Tight prior open source equilibrium
First Monday

Tight prior open source equilibrium: The rise of open source as a source of economic welfare by Matthias Barwolff



Abstract
Open source has become a viable mode of production and resource allocation not only for intrinsically motivated communities but for commercial firms as well. This may be due primarily to the fact that open source ultimately produces greater value on both the use and production sides. Open source thus acts as an institution that affects the structure of the software industry much more efficiently than politics and law. It also provides an economic perspective that may help refine the standard notion of the firm since it emphasises the link between firm and market, not the frontiers that separate the two.

Contents

Introduction
The value of open source
Firms in the open source world
Innovation and open source
Economic viability of open source
Social welfare through open source
Conclusion

 


 

Introduction

Open source has come a long way since it first hit the radar screen of the academic community. The initial excitement soon gave way to empirical research and academic elaborations on the nature of open source. Scholars now have some idea about motivation behind open source development, the specifics of how open source projects organise and evolve, and the crucial institutions affecting open source [1].

However, it has been a widespread belief, if not assumption, among most observers that the creation of open source software is effectively incompatible with the commercial objectives of software firms. In this vein open source is often depicted as something that is invariably driven by communities of software developers motivated not primarily by pecuniary returns but intrinsic motivations (Osterloh, et al., 2004). Some observers acknowledge the relevance of rational economic objectives for individual programmers (Lerner and Tirole, 2000; Ghosh, et al., 2002; Lee, et al., 2003). Yet apart from summaries of the principal motives for firms to engage with open source from a business perspective (Koenig, 2005) little academic attention has been paid to the specific role and importance of commercial software firms for open source in general.

Only very recently have scholars directed more attention to the specifics of commercial firms engaging in the development of open source (Dahlander, 2004; Grand, et al., 2004). Indeed, it is starting to emerge that firms have been more than but passive beneficiaries of open source developments. A number of high–profile software firms contribute to open source projects very much in line with traditional open source ethics. Over the past few years there has been a considerable upsurge of commercial contributions to and engagement with open source projects by commercial firms such as RedHat, IBM, JBoss, and MySQL.

In this paper we try to explain some of the commercial activities surrounding and contributing to open source software, and put them into a due economic perspective. In particular, we explain the economics of firms’ open source activities on a more abstract level beyond mere descriptions of certain commercial open source business models.

 

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The value of open source

By its very definition open source has traditionally been at odds with the widely accepted notion of value stemming from the transactions of private properties. Current economics has largely been preoccupied with the question of how to allocate a given set of resources such that the resulting overall utility is maximised. The answer of virtually all economists has been an emphasis of private property entailing exclusion and tradability (Coase, 1937; Coase, 1960). In such a property rights framework economic value stems from transactions: people transact their labour for wages, and their money for things they consider more valuable to them than the price tag they carry. Thus, transactions will occur whenever the use value of a thing outweighs the costs of its creation. And the creation of things depends on the prospect of profitable transactions.

Open source, however, is fundamentally different. The social process of open source development creates value without any prospect of exclusive property and tradability (Weber, 2004). It is based on common property by virtue of its specific licensing terms that in effect stipulate a complete waiver of private property rights to the software code. Software that is subject to such terms may be freely and repeatedly transacted without any consideration on the part of the receiver [2]. Hence, appropriation of profits based on the exclusion of others becomes impractical in most cases.

Still, open source has proven to create economic value despite its apparent incompatibility with the ubiquitous private property regime. The value of open source is twofold. On one hand, value is being generated through the usage of open source software. Given the absence of licensing fees for open source software and its non–discriminatory availability, the surplus on the use side exceeds that of comparable proprietary software. Not only does value stem from the mere usage of software, value also stems from the option of making modifications to the software. With proprietary software such modifications are typically neither permitted nor feasible given the absence of source code.

Estimates indicate that the commercial value of open source is indeed significant. Open source products have emerged as a competitive alternative to proprietary ones that are widely being deployed creating considerable surplus on the use side (Tiemann, 2004). Adding to this, open source has been identified to be an important source of value for developing countries such as Brazil (Ghosh, 2003).

... rarely do firms base their business on intrinsic motivation.

