Software piracy and outsourcing in two-sided markets

This paper examines the role of software piracy in digital platforms where a platform provider makes a decision of how much software to produce in-house and how much to outsource from a third-party software provider. Using a vertical differentiation model, we theoretically investigate how piracy influences the software outsourcing decision. We find that when piracy is intermediate, the loss in in-house software profits due to piracy outweighs the loss in licensing fee profits. As a result, an increase in piracy leads to more outsourcing. However, when piracy is high, it becomes too expensive for the platform provider to subsidize the software provider, resulting in a decrease in outsourcing. Moreover, when software variety is also endogenously chosen by firms, the platform provider's incentive to develop software variety in-house depends not only on the return from software profits but also on the return from hardware profits. Under such a situation, an increase in piracy always leads to less outsourcing and less total software variety. To provide additional insights on the outsourcing decision, we conduct empirical analyses using data from the U.S. handheld video game market between 2004 and 2012. This market is a classical two-sided market, dominated by two handheld platforms (Nintendo DS and Sony PlayStation Portable) and is known to have suffered from software piracy significantly. Our regression results show that in this market, piracy increases outsourcing but has no effect on the total software variety.