Analysis of US Software Industry - Part 1

1 Introduction

The Information Technology (IT) industry has experienced immense growth in the last couple of decades. It has changed the working methods in almost all other sectors in the economy and achieved an increasing economic importance. The software industry is a critical sub set within this Information Technology industry.

The United States has been the world leader in the software industry since its inception. The United States is the largest single software market representing total revenues of $100.6 billion in 2010 accounting for more than 40% of global software market revenue of $265.4 billion in the same year (Datamonitor 2011). The largest software companies in the United States are Microsoft, IBM and Oracle. Together they form the top 3 software firms in the world and out of the Top100 software companies in the world, 63 companies are US based (Software Top100 2011). The U.S software firms dominate the worldwide software market such that sixty cents of every dollar spent on software worldwide goes to US-based companies (Holleyman 2011).

2 Background

Originated with the entrepreneurial computer software companies of the 1950s and 1960s, US software sector grew dramatically through the 1970s and 1980s with the rise of personal computer. By the 1990s, internet revolution, there was also an increased demand for large system integrators , which sought to offer more complete solutions to large corporations running large computers. Most successful firms developed specialized capabilities that enabled them to prosper within their sector and by the 21st century software industry has become a market force rivaling that of the computer hardware companies.

Software market consists of customized software and packaged software. Customized software, also known as Business software is designed or modified for a specific end-user like large public agencies or private businesses and frequently installed by the vendor, who may provide extensive pre and after sale technical support. Packaged software are shrink wrapped software products sold vua retail distribution channels. These are also known as Mass Market software with minimal additional technical support.

Softwares products are always delivered within the frame of consultancy. Despite the fact that "packaged software" products more closely resemble a good in their methods of distribution and reproduction Software is classified as a "business service" (Stienmueller 1995). Software companies provide “solutions” which involves some combination of custom developed software, packaged off the- shelf software bundled with hardware products. A sale will include consulting, systems design, systems integration, contract programming and maintenance. Note that, the Software sector includes only the firms whose core business is producing and selling software i.e, their revenue is derived from the selling of software products. Firms like Apple or Sony who develop software products for their own electronic products are not included in this sector. Also not included in this sector are the entertainment software and gaming firms like Electronic Arts or Zynga.

3 Industry Structure

There are several types of businesses within the software industry. According to Campbell- Kelly (2003), a software industry can be classified into three sub-sectors based on their business models:

• Software contractors/consultants
• Producers of customized software products
• Producers of the packaged software products

All the above sub-sectors are dominated by US companies. Within one sub-sector companies compete against each other; outside of these sub-sectors there is hardly any competition because of different markets and capabilities. Each of these sub-sectors has its own business characteristics.

Software contractors/consultants :

Software contractors provide customization, installation, integration and maintenance of other firms' products, along with consulting and other services. They compete on economies of scope, cost estimation and project management. Some of the key players are IBM corporation and Accenture.

Producers of customized software products :

Producers of customized or Business software products target large businesses in retail, banking, manufacturing industries and also various government agencies. They compete on economies of scale, corporate marketing skills and and after sales support. The lead US company in this sub-sectors is Oracle Corporation.

Producers of the packaged software products :

And the producers of packages software products compete on economies of scale, marketing capabilities, and user friendliness. Some of he key players in this sub-sector are Microsoft Corporation, Adobe Systems and Symantec.

Almost all software product firms eventually provide some services and drift towards the hybrid business model. It is easy for software firms to transition from the product business model to the hybrid one because they already have a client base to whom they can market.

3.1 Cost Characteristics

The software industry is a highly competitive industry characterized by rapid technological change and high degree of uncertainty. As the knowledge and skills become outdated quickly, it is absolutely necessary for the firms to employ the latest technologies in their products. As a result, software companies tend to spend huge amounts of money on research and development and equally huge amount marketing them. Business Software Alliance’s publicly traded member companies spent nearly $43 billion on R&D in 2008, equal to 7.1% of their collective revenues (BSA 2010). The Software product development is associated with high fixed cost, but very low marginal costs. Although the software industry's R&D costs and marketing costs are very high, its operating costs are relatively low as the software is reproducible at very low costs relative to the costs of its creation. By producing multiple copies of the same software product at a very low marginal costs, software product firms can gain an economy of scale that enables them to increase revenues without substantially increasing their costs, thereby becoming very profitable within a short period of time. This is one of the reasons why companies like Microsoft and Oracle have billions of dollars in revenue and market capitalization in a relatively short period.

