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The Economics of Software, redux

December 16, 2004

So there has been quite a bit of reaction to my thoughts on the economics of software. While most of the reaction has been quite positive, several economists have taken issue with my analysis. (Not surprisingly, I suppose; I’m sure I would take issue with any software written by an economist.) For example, Susan Stewart brought up the legitimate point about my conflation of macro- and microeconomic analysis, especially with regard to the supply curve for the firm. Susan is right on this, but we agreed that it doesn’t change my overall analysis. While feedback like Susan’s was quite helpful, that of another economist was decidedly less so: he was foaming at the mouth because I had the gall to ignore the theories that he set forth in his dissertation. His (largely ad hominem) attack revealed that (a) he didn’t read past the first paragraph or so of my blog entry and (b) that he knows absolutely nothing about software.1 I ultimately got him to agree to (b), after which point I stopped trying to convince him of anything else. And at any rate, these qualms from the academy didn’t have anything to do with the crux of my thesis: that demand for a particular software product is largely price inelastic, that software vendors act as natural monopolists, that open source is an effective way of driving demand for complementary goods, and that this all adds up to a powerful supply-side open source movement.

From my peers in the software industry, the reaction has been more positive — and certainly much better informed. David Ogren had a thoughtful follow-up exploring the genesis for tiered pricing in software, and then another discussing the economics of software support. I view software and support as two different products, so I don’t think that David’s analysis invalidates any of my own. Paul Brown added his thoughts on how the economics of software and the economics of software support relate to one another. And John Mitchell was apparently inspired to ask an intriguing question: “what do examples of post-fiat economics have to do with open source?” I have absolutely no idea, but if I start getting paid in Papiermarks, there’s going to be big trouble.

The most common point of disagreement from those in the industry has been that I didn’t include the cost of sales and marketing software in the cost of software. At the risk of stating a tautology, the cost of marketing a product is not a part of the variable cost of making the product; the variable cost is simply the cost of manufacturing one more unit, and (for software at least) that cost is damn near zero. (The cost of bandwidth is the only argument to be had, and that’s pretty cheap.) This isn’t to say that sales and marketing aren’t necessary to ship a product, just that they don’t factor into the variable cost.

Another point of disagreement is my contention that software doesn’t wear out. I’m not budging on this one, and I refer doubters to my recent experiments with VENIX, software that has had zero maintenance applied to it in the last twenty years. The software works exactly today as it did twenty years ago — it’s as good as new.2 Some mistake software that stops working as having “worn out”, but this is an incorrect inference: the software itself has not changed; a heretofore unknown attribute has merely been exposed — an attribute that was there all along.

I’ve been meaning to do this round-up of reaction for a while, but I was prompted by this tale of one
database customer and the Firebird database. This vividly shows pretty much everything I described: a software company, seeking to extract additional revenue, jacks the price of the software that the customer already has by using one of the ugliest tricks in the book: the software audit. But the software company gets a bit too greedy, and overplays its hand by raising the price four-fold (!) — pushing the customer above their FYO point. (As an aside, I obviously stand by my original nomenclature.) Meanwhile, a hard-on-its-luck also-ran software product written ages ago ends up in the hands of a company that isn’t making much money off of it. Of course, it costs them nothing to manufacture it, so the company decides to give it away for free by open sourcing it. After that initial supply-side push, the demand-side takes off: development begins to blossom, with the demand-side adding many long sought-after features. And in particular, a compatibility layer is added that dramatically lowers the FYO point of everyone running the proprietary database. The pissed customer finds the open source product — and the proprietary product gets the boot (and a lawsuit, I might add). Everyone’s a winner. Or rather, almost everyone…

Despite Larry Ellison’s (expensive) attempt to fulfill his own prophesies, this is the true future of the software business: it may take years — and it may even take decades — but open source from the supply-side coupled with energy from the demand-side will ultimately drive the FYO point towards zero for many existing software products. Companies that can use open source to drive complementary goods will survive and thrive; those that can’t will slowly whither away, until one day their software is acquired for pennies-on-the-dollar by some company that just happens to have some complementary goods to sell…

1A choice quote: “I define software as anything that is an organized collection of information.” Seeing as the ancient Sumerians were writing software by this definition, I found myself wondering what his definition of “hardware” must be…

2That is, as good as it ever was. Software doesn’t wear out, but that doesn’t mean that it’s perfect…

11 Responses

  1. In the early days of the industry, people didn’t buy software, they developed it in house. Then, common stuff was effectively outsourced, and became software packages, which customers had to pay just to get the media. Now, for a lot of software, the cost to get the media is approximately zero. In particular, it’s now quite practical to have wide-scale beta programs, which are generally free of course – to some extent, software is becoming dependant on being free to help development, testing and qualification. Finally, the right to use license for software is increasingly becoming zero.
    I guess the next interesting thing becomes the forces which will shape how quickly this happens. My initial thoughts are that this is mostly an issue of substitutability and suitability. For customers who buy software for which there is not free alternative, there is little choice – though if there are multiple ISVs offering similar products, one may decide to go more agressive on pricing to gain market share. Even if free alternatives are available, they may no offer everything the more demanding customers need, both in terms of features and all scalability and reliability.
    PS It might be better to say the “marginal cost” instead of “variable cost” – “the marginal cost of producing one extra unit” is how I learnt it.

  2. I thought you might find these paragraphs from the latest Cringely article interesting:
    Sun will be immediately hurt more than any other company [by the sale of IBM’s computer division to Lenovo] because Sun gets more of its revenue — close to 90 percent — from the server market IBM is about to target. Sun is in an extremely difficult position. Its strengths have traditionally been in enterprise software and high-end hardware, both of which mean that it can’t flirt too much with Linux and AMD or risk its traditional customer base. At the same time, IBM is targeting the same customers as Sun, will be offering more powerful, cheaper hardware and a great depth of software options, including a Linux that doesn’t in any way threaten other parts of IBM. Sun can’t compete on chips, can’t compete on price, can’t compete on depth. What are they to do? Their current strategy of selling processing power by the cycle is like a new car dealer renting back seats of cars on the lot to teenagers looking for a place to make out.

    What Sun needs to do is to establish itself as the de facto UNIX (not Linux) software vendor. Drop the hardware, make Solaris run beautifully on every high-end system from every manufacturer and compete with Linux by offering world-class consulting, service and support. Fortune 500 companies would sigh with relief, but Sun would also have to accept that the company will shrink in sales and headcount, though not in profit. This is the only viable strategy left for Sun, which is going to shrink dramatically anyway, possibly to nothing.

  3. I am from TAIWAN I’m a collge student. My majority is computer science. I am a freshman. I want to learn unix kernel. I find a book”Lion’s Commentary on UNIX 6th Edition”in our college’s library. please tell me how to learn UNIX kernel. Do you have any friend who is kernel developer in SUN ? could they give me a direction? THANKS you for tolerating my poor english

  4. at the risk of asking a dull question – have you read the Wired article The Long Tail – which looks at the economics of digitizing world? mass markets become less relevant in a world without shelf life concerns.
    lots of cross cutting elements with your work here, and an intriguing take on legacy value.
    after the analyst conference i wrote this
    – which talks to your firedupness – apparently you have some. and also what i call Service Oriented Economics. the thinking may be too aggregational for you, but i am not a kernel developer….

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