On the other hand, part of the incentives behind the development of open source has been attributed to the utility stemming from the very process of participating in the development of open source (Osterloh, et al., 2004; Ghosh, et al., 2002; Fehr and Falk, 2002). Hence, not only does open source create value through its usage but additionally through its creation. This quality sets open source apart from received processes of value creation which assume the immediate prospect of rewards from transactions. It has also been making for much of the excitement about open source as a possibly novel mode of production based on entirely voluntary contributions to the production of economic goods.

However, while there is undoubtedly some value stemming directly from participation in open source projects the role of intrinsic motivation must not be exaggerated, for it only provides part of the answer as to the motives behind open source. Indeed, commercial firms have started to become vital participants in the creation of open source, and rarely do firms base their business on intrinsic motivation.

 

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Firms in the open source world

The role of firms in open source started prominently in 1998 when Netscape — in the face of stiff competition from Microsoft — decided to release the source code of its Web browser client Communicator [3]. At this point its latest descendant, the open source browser Firefox, has won a host of favourable reviews and has taken a significant slice from Microsoft’s share in the browser market [4].

Although Netscape never actually managed to profit from their decision to release the source code for their browser, the creation of open source software has by now become the foundation of business models successfully pursued by a number of commercial firms. Revenue models of companies such as RedHat (http://www.redhat.com/) and JBoss (http://www.jboss.com/developers/index) are typically based on in–depth expertise about software and the ability to offer excludable and rivalrous services such as consultation, training, or customisation; see Table 1. Given the emerging empirical picture it is fair to say that commercial firms now form a vital part of the open source world.

 

Important open source companies

 

Those companies are often critical driving forces behind the respective open source projects they build upon. Since their business model does not directly depend on generating licensing revenues from software products they have an incentive to cooperate with an external community of developers and users, and abide by the norms and rules of open source communities (Figure 1).

 

Role of firms in open source

Figure 1: Role of firms in open source.

 

The proliferation of firms engaging with open source is affecting the organisation of the software industry (Demil and Lecocq, 2003). A growing number of commercially motivated activities based on open source unfold on the production side, the use side, and in between, too. Traditional commercial software firms, such as Microsoft, are beginning to question their business models and consider how they may adapt to the reality of open source (Seemayer and Matusow, 2005) [5].

 

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Innovation and open source

It has been a standard if hotly contested argument in economics that technological progress depends on the availability of state–granted intellectual property rights to novel and non–obvious solutions to practical problems (Carlton and Perloff, 2000). Notwithstanding its cursory appeal, there has thus far been little empirical backing for this assertion. A number of scholars have argued that the availability of intellectual property rights does not significantly affect technological progress and innovation. Boldrin and Levine (2002) argue that even without intellectual property rights there would still be sufficient commercial incentives for the creation of original works. Benkler (2002) reasons similarly that open source indicates the irrelevance, if not detrimental effect, of intellectual property for innovation in the software industry. Bessen and Maskin (2005) argue that intellectual property rights have a particularly adverse effect on sequential innovations typical for the software industry.

Eric von Hippel (2005) makes another important point in favour of open source and against strict intellectual property rights: Open source allows for greater efficiency and advances on the production side as the dichotomy between producers and consumers begins to blur. The basic point in his argument is that the users’ role in successful innovation cannot be assumed by a firm, thus rendering open source a superior mode of production in incorporating innovations on the user side into products. According to Hippel the combined surplus of consumers and producers will be raised by open source. Firms may still create viable business models around open source.

The impact of open source on innovation in the software industry as whole is subject to an ongoing debate. While some have lamented that the competition of open source adversely affects the innovative potential of commercial firms (Kooths, et al., 2003) [6] others have argued that innovations are, in fact, not necessarily tied to the research and development efforts of proprietary software producers (Wheeler, 2005a). Given the available evidence it is probably fair to say that innovation in the software industry is not significantly related to either proprietary or open source software. Rather, many innovations are often made by smaller companies or individuals inside and outside academic institutions (Segelod and Jordan, 2002b; Segelod and Jordan, 2002a).

