Competitive Strategy for Open Source Software

1. Competitive Strategy for Open Source Software Vineet Kumar (Harvard Business School) Brett R. Gordon (Columbia University) Kannan Srinivasan (Carnegie Mellon University) Presentation at Chicago Booth School of Business, March 2011

2. What is Open Source Software? • Software for which source code are in the public domain • Examples: Linux, OpenOffice, Firefox Browser, Android, etc. • Anyone can view, modify, customize for personal use • Contributions made by individuals and firms • Different from free software (Adobe Reader, Skype, etc.)

3. Microsoft on Open Source • Microsoft CEO Steve Ballmer on Linux: • “…a cancer that attaches itself in an intellectual property sense to everything it touches.” (NYT, 2003)

4. Open Source Markets Two types of open source market structures, depending on license Private Features (BSD): • Open source features are freely available to anyone, including firms without restrictions. • Commercial firms can reuse these features in their products Shared Features (GPL): • Open source features are available for use. • Commercial firms who use these features in product must give back ALL features to the public domain

5. The Software Industry and Open Source

6. Puzzles from theOpen Source Industry • Why Do Developers Contribute to Open Source? • Numerous studies (more later) • Why would COSS firms contribute to features knowing that their competitors can take advantage of these contributions? • Are firms and/or consumers worse off from the “cancer” of free-riding? • How can a market based on free-riding produce better quality products? • Industry observers note that some COSS products are of better quality than traditional closed-source software products.

7. Related Research • Product Development and Co-creation • Prahalad (2002), Ramaswamy & Gouillart (2010): How should a firm enable and incentivize consumers to create products? • Rowley et al (2007), Lorenzo et al (2007) • Open source versus Closed source • Leppamaki & Mustonen (2009) : should a firm open source its products? • Casadesus-Masanell & Ghemawat (2006) : Windows versus Linux Little to no research on competitive strategy of COSS firms

8. Why Do Developers Contribute? • Use value • Intrinsic motivation to create something useful for them • Altruism • Want to help the world (through open source) • Signaling • Want to prove programming skills and capabilities in order to improve employment possibilities • We focus on this explanation

9. Open Source & Developers

10. Open Source & Developers

11. Why Do Developers Contribute? Relevant literature on developer motivations to contribute: • Hars & Ou (2002): survey of developers reports that a majority list career concerns as primary reason for contributing • Roberts, Hann, & Slaughter (2006): extrinsic factors, such as job concerns, play largest role • Fershtman and Gandal (2007): less restrictive and more commercially-oriented licenses result in more contributions • Lerner and Tirole (2002): in a lit review, find most evidence consistent with signaling perspective

12. Model • Duopoly market with firms 1 and 2 • Based on vertical differentiation models (Shaked and Sutton 1982, Moorthy 1988) • Each firm develops one product • Consumers have heterogeneous value for quality, • Each consumer buy either one of the products or nothing • Firms endogenously differentiate on quality in equilibrium

13. Model Timeline Firms hire developers and determine product features and usability Market structure is exogenously determined Firms set prices in the product market 0 1 2 2S 3 4 Developers contribute to open source to signal their skill-level Firms decide how many features to copy from competitor (only for shared features) Consumers make purchase decisions

14. What is Software Quality? • Features (F), or functionality: basic operations of software • e.g. support for budget functions in excel, a calculator built into a word processor • Usability (s): enables a user to effectively utilize the functionality available • e.g. user interface enhancements, online help, tech support and service • Recall that • Usability is always kept private • Features may have to be shared in the public domain

15. Open Source Markets Two types of open source market structures, depending on license Private Features (BSD): • Open source features are freely available to anyone, including firms without restrictions. • Commercial firms can reuse these features in their products Shared Features (GPL): • Open source features are available for use. • Commercial firms who use these features in product must give back ALL features to the public domain

16. Initial OSS features available to all Private Product Market OSS Private Features Firm 1 chooses and Firm 2 chooses and Firm 1’s Product Firm 2’s Product

