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Innovation and the Durable Goods Monopolist: The Optimality of Frequent New-Version Releases

School of Business, University of Connecticut, Storrs, Connecticut 06269
rsankaran{at}business.uconn.edu

When an improvable durable good (such as packaged software) saturates the market, the seller could be tempted to release new versions too frequently, hurting her profit. A novel contractual device, which I term as a Free New Version Rights warranty (free NVR warranty), can help the seller overcome this temptation. In a two-period game-theoretic model involving a monopolist firm facing heterogeneous consumers, I derive conditions under which a rational monopolist can act suboptimally: She could face a commitment problem and offer the new version, even if doing so lowers her overall profit. Profit is hurt because when consumers expect a new version, (a) fewer consumers buy the initial version, and (b) the monopolist is forced to charge a lower price for the initial version. I show how the free NVR warranty, which requires the monopolist to offer consumers the right to receive the new version for free for a limited period, can solve her commitment problem. This is a new, surprising finding: By bundling new-version rights with the initial version, the monopolist at first appears to be denying herself future revenue. I derive conditions under which this apparently unprofitable action is optimal, which is my main contribution. When free NVR is offered, consumer surplus decreases and social surplus increases. This work extends prior literature on durable goods and the Coase conjecture to innovative durable goods with network externalities. The findings have important practical implications for firms selling new versions of innovative durable goods subject to network effects, as well as for their consumers.

Key Words: high-tech marketing; game theory; innovation; marketing strategy; product development; product life cycles; product policy; signaling
History: Received: February 3, 2006;

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