998 initially. What fraction of income does this imply is spent on software products? How many firms does this model predict will exist in equilibrium under the parameters of this model assuming fixed entry costs are $100 million? What happens to the number of firms as FC falls to $10 million, $1million and $100,000?
(f) Suppose that FC is $1,000,000. What happens as α falls from 0.998 to 0.99 in 0.002 increments as demand for software expands through changes in representative tastes when more consumers have computers?
(g) Suppose FC is $1,000,000 and α = 0.99. What happens if demand increases because income increases by 10%?