Another peculiar characteristic of the software industry is that software must be supported,

maintained and upgraded. Software companies will typically sign a multi-year support contracts with

its customer to support and maintain the software which they sell. It is not common for the cost of

maintenance to exceed the cost of software, and can be as high as twice or three times the purchase

price over the life of the software. Software firms thus have an established client base who provide it

with a recurring revenue stream from maintenance fees, updates, customization and other services.

Support fees are largely profit, once the product is stable. Since the support revenue stream is based

on multi-year contracts it is a very stable source of income.

3.2 Demand characteristics

The software industry is cyclical, meaning that its earnings track both the ups and downs of the business cycle with their profits benefiting from economic upturns but suffer in a downturn (Sloman, Hinde & Garatt 2010). The software industry follows the business cycle closely because the sector primarily caters to large corporations. The investment decisions of the large firms are susceptible to the global economy,during economic downturn large companies will cut back on their Information Technology spending which software sector is part of. A lack of disposable income in households will also affect sales of personal computers which in turn affects packaged software sales.

The stock prices of the large software companies has followed the broader market index, like S&P 500. When the market was yielding steady returns between 2004 and 2007, the software companies also had a steady growth. During the 2008 recession period, prices in these companies dipped. As financial institutions are by far the largest customer segment for the software industry, the credit crisis impacted software companies. After the initial decline in 2008 and 2009, the software industry is back in the upward.

3.3 Competition

The entry and exit cost for a software company is low. In principle software can be developed in small room with just a personal computer. However it is very difficult for a start-up software company to compete against large and stable software giants. These established firms work in an oligopoly structure where significant barriers come from having already locked-in bulk of the market. For example, Oracle and SAP can be considered an oligopoly in business software segment, whereas Microsoft has a virtual monopoly in personal computer software segment. These large companies create barriers to entry by “Proprietary product technology” and “Locked-In Customers”.

Proprietary product technology :

The successfully software firms differentiate their products by using innovative

technologies and/or techniques. These know-hows are either hard to replicate or are protected

by Intellectual Property and patents secrecy. Patents have a significant effect on competition

as the larger software companies stockpile patents, both as revenue earners, and as a defense

against other companies offering similar technology.

Locked-In Customers: 

It is very expensive and exponentially difficult for customers to switch from one software provider to another software provider. Switching costs’ are the psychological, physical, and economic costs that consumers face in switching between technologies (Hyun & Pae, 2005).These software switching can be so complex and time consuming that switching suppliers is virtually unthinkable. The large software companies with their established brand make it hard for competitors due to their economies of scale and ability to spend more on marketing, to attract and lock-in new customers on multi-year support contracts.

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Corporate Social Responsibilities & Profit Maximization

Corporate Social Responsibility (CSR) is a form of corporate self-regulation. According to Johnson (2008), CSR can be defined as the ways in which a firm goes beyond its minimum obligation to stakeholders per law and regulations. This voluntary social responsibilities of an organization may range from adoption of a more costly and environmentally sustainable production process, improvement of wage and non wage benefits to workers, taking on philanthropic projects for the welfare of the community, or combination of all these. This is contrary to the Laissez-faire view of capitalism representing firms that only meets the minimum obligation required by law and not more with sole objective to maximize profit (Johnson et al, 2008).

Laissez-faire firm;

Maximization of profit occurs by maximizing the profit to cost ratio. The profit maximization theory states that
the firm maximizes its profit by reducing its fixed and variable costs to the minimum. For a firm to achieve the highest total profit it has to conduct its business operations by locating and selecting its factors of production based upon comparative advantage where the product can be produced the cheapest. The theory takes into account the characteristics of factor inputs like land and labor costs, transportation costs, government regulations, political environment and all other

transactional costs. The firm will choose least expensive factors to operate in order to maximize the profits and at the same time staying within the limits of the law. This is based on the Laissez-faire view of the organization and advocated by Milton Friedman (1970) in his famous New York Times article.

The Laissez-faire firm is not taking into account consequences of externalities like destroying environment and exploitation of natural resources in an under-developed country due to inadequate local regulations or paying low wages and working condition which can be considered unfair and even a human right violation from a developed world perspective but perfectly compliant with the local regulations. This firm is limiting itself to compliance with existing regulations and in essence is not being socially responsible per the CSR theory.

