Software Design Strategies in Markets with Open Source Competitors

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1 Association for Information Systems AIS Electronic Library AISeL ICIS 00 Proceedings International Conference on Information Systems ICIS 00 Software esign Strategies in Markets with Oen Source Cometitors Zhe u University of Texas - Pan American, uz@uta.edu Follow this and additional works at: htt://aisel.aisnet.org/icis00 Recommended Citation u, Zhe, "Software esign Strategies in Markets with Oen Source Cometitors" 00. ICIS 00 Proceedings. 4. htt://aisel.aisnet.org/icis00/4 This material is brought to you by the International Conference on Information Systems ICIS at AIS Electronic Library AISeL. It has been acceted for inclusion in ICIS 00 Proceedings by an authorized administrator of AIS Electronic Library AISeL. For more information, lease contact elibrary@aisnet.org.

2 SOFTWARE ESIGN STRATEGIES IN MARKETS WITH OPEN SOURCE COMPETITORS Stratégies de concetion de logiciels our les marchés confrontés à la concurrence des logiciels libres Comleted Research Paer Zhe u eartment of Comuter Information Systems & uantitative Methods College of Business Administration, University of Texas-Pan American 0 W University rive, MAGC 3.30 Edinburg TX 7539 uz@uta.edu Abstract There is a growing body of literature investigating the strategic interaction between rorietary software vendors PRs and their oen source OS counterarts. Most rior studies focus on software market where PRs revenue comes mostly from software license. Nevertheless, oen source software OSS is rominent in software markets where both software license and software service contract for the urose of maintenance, technical suort, ugrade, etc constitute some considerable ortion of PRs revenue. This aer aims to underline the difference between software characterized by high demand for service and by low demand for service in studying how OSS shaes PR s software design strategy. The analysis of an economic model imlies a magnetic henomenon in the design of rorietary software with high demand for service, which is not observed in the design of software with low demand for service. The findings imly that in software markets characterized by high demand for service, when OSS is not very sohisticated PR could introduce more basic version of their software in resonse to the growth of the OS counterarts. This imlication is found to be very much inline with industry ractice. Keywords: Oen source software, rorietary software, maintenance, suort, cometition, software designs, ricing Twenty Ninth International Conference on Information Systems, Paris 00