17. Firm 1 chooses and Firm 2 chooses and Shared Product Market OSS Shared Features Initial OSS features available to all Contribution to OSS Contribution to OSS Firm 1’s Product Firm 2’s Product

18. Summary: Product Market • Duopoly market with firms 1 and 2 • Consumers are heterogeneous in taste in quality: • Quality depends on the market type (P or S) • In shared market, each firm also decide degree of copying • Each consumer buy either one of the products or nothing

19. Developer Market Incentive Compatibility & Individual Rationality IR for low-skilled developers does not need to be satisfied External market hires developers OSS Features Developers (High and Low) Developers expect wage High-type Low-type Firm 1hires developers Firm 2hires developers Initial level of OSS features available to all Product Market

20. Developer Signaling • Spence (1973) models education as a signal of ability • Assumes a perfectly competitive market for employers • We model an imperfectly competitive market for developers • Signals have a “spillover” effect in two ways: • Developer-Firm: Substitutability between developer contributions and firm contributions • Firm-firm: Shared features market implies competitive spillovers

21. Model Timeline Firms hire developers and determine product features and usability Market structure is exogenously determined Firms set prices in the product market 0 1 2 2S 3 4 Developers contribute to open source to signal their skill-level Firms decide how many features to copy from competitor (only for shared features) Consumers make purchase decisions

22. Equilibrium Analysis Solve the game by backward induction • Stage 3+4: Pricing sub-game • Given product quality, firms simultaneously choose prices and consumers make purchase decisions • Stage 2: Given developer market outcome, firms determine product strategies and quality decisions • Firms determine how much to invest in features and usability by hiring developers to create more features. • Usability is available through a competitive market where the COSS firms are price takers

23. Pricing Game Equilibrium • Prices are determined as function of quality • Common to both private features and shared features markets

24. Product Strategy Equilibrium • Complete free-riding in equilibrium in shared features market • Full copying occurs

25. Developer Equilibrium Analysis Solve the game by backward induction • Stages 2+1: Developers and Firms • Firms determine how much to invest in features and usability by hiring developers to create more features. • Developers of high and low types make contribution decisions • Firms attempt to infer developer skill-level by observing contribution. • Low-skilled developers make different contributions than high-skilled developers. • Signaling game yields multiple (infinite) equilibria • Filter out unreasonable equilibria using Intuitive Criterion (Cho and Kreps, 1987) • Focus on Least Cost Separating Equilibrium

26. Analysis of Developer Market High-skilled developers Incentive Compatibility & Individual Rationality IR for low-skilled developers does not need to be satisfied R 0

27. Connecting Product & Developer Markets • Demand for high-skilled developers: • COSS Firms and External Market • Supply of high-skilled developers by signaling Determine market wage by equating Excess demand (w) = demand(w) – supply(w) = 0

28. Wage Comparative Statics • Equilibrium wage is determined from implicit equations • “w” increases with market size M, cost of signaling and decreases with cost of usability

29. Puzzles from theOpen Source Industry • Why would COSS firms contribute to features knowing that their competitors can take advantage of these contributions? • Are firms and/or consumers worse off from the “cancer” of free-riding? • How can a market based on free-riding produce better quality products? • Industry observers note that some COSS products are of better quality than traditional closed-source software products.

30. Results • Why would COSS firms contribute to features knowing that their competitors can take advantage of these contributions? • A larger base of features increases the value (to firms) to differentiating even more on usability • Requires that features and usability are complements • In the presence of free-riding behavior, can COSS firms make positive profits? • Yes, differentiating on usability and reducing the intensity of competition in the developer market helps.

31. Results • Which market result in more available open source features? • When market size is large, private features market results in more open source features. • Copying in shared features market – who copies from whom? • Both firms end up copying the maximum possible features from each other

32. Results • Who is hurt by the cancer of “free-riding”? • Consumers ALWAYS benefit from the shared features market. (Both) firms may also benefit from the shared features setting if the market is large enough.

33. Extensions and Limitations • Firms do not choose which license • Multi-product firms that compete across markets with different licenses • Allow firms to endogenously release software to open source

34. Thank You