International Think-Tank on Innovation and Competition
The Economics of Proprietary vs. Open Source Software
March 12th , 2008
It is hard to overemphasize the importance for the New Economy of the scenarios emerging after the virtual conclusion of the Microsoft antitrust case with the recent events. First, with the European Commission admitting that, at least since last October, the American company has complied with the requirements on interoperability (the last huge fine was related to the lack of compliance until October 2007). Second, with the announcement made by Steve Ballmer for which Microsoft is going to take further substantial steps to promote further interoperability in the software industry, even with the open source community, with which there has been a strong contrast until now. This will happen at the global level, going beyond the requirements of the EU antitrust authorities, whose reaction, nevertheless, has been quite cold. Not surprising, if we recall that the Competition Commissioner has explicitly cited as one of her objectives a radical reduction of the alleged monopolist’s market share (a view reiterated in many public interviews).
Such an objective may reflect a dangerous misunderstanding of this dynamic market. As a wide academic literature on the endogenous market structures has shown, a large market share in a high-tech sector can be the consequence of low prices charged by a leader in a market with network effects and endogenous entry, and not of unconstrained market power; therefore, antitrust enforcement to promote consumer welfare should not be driven by the aim of reducing a firm’s market share, but should instead preserve competitive entry in the market. Moreover, we should remember that a forced disclosure of intellectual property rights and trade secrets may be welcomed by competitors, but it may also act as a threat for the innovative efforts of other European companies that base their success on costly innovations - think of the biotech sector or the pharmaceutical one. Therefore, not only should Microsoft’s move not be dismissed, but it should be welcomed as a major change in the software sector that will help ensure endogenous entry by facilitating the development of products that work well with Microsoft’s own, and that will contribute to reduce the contrast between the open source world and the proprietary software world.
The lasts events in the software market lead us to an analysis of the economics of proprietary software versus open source software (OSS). Here, we will evaluate the relation between the two, and the role of the open source community in the R&D activity within the software market. While IPRs are fundamental drivers of innovations in all sectors, software development has recently been characterized by a certain amount of innovations obtained in a decentralized, voluntary and uncompensated way by programmers within the so-called open source movement. Let us first define the subject of our discussion: OSS is a software which is made available for direct use and modification (through direct access to the source code) under limited protection. For instance, the General Public License (GPL) grants unlimited right to use, modify and distribute software as long as its redistribution makes available the modified source code and does not impose further restrictions on the rights granted by the GPL. Besides software that is freely distributed, there is an increasing number of companies, like Red Hat and Novell, that profit from collateral services supplied jointly with free software. In a sense, the difference between proprietary software and open source software appears much less relevant: the former earns from licenses to end-users, the latter mainly licenses software free of charge and earns from selling support description needed by end-users to install and run the software.
These factors imply some limitations of the benefits of OSS compared to proprietary software:
- the effective total cost of ownership of OSS is not necessarily lower than the total cost of ownership of proprietary software, since the expected discounted value of the costs of consulting, maintenance, personnel training and of the updates represent the main part of the mentioned total cost;
- the short run cost of OSS can be lower, but the long run cost is typically higher compared to proprietary software, therefore institutions with short term constraints or objectives, or with a myopic management may adopt the former even when the latter is the best option in the long run (think of local government procurement under budget balance or political constraints).
While many private corporations support OSS because they supply products that are complementary to open source software, it remains surprising that such a large innovative process can take place, at least in part, through directly unrewarded efforts. Lerner and Tirole have provided a few explanations for the incentives of these individual programmers: career concern, ego gratification and signalling activity are quite powerful and effective in this field. Unfortunately, the same nature of these incentives shows the possible limitations of the innovative activity in the open source community:
- R&D in OSS is limited by the usual free riding problems emerging in the private provision of public goods (suboptimal incentives to invest in the creation of a public good as free knowledge);
- voluntary engagement in the development of OSS requires a complementary activity in the for-profit sector to motivate the career concern and the signalling activity;
- decentralized and voluntary R&D in OSS may be biased by research efforts that are different from general consumer needs and by adverse selection of the contributors;
- voluntary contribution to OSS may be effective to solve a number of small and short term problems, but less effective to solve multi-sided challenges and approach long term projects: for instance, it is often claimed that OSS is more effective than proprietary software in debugging activity (since many programmers find and solve many defects within a software and make the solutions freely available), but may have big problems confronting issues as synchronization of upgrades and efficient levels of backward compatibility.
These factors imply that OSS cannot replace the role of proprietary software in the software industry, but can only preserve a limited and complementary role. Beyond this, a complete evaluation of the role of OSS in research & development within the software sector must consider the crucial issue of the proper incentives to invest. Most academic researchers agree that the protection of intellectual property rights is the best way to promote innovative investments, and that the value of IPRs, and in particular of the patents, must trade off these benefits with the distortionary effects associated with pricing. A field in which patents are particularly valuable and induce high investments in R&D is exactly the software sector. Nevertheless, we cannot rule out the possibility that R&D in the OSS community can exert a positive effect on the incentives to invest of the major innovators in the field, the leaders in proprietary software: the competitive pressure from OSS has led technological leaders to continue investing in R&D, and major advances such as the iPhone or Microsoft Surface keep arriving from the commercial software world.
However, restrictive open source software creates a fundamental asymmetry. On one side, open source software companies (allied with big business, such as IBM) can use proprietary software within their products and freely distribute them while covering license expenditures through customer support services. On the other side, commercial companies cannot pursue their business model when including open source within their software, because they would infringe the "copyleft" if they apply a price to the license. This asymmetry can create substantial problems for the conventional business model, and may inhibit or bias consumer-driven innovation.
Finally, the notion, sometimes suggested by OSS advocates, that European competitiveness vis a vis fast growing countries as China or India will be enhanced by the promotion of the open source software model is preposterous. GPL is built on the proposition that anything you do and distribute can be freely appropriated by anyone within or outside Europe, in fact handing over the result of your investment to others on a silver platter. Moreover, notice that the same rapid development of the software sector in India has been entirely based on proprietary software and not on open source software: the most spectacular example in the world of growth driven by research & development in the software sector has nothing to do with OSS.
A last crucial point concerns the claimed advantages of OSS in terms of interoperability. It is sometimes claimed that there may be a trade-off between IPRs and trade secret protection and "interoperability" between products. Interoperability is important in the PC industry and it has strongly increased in the last decades. Problems arise, however, when interoperability is confused with "interchangeability" or with a right to clone the innovations of the competitors, a right often presented as natural sign of openness in the open source community. Fortunately, giving up the precious role of IPRs in promoting innovations is not needed at all to solve interoperability challenges. The market can do it much better: valuable ideas can be selectively commercialized on a voluntary basis through licenses, for instance under RAND (reasonable and non discriminatory) terms, a type of licensing typically used during standardization processes to promote the rapid adoption of standards and new technologies and to encourage entry. The RAND terms include a definition of reasonable royalties, and can include further restrictions as field-of-use clauses (that allow licensees to utilize a patented technology in a use that is directly related to the implementation of the standard), reciprocity clauses, or limits to sublicensing. Notice that extreme open source licenses can create frictions with RAND terms associated with other licenses, so as to jeopardize useful innovative activity - this is the case of the GNU General Public License, which is incompatible with technologies licensed with any positive royalty, field-of-use limitations or other standard restrictions.