According to Watts (2003) the ultimate sources of innovations almost always trace back to individuals, whilst broader networks subsequently adopt such an invention if they consider them useful, thus rendering the invention an innovation. An advantage of open source communities over firms in creating innovations lies in their potentially superior capability of incorporating and developing inventions due to their typically loosely coupled network structure (Benkler, 2002). On the other hand, one might argue that conventional firms excel in reducing the transaction costs accompanying the organisation of resources.

Whether or not open source is the more innovative mode of production, open source no doubt has proven its merit in making software robust and affordable. Arguably, the most well–known and successful open source software products are those that resemble or establish functionalities whose demand is well specified: Linux is a POSIX conforming operating system, Apache is a Web server implementing widely accepted RFC standards, and Firefox is a Web browser that equally implements HTTP and HTML standards (Table 2). The same holds for e–mail clients such as Thunderbird, desktop environments such KDE, and file servers such as SAMBA.

 

Most high profile open source companies

 

 

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Economic viability of open source

The increasing impact of open source raises the question whether open source ultimately is an economically viable mode of production. At first glance open source exhibits a number of features that make it rather unattractive as a mode of production for commercially motivated producers. It makes the commercial licensing of digital copies of a creation practically unfeasible since open source licensing stipulates that no restrictions on further dissemination may be asked of any recipient. Yet, the conventional business model of most commercial software producers is vitally based on such restrictions.

One might ask why a firm would forego profits from licensing its software to users. When we adopt a dynamic Schumpeterian perspective on economic development, however, open source becomes a very natural development.

According to Schumpeter (1942) economics may be understood as a dynamic process that always creates new disequilibria stemming from innovations. Such innovations create temporary monopolies serving as sources of above average profit for the innovator. Competition will erode these profits after a period of time. When we apply this idea to software it follows inevitably that a competitive market in software may only be realised through open source. The competitive equilibrium in software not only drives profits to zero but prices as well. This being the case, open source as a mode of licensing becomes the natural result stemming from competitive forces in a market since it leaves but a small portion of surplus in the hands of producers and puts the bulk of surplus in the hands of consumers. The firms mentioned above build their business model precisely on the premise that a sustainable competitive equilibrium in code inevitably drives software towards open source.

Of course, reaching this competitive equilibrium depends on competitors imitating specific programs. Software, in this respect, differs from other goods such as cars. A new technology will typically propagate to competitors after a certain time lag (Carlton and Perloff, 2000). Either an innovation will be plain copied or — if it is subject to intellectual property rights — its functionalities will be imitated. In the software market functionalities may be concealed making reverse engineering difficult, if not unfeasible (Samuelson and Scotchmer, 2002). Thus a software firm may very successfully fend off competition by exerting specific intellectual property rights (Auletta, 2001). However, even if intellectual property rights and the specific nature of software unduly increase the time lag for competition to emerge a number of economic factors serve to offset this effect.

One important factor that makes for a structural competitive advantage of open source over proprietary software is its unique value proposition that cannot be matched by producers pursuing proprietary business models. Apart from its competitive price open source delivers greater value to customers, for they can utilise software in many ways. To put it differently, the unfettered modifiability of open source (as part of its use value) may be seen as a distinct feature that adds significant value [7].

Along these lines Frischmann (2005) provides another argument in support of open source: an economic good that exhibits infrastructure properties will create the greatest benefit on the use side when its access is not restricted. That is true not only for traditional infrastructures but for software in general. While it is true that there is an economic incentive for producers not to give up control over intellectual property the higher use value of open source creates an economic pressure from the consumer side to the opposite, particularly in the presence of existing open source alternatives.

The conflict between keeping control and delivering greater value through flexible software certainly proves a challenge for existing business models [8]. It might be argued that this conflict could be resolved by proprietary producers drafting contracts over their software in ways such as to give their customers more control over software. This would also allow the exclusion of third parties from using software and, thus, possibly increase the competitive position of parties to the transaction. However, such exclusion might eventually lower the value of the software for the buyer should he decide to use the software in ways that conflict with a given contract. Also, the transaction costs of agreeing upon and enforcing such contracts on both parts of the transaction are likely to be much higher than simply agreeing on an open source development contract.