Now, when a firm voluntarily adopts CSR policies like deciding to pay more than the market determined wages or engaging in costly but socially responsible production processes, then it is essentially increasing its production cost and encroaching its profit potential. CSR activities entail significant extra costs for the firm. The only way a firm can continue engaging in voluntary CSR activities and still maintain its profit margin is by raising prices or lowering costs in its value chain, or combination of both. But this is not profit maximization as the firm is either taking in the extra cost themselves or merely passing it to customers. Thus the CSR theory and profit maximization theory are at odds with each other, so the firm ends up pursuing one at the expense of other, but not both. So why is that almost all of the large firms today have CSR policies as part of their strategy, are they voluntarily sacrificing profits for the welfare of society or are they influenced by the future financial gains from CSR activities?

CSR as business strategy;

The traditional profit maximization theory does not make a distinction between maximizing profit on the short term or the long term. This theory is based on a transactional model taking short term view and ignoring long term consequences. The negative consequences of being a laissez-fairefirm like bad reputation will affect the market share and the long-term profitability of the firm. So firms include certain CSR activities into their business strategy as they are trying to maximize profitability over the long term with a short term decrease in profits followed by a more than compensatory increase

in long-term profits. It is safe to assume that these firms believe CSR activities will maximize their profit and not necessarily sacrifice profit over the long term, else why would CSR be part of the firm Public Relations Instrument. There are variety of CSR activities a firm might decide to engage in to maximize their profits.

CSR and Product differentiation;

A firm which is not in a perfectly competitive market structure will voluntarily engages in socially responsible activity, to differentiate its product and boost profits. These firms can set their price to maximize profit and pass on the additional costs of being socially good to the consumers. Firm who indulge in more socially responsible production, for example, organic or fair trade production, pass on the additional cost to consumers and still maintain their profit and at the same time increase market share by differentiation. If consumers are willing to pay a premium for more socially responsible production and increase their market share, then those firms are pursuing profit maximization. A recent study conducted by Siegel and Vitaliano who examined firms that strategically engage in CSR activities highlights that certain types of CSR activities contributed to profit maximization (Murillo & Martinek, 2009).

CSR and Stakeholder Relations;

Alternatively some firms will attempt to maximize their benefits by taking on CSR activities that minimizes the externality effects on its stakeholders. These firms view CSR actions as any other business activities like marketing, advertising or R&D. The objective behind this is that although the costs might increase in the short term, this will be outweighed by the advantages the firm enjoys in the future increases due to greater benefits it provides to its stakeholder. This could be in the form enhancing the firm’s reputation, the ability to generate customer loyalty, to attract and motivate their employees or to satisfy NGOs/advocacy groups. The firms typically identifies social activities that their stakeholders value and integrates those activities into its profit-maximizing strategy. It is difficult to predict if these CSR activities actually contributed to maximizing profit as the range of CSR activities adopted can vary from firms to firms and from industry to industry. A study conducted by Margolis, Elfenbein, and Walsh suggested that these CSR activities were not increasing profits but at the same time, they were not encroaching their profits either as CSR costs pays for itself (Reinhardt et al 2008).

Conclusion;

Clearly CSR activities entails an added cost burden which firms absorb and hence theoretically the firms are not maximizing profits. That said, these days CSR policies have become an integral part of all corporations with a motive that CSR actions will maximize their profits in the long term. Recent studies have shown that some CSR actions have contributed to increased profits but it is inconclusive that CSR policies in general will actually maximize profit over the long term, but at the same time it is difficult to determine if the firms are in fact sacrificing profit either.

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Effects of a customs union on the global economy.

Customs Union is a form of regional economic integration. In a custom union, member

countries trade freely among themselves, but agree on a common form of trade barriers with nonmember countries (Sloman, Hinde & Garatt, 2010). The main impact of the customs union is that it

creates a single large market among the member countries with common trade laws but protected by

non-member competition. Thus within the customs union, there will be a improved business climate

for businesses to exploit new opportunities and make better use of available resources. In essence the

immediate effect of customs union are the trade creation an trade diversion effects as it combines

principles of free trade with protectionism.

Effect on businesses within the Customs Union;

Trade creation can be beneficial to some firms and disadvantage to others. Trade creation occurs

when consumption shifts from a high-cost producer to low-cost producer within the union bloc

(Sloman, Hinde & Garatt, 2010). The effect on businesses within the union depends on their situation

prior to the formation of customs union. Greater competition among domestic firms due to trade

creation will force the firms within formerly protected industries to improve efficiency or lose out.

Also if a firm which is dependent on importing from outside the union bloc will be at disadvantage if it

faces a higher import tariffs due to common external tariffs imposed by the customs union. But overall

the businesses within the union bloc will benefit from trade creations and market expansion.

