How do you make money off software?

This is my response to a question over at on making money from software when the marginal cost is zero.

Background : supply, demand and equilibrium

Most people know that supply and demand work together to determine price: this is almost intuitively obvious. But the 'how' is a bit more complex than that.

Over the long term in an efficient market, price will end up being approximately equal to marginal cost (that is, the cost of making the last unit). This is called equilibrium. This happens because whenever the price is higher that the marginal cost, competitors will move into the market and price their product between the marginal cost and the orginal price. This continues to happen until P = mc.

So how do you make a profit?

Market equilibrium doesn't happen immediately. If you release a product with no direct competitors, it takes time for others to create competing products. During that phase you charge whatever you want (this is essentially a temporary monopoly).

How hard it is for competitors to turn up is known as the 'barrier to entry'. In a highly efficent market, barriers to entry are low and competitors arrive quickly, pushing down price.

So you have basically two strategies for making a profit:

  1. You continually come up with awesome new products and ride them until the market catches up, then move on to the next thing
  2. You do whatever you can to increase the barriers to entry
The second point can be done a few ways: some legal, some not. For example, you can buy up all your competitors, but at some stage you'll attract the attention of the regulators. Or, you can make products so well or so complicated that they're hard to compete with. Or you can look at ways of locking in customers so switching is difficult.

In the long run though, price will tend towards marginal cost. You're delaying the inevitable, but you might make a lot of money in the process.

The third way

The third way to make money "off software" is to use it as a loss-leader, and make your money off a complimentary product: eg service and support.

Final thoughts

It's important to note that this is true for all products, basically. Even those with non-zero marginal costs. Whenever P = mc, there's no profit. The reason that the service industry is so attractive is because it's relatively easy to differentiate your service and hence charge a premium for it.

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