Competition between saas and on-premise software: The impact of upgrade cost and switching cost

As a form of cloud computing, software-as-a-service (SaaS) is one of the fast growing segments of the information technology. The key market driver is its automatic upgrade without additional fees. By contrast, the on-premise software entails a large implementation cost as well as nonnegligible upgrade related costs on users. The upgrade costs may be caused by the need to upgrade the complementary hardware and reinstall the compatible application software. We formulate a game theoretic model involving an on-premise software provider and a SaaS provider to investigate the impact of switching cost and upgrade cost on equilibrium pricing of the providers. We find that the optimal pricing strategies in equilibrium depend on the levels of the switching cost as well as the upgrade cost. However, the equilibrium is not necessarily a pure strategy equilibrium especially when the market is characterized by sufficiently high switching cost and upgrade cost. Furthermore, the results indicate that an increase in the switching cost can never benefit the SaaS provider, but it can make the on-premise software provider better off provided that user upgrade cost is sufficiently high. However, an increase in the upgrade cost benefits the SaaS provider and hurts the on-premise software provider's profit in most cases.