Customs Union effects on businesses can be summarized as resource allocation,

competitiveness economies of scale and investment. Free trade within the union bloc improves the

efficiency of resource allocation (Oatley, 2010). With the removal of trade barriers between member

countries, the resources among member countries will be applied to activities for which they have the

lowest opportunity costs among the member nations, thus gaining comparative advantages. Businesses

are able to expand their products to all over the union bloc as they now have a bigger population to sell

compared to selling domestically. They can reduce a significant amount in costs by producing more and

attaining benefits through economies of scale. As market gets competitive, inefficient firms are forced

to improve efficiency and innovate. Customs Union provides an incentive to foreign direct investment

to locate and produce in the countries within the union bloc. Businesses will increase output growth

through investments in latest technology that enhances efficiency and productivity

Effect on Business outside Customs Union;

Customs Union adopts elements of protectionism causing market distortions. External trade

barriers created by the union will have trade diversion effects. Trade diversion occurs when

consumption shifts from a lower-cost producer outside the customs union to higher-cost producer

within the customs union (Sloman, Hinde & Garatt, 2010). The disadvantage or benefit to the external

firms is dependent upon the level of tariffs they were facing before the formation of the union. Being

outside the customs union will often mean that a business loses out through the trade diversion effect,

as they are hindered the most by tariffs or quotas. If the firms outside the union now faces higher

import tariffs, then they are not able to export as much, as their goods are priced higher. The firms

within the union are benefiting from the tariff because they are protected by foreign competition.

On the other hand, if the firms outside the bloc now faces a lower import tariffs due to adoption

of common external tariffs by the customs union, then it will see a benefit as goods by the external

firms exporting to the regional bloc gets cheaper due to lower import tariffs and also they can sell more

goods as they get access to a larger market.

Implication on the Global economy

• Disadvantages ;

Customs unions are characterized by discriminating trade arrangements. Any kind of

protectionist policy will only benefit some at the expense of others (Oatley, 2010). The tariff will help

increase the producer surplus within the member countries, but the consumers pay a higher price for

products, so their quantity demanded has decreased along with their consumer surplus. The countries

outside the union bloc suffer with lower demand as their export cost has increased due to tariffs. Lower

demand leads to lower gross national product (GNP) which in turn leads to more unemployment in

non-member countries. Thus the non-member economies suffer because of custom unions.

The tariff decreases allocative efficiency as the global market cannot move to an equilibrium

state, i.e the point at which supply meets demand. By giving preferential treatment to member

countries, the production of the goods will shift from the lowest cost producer to a higher cost

producer. This represents a shift away from comparative advantage and a less efficient allocation of

resources. Global economy will eventually suffer when resources are not allocated efficiently.

Another unintended consequence of protectionism in a customs union, is that it creates import

substitution with tariffs, then the non-member countries will have trade deficit and hence less money to

import goods from the customs union members. Now the export demand of customs union will

decrease. This occurs when the level of import tariffs remains suboptimal or in worse case tariffs are

increased then the effect of trade diversion will outweigh the benefits of trade creation within the union

members (Frankel, 1997). So over all global economy suffers when the customs union doesn't adopt an

optimal level of trade barriers.

• Benefits to Global Economy;

Customs Union are considered a stepping stone towards global free trade (Oatley, 2010). As

long as the trade diversion affect doesn't outweigh trade creation effect then customs union will have a

positive spill over effect on the global economy. As the countries within the customs union experience

rising living standards, increased efficiency, higher rates of economic growth and regional political

stability,it will stimulate trade by shifting world's aggregate demand and aggregate supply.

Poverty has negative effect on global economy. Customs union has advantages over getting

under developed countries out of poverty trap. Customs Union will promote employment of local

factors of production and resources. Without union blocs the resources in these under developed

countries will never get exploited and thus they continue to remain within the poverty trap. By creating

a large economic to attract trade and foreign direct investment, and by adopting protectionism policies,

the member countries will decrease imports and increase exports. Regional demand increase creates job

opportunity for people which in turn can get them out of poverty trap and the growth rate of the gross

national product (GNP) will rise. Thus the customs union will shift these under developed economies

from high dependency to self-reliance.

Conclusion;

The creation of a customs union has some positive and some negative effects for businesses.

The firms within the union bloc will benefit with trade creation due to larger market and trade diversion

due to protectionism. But it is important that the union adopts an optimal tariff policy against nonmembers so that trade diversion effects does not outweigh the net benefits of trade creation.

Customs union can increase economic output of the member countries, and especially bring

under developed countries out of poverty trap. As the economies in the underdeveloped countries

grows it will reduce negative effects of poverty on global economy and at the same time stimulate

global economy further. And it is possible for a customs union to affect the external terms of trade

through tariff reduction and gradual union expansion, thus increasing global economic growth

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