3 Organization Theory, Strategy and IS Résumé Ce aier examine comment les logiciels libres contraignent la stratégie de concetion chez les vendeurs de logiciels roriétaires. Une analyse ar modélisation économiue indiue un hénomène magnétiue dans la concetion de logiciels, lorsue ceux-ci nécessitent une forte demande de services associés maintenance, mais as our les logiciels à faible demande de services. Ce résultat est en accord avec les ratiues constatées dans le secteur. Introduction esite all the critiues about oen source software OSS, OSS has made significant inroads in many areas of software develoment, from oerating systems Linux, rogramming languages Perl and Web browsers Mozilla Firefox to Web servers Aache, database management systems MySL, mail management systems Sendmail and tyesetting engines Tex Bitzer and Schroder 006; Economides and Katsamakas 006; Gaudeul 007; Lerner and Tirole 00; Lerner and Tirole 005; Schmidt and Schnitzer 003; Sen 007. The growing market share and volume of installed base of some OSS force major rorietary software vendors PRs to seriously consider the cometitive osition of OSS in the industry and emloy a variety of strategies to counter the challenges of successful oen source OS movement. For instance, Oracle stated in its analysis of key cometition in 007 that The enterrise software industry is intensely cometitive oen source alternatives such as MySL AB in database, Red Hat, Inc. in middle ware, and SugarCRM Inc. in alications, are also imacting the cometitive environment in the sale of database software our cometitors include the oen source databases, MySL and PostgresSL In the sale of middleware roducts, our cometitors include oen source vendors such as Red Hat, Aache and ObjectWeb. Business intelligence cometitors include oen source vendors Netezza Cororation Oracle annual reort 007 Sun Microsystems similarly stated in its 007 annual reort that we are seeing increased cometition and ricing ressures from cometitors offering systems running Linux software and other oen source software. BEA Systems acknowledged that cometitive ressures and oen source availability of functionally cometitive software could reuire us to reduce the rice of our roducts and related services, which could harm our business. Facing the challenges from OSS, commercial firms emloy a number of strategies and build innovative business models to counter the challenges and to caitalize on OS movement e.g., Bank 003; Lawton 007; Tam 004. For examle, Red Hat uses a suort business model where it commercially rovides comlementary services that are not sulied efficiently by the Linux community. Major PRs such as Oracle, HP, Novell, IBM, SAP and Sun Microsystems are well-known advocates of OS movement Kerstetter 004; Stone 004; Tam 004; ara 006. For instance, Oracle started selling its own technical suort for Red Hat's version of Linux in 007; Sun Microsystems is also determined to offer free downloads of its Solaris software; In 004, IBM submitted a lightweight database called Cloudscae to the OS community - Aache Software Foundation, an organization that manages the widely used Aache Web server. Academic researchers have also made significant contribution examining the issues for cometitive strategy in the landscae of OS movement e. g., Bessen 006; Bitzer 004; ahlander and Magnusson 006; Economides and Katsamakas 006a; Haruvy et al. 005; Lerner and Tirole 00; Lerner and Tirole 005; Rossi and Bonaccorsi 006; Schmidt and Schnitzer 003. esite the growing body of literature investigating the strategic issues between PRs and their OS counterarts, most of the rior ieces focus on software market where vendors revenue mainly comes from software license. Nevertheless, OSS is also rominent in software markets where there is significant demand for maintenance and suort service after the sale of software license. That is, both software license and ost-sale service contract reresent considerable ortion of some PRs revenue. This is shown in Table. Table is a snashot of influential OSS. It shows that OSS is not only rominent and known in software markets where users do not reuire much suort and service e.g., Web browser and tyesetting, but also in software markets where a significant ortion of PRs revenue comes from maintenance and suort of software e.g., infrastructure software and database management systems. For instance, as one of the world s largest database software roviders, 33% of Oracle s total revenue in 007 came from software license, and 46% from software maintenance and roduct suort; maintenance and suort also reresented the highest margin business unit for Oracle Oracle annual reort 007. Sun Microsystems, a major rovider of infrastructure roduct, earned Twenty Ninth International Conference on Information Systems, Paris 00

4 u/software esign in Markets with Oen Source Cometitors Program Nature of rogram Year of introduction Table : Major Oen Source Projects Cometitors MySL BMS 995 Oracle, IBM, Microsoft Linux Sendmail Server oerating system Internet mail transfer agent 99 Microsoft Windows 979 Microsoft Exchange Aache Web server 994 Microsoft IIS Perl System administration and rogramming language 97 Java Sun B, ActiveX Microsoft Tex Tyesetting 9 Microsoft Word Mozilla Firefox Market enetration > million installations % of total shiments in 00 IC rediction Handle ~0% of Internet traffic 00 ~55% February 00 Estimated to have million users 00 Web browser 004 Microsoft IE 7.3% of the recorded usage share of Web browsers March 00 For rofit? Yes MySL Yes Red Hat Yes Sendmail Inc. No No Business model Warranty, customer suort, otionally additional functionality Suort and other comlementary services of Linux Service N/A N/A N/A No N/A Note: information resented in the table is from ahlander and Magnusson 006, Economides and Katsamakas 006b, Gaudeul 007, Lerner and Tirole 00, Netcraft 00, Net Alications 00, Wheeler 005, Wittig and Inkinen % of its total revenue in 007 from suort services consisting rimarily of maintenance contract Sun Microsystems annual reort 007. BEA Systems, Inc., a world leader in enterrise alication and service infrastructure software, earned 40.9% of its revenue in 007 from license fees and 59.% from maintenance and suort of its infrastructure software. Generally, customers who urchase enterrise software licenses may also enter into maintenance contracts covering technical suort services, regular software maintenance, and software udates and enhancements. These maintenance contracts generate ersistent revenue for enterrise PRs after the transaction of software license e.g., Banker and Slaughter 997; Tan and Mookerjee 005. This aer is motivated by the significant difference between the two families of software, both of which witness notably dynamic and influential OS movement in recent years. Software like database management systems BMS in general reuires much more maintenance service and suort than software for tyesetting, Web browsing or gaming urose. The amount of suort and service needed is determined in general by the comlexity and scoe of the software and whether the software is mission-critical. For examle, database tyes of software normally have higher comlexity, are of larger scoe and are more business-critical than software such as Web No N/A BEA Systems was acuired by Oracle in 00. Poor design in software may also lead to high demand for suort. In this aer, I focus on service demand driven by software characteristics and assume good uality in software design. Twenty Ninth International Conference on Information Systems, Paris 00 3

