Impact of Network Externality in the Security Software Market∗

The market for security software has witnessed an unprecedented growth in recent years. A closer examination of this market reveals certain idiosyncrasies that are not observed in a traditional software market. For example, it is a highly competitive market involving several major vendors, often with a very aggressive pricing strategy adopted by new entrants. Yet, the market coverage seems to be quite low. Prior research has not attempted to explain what aspects of security software make this market deviate from the traditional ones. In this paper, we develop a quantitative model to study this market. Our model identifies the primary reason behind this behavior—that of a negative network externality effect, which pulls the market in exactly the opposite direction when compared to the positive network externality observed in traditional software markets. Using our model, we first show that a monopoly security software market has a lower market coverage, a higher price, and a higher revenue compared to a traditional monopoly market. We then extend our analysis to an oligopoly competition. There is a unique symmetric equilibrium in the oligopoly competition, and we find that the number of vendors in the security software market tends to be larger than that in a traditional market. We also consider the effect of a new entry in an oligopoly market. Next, we evaluate the strategy of vertical differentiation. We find that, while this strategy is not desired by a monopolist, it may be adopted in a duopoly competition if the cost of development is sufficiently high, although the feasible region for differentiation is more restricted than in a traditional market. Finally, we consider two extensions to the model to account for two other possible types of network externality and find that our results hold in these extended models as well. Overall, our results highlight the unique nature of the security software market, furnish rigorous explanation for several counter-intuitive observations in the real world, and provide managerial insights for vendors on market competition and product development strategies.