In sum, aside from competitive pressure that drives software towards open source economic rationality on part of the consumers put further pressure upon producers to move towards open source. Thus, open source is an attractive and viable economic mode for both customers and producers.

 

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Social welfare through open source

Social welfare through open source comprises more than the economic value stemming from its creation and usage. The increased competition put upon proprietary producers also shifts economic power to the user, thus increasing his welfare. Adam Smith, often quoted as the founding father of modern economics, has already noted that power needs to be diffused on both sides of a transaction for the market mechanism to produce desirable results and that institutions have to be in place to balance the power distributed in a society.

It has been a widely held view that the state has to create the due legal conditions in order to foster open source (Lessig, 1999). In particular, the intellectual property rights regimes disseminated throughout the world by the World Intellectual Property Organization (WIPO; http://www.wipo.int/) have repeatedly been blamed to disadvantage open source over proprietary companies with the means to engage in costly legal activities (Weber, 2004; Bessen and Maskin, 2005). This view, however, might have been rendered futile by increased corporate backing for open source. Their support creates an institutional framework that allows for open source to prosper even in the face of proprietary opposition and offsets some adverse legal environments.

Additionally, different commercial actors have started to assume some of the business risks stemming from market and legal uncertainties in the field of open source. Venture capitalists have entered the open source arena, thus taking on some financial risks (Chitnis, 2004). Indemnification programs assuming some of the legal risk involved in open source have been set up by corporations like IBM, HP, and Novell, as well as third parties [9].

The significance of open source as a means of restoring competition and driving markets towards sustainable equilibria must not be underestimated since it renders state intervention largely unnecessary. It has often been duly remarked that state intervention carries the risk of creating wrong incentives and should thus be avoided if possible (Coase, 1960). In the context of open source Comino and Manenti (2003) remark that government intervention in favour of open source should not go beyond the provision of information. However, in a free market economy even such a stance requires a non–trivial level of political justification [10].

Ultimately it is not ideology or government intervention that brings about the institutional change, but economic rationality on part of consumers and producers.

In short, the role of law in establishing favourable institutions for open source as a mode of production and consumption may have been exaggerated. It appears that open source has changed the whole value equation in the software industry [11]. Ultimately it is not ideology or government intervention that brings about the institutional change, but economic rationality on part of consumers and producers.

Contrary to what has been widely believed, it might well turn out that liberal market economics is very capable of incorporating open source. The growing involvement of firms in open source indicates that as a mode of consumption as well as production it is compatible with tight prior equilibrium theory (TP) which holds that

“decision makers so allocate the resources under their control that there is no alternative allocation such that any one decision maker could have his utility increased without a reduction occurring in the expected utility of at least one other decision maker.” [12]

Not only does open source realize this assertion for the consumption of software but, importantly, for its production as well. It resolves the often assumed dilemma between the production and the consumption of an intangible good, at least in the instance of software products [13].

 

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Conclusion

Open source emerges as a major force of economic wealth that is helping to tilt the balance of power from the producer back to the user side. It appears to serve as a due means of driving software markets towards competitive equilibrium states. It does so without major assistance from the government by means of interference with the market. The success of open source is very much independent from antitrust and competition policies aimed at curtailing adverse influences of existing monopolies.

Most scholars have thus far argued that in the face of strong incumbent monopolies and intellectual rights regimes favouring bigger competitors open source would well deserve some respect if not assistance from policy–makers (Lutterbeck, et al., 2000; Weber, 2004; Lessig, 1999). Yet, open source may not even require such support. The rationality of people on all sides turns out to effectively “promote an end which was no part of [their] intention” (Smith, 1910).

We have mentioned above the premise of TP that people always act rationally in increasing their utility towards a Pareto–efficiency situation. We have shown that not only is the consumption of open source compatible with this notion but production as well. The most important realisation is that people do derive utility from dispensing with the exertion of maximum legal and factual control over assets and choosing to cooperate rather than compete with one another. Richard Stallman once remarked: “[K]nowledge should be shared with other people who can benefit from it, and that important resources should be utilized rather than wasted.” It has turned out that this approach not only makes for a moral imperative but for viable business models, too.

There is a wider implication of the growing importance of open source in the software industry and beyond (Benkler, 2004). The success of open source as a mode of production puts into question the frontiers of the firms and with it the entire received notion of the firm. While Coase (1937) was right in his assertion that firms capitalise on transaction costs in the market the question that has remained open ever since is how the link between a firm and its customers may be shaped best. The emergence of open source indicates that a good part of the value stemming from transactions at this intersection may only be realised when a significant portion of control and power comes to rest with the customer. While most marketing textbooks have come to appreciate the role of the customers in the shaping of a firm’s products and communications, an economic theory that properly deals with the firm in its relation to its customers remains to be put forward. End of article

 

About the author

Matthias Bärwolff is a research assistant in the Computers and Society department at Technische Universität Berlin.
E–mail: mbaer [at] cs [dot] tu [dash] berlin [dot] de

 

Notes

1. Weber (2004) provides a good account of the current state of academic knowledge in this field.

2. For a closer description of open source licenses and a list of such see the Web site of the Open Source Initiative at http://www.opensource.org/. You may also want to examine Bruce Perens’ definition of open source at http://www.opensource.org/docs/definition.php.

3. See Netscape, 2000. “Netscape Communicator Open Source Code White Paper,” at http://wp.netscape.com/browsers/future/whitepaper.html, accessed 30 December 2005.

4. See, for example, John Markoff, 2005. “Mozilla plans faster growth for its browser,” New York Times (3 August), at http://www.nytimes.com/2005/08/03/technology/03browse.html?ex=1280721600&en=5a70f4ba27e035d6&ei=5090&partner=rssuserland&emc=rss, accessed 30 December 2005. According to NetApplications, as of December 2005, 85.05% of the browser market belonged to Microsoft’s Internet Explorer, with 9.57% for Firefox, 3.07% for Apple’s Safari, and 1.24% for Netscape. See http://marketshare.hitslink.com/.

5. See, for example, Stephen Shankland, 2005. “A Microsoft–Red Hat warming trend?” CNET News.com (10 May), at http://news.com.com/A+Microsoft-Red+Hat+warming+trend/2100-7344_3-5701700.html, accessed 30 December 2005; and, Todd Bishop, 2004. “Microsoft open to open source,” Seattle Post–Intelligencer (24 June), at http://seattlepi.nwsource.com/business/179256_msftopen25.html, accessed 30 December 2005.

6. Following standard economic theory Kooths, et al. (2003) have argued that open source inevitably fails to bring about an efficient allocation of resources in the market. However, Pasche and von Engelhardt (2004) and Grand, et al. (2004) have shown that this argument is tenuous given that software markets are far from a perfectly competitive market.

7. There is an ongoing debate over the true costs of open source. One concept that has been introduced by Bill Kirwin of Gartner Research in this vein is that of total cost of ownership (TCO). Some studies claim that the cost of proprietary software is ultimately lower than that of open source software. However, Wheeler (2005b) has shown that most of these studies are seriously flawed.

8. See Seemayer and Matusow (2005).

9. Practically all firms that offer open source products indemnify them from legal problems due to possible copyright and patent infringements. See also the Web site of Open Source Risk Management, Inc. (http://www.osriskmanagement.com/) who offer insurances specifically for open source users and developers.

10. Imagine the state would grossly interfere with the market by advertising what he considers to be disadvantaged products. Coase (1960) is probably right in this respect, arguing that the cost of acquiring appropriate information generally exceeds the possible benefit of such remedies.

11. Paul Romer (quoted in Ludwig Siegele, “Lieber Ruhm im Netz als Rubel im Sack,” at http://hermes.zeit.de/pdf/archiv/archiv/2000/12/200012.open_content_.xml.pdf) remarked that open source represents a novel mode of production that questions some of the prevalent assumptions about the ubiquity of the market.

12. Reder, 1982, p. 33.

13. See Watt (2000) for an economic elaboration of the conflict between economic theory and intellectual property law.

 

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Editorial history

Paper received 19 August 2005; accepted 12 December 2005.


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Tight prior open source equilibrium: The rise of open source as a source of economic welfare by Matthias Bärwolff
First Monday, Volume 11, Number 1 - 2 January 2006
http://firstmonday.org/ojs/index.php/fm/article/view/1309/1229





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