5 Organization Theory, Strategy and IS browser and comuter games. As a result the former naturally reuire much more maintenance and suort than the latter do. Furthermore, as suort for software is comlementary to software characterized by large demand for suort service, the software itself and the suort associated with it intervene with each other. Hence, it is imortant to examine them in an integrated framework; while for software with low demand for suort service, examining the software alone would be sufficient. The fundamental difference between the two families of software demands searate treatments in investigating commercial software firms OS strategy. For examle, do PRs emloy different OS strategies for software with low demand for service versus for software with high demand for service? How does the imact of OSS differ on the market structure for the two tyes of software market? The urose of this Chater is threefold. First, I investigate how activities in OS community enhance or relace the economic activities of PRs. In articular, how does the rise of OSS have an effect on PR s software design strategy in terms of number of features and functions bundled in the software? Second, I investigate the imact of OSS on software market structure and on ricing strategy of PR. Third, I examine how the imacts of OSS differ between software market characterized by high demand for service and by low demand for service. The remainder of the aer is organized as follows. The next Section rovides a review of the literature. Then I resent a case study of MySL followed by an economic model. Analysis results of the model are resented in the Section of Euilibrium followed by managerial imlications. The last Section concludes. Literature Review This aer is related with two streams of research: commercial software firms OS strategies, and the imact of OS movement on PRS design. There is much discussion among industry exerts about commercial software firms OS strategies e.g., Bank 003; Lawton 007; Tam 004. The key uestion among these is: How do firms seeking to sell roducts comete with free? von Krogh and von Hiel 006 Academic researchers summarize these strategies into four categories: a market segmentation strategy i.e., PRs cover a market segment different from the one covered by OSS Bessen 006; Bitzer 004; b comlementary roduct/service strategy ahlander and Magnusson 006; Economides and Katsamakas 006b; Haruvy et al. 005; Lerner and Tirole 00; Lerner and Tirole 005; Schmidt and Schnitzer 003; c subsidy/suort strategy i.e., PRs articiate in or subsidize OS rojects Bessen 006; ahlander and Magnusson 006; Haruvy et al. 005; Lerner and Tirole 00; Lerner and Tirole 005; Rossi and Bonaccorsi 006; d releasing rorietary codes strategy Lerner and Tirole 005. Gaudeul 005 investigates the direct cometition between one OS and one rorietary roject in a duooly model where both the cost and benefit of OSS are comared with PRS. The cost of adoting OSS includes lack of coordination in develoment and lack of interface. The cost of adoting PRS is that develoers may choose to develo a limited number of features. The author found that OSS and PRS can coexist in euilibrium, but OSS is used by low-income customers or by develoers. This roves the validity and stability of the market segmentation strategy. Bitzer 004 similarly showed that decreasing heterogeneity between OSS and PRS can drive the rice of PRS below its average cost, leading to PR s loss of incentive to develo PRS and forcing PR to exit the market. The comlementary roduct/service strategy has been brought u in a number of studies. Economides and Katsamakas 006a develoed a framework to investigate a latform firm s ricing strategy for the latform and for comlementary alications to the latform two-sided ricing strategy of a latform firm and how the ricing strategy influence the industry structure of the rorietary system as well as the OS system. They found that the overall rofit of a rorietary system is larger than an OS system when users have a strong reference for alication variety; however the variety of alications in the OS system is larger than in the rorietary system. The authors also examined the cometition between OS latform and rorietary latform. They found that a vertically integrated rorietary system rorietary latform and alications to the latform are rovided by one firm has a larger market share than an OS system if there is a relatively large demand for the rorietary alication, a large transition cost for the OS latform and a relatively small demand for alication of the OS latform. Although the ayback of market segmentation strategy and comlementary roduct/service strategy to commercial software firms is straightforward, researchers found that the gain of releasing codes to OS community is not guaranteed. Haruvy et al. 005 examined conditions when a software firm should oen its source codes versus close its source codes. They comared the revenue of a software rovider under two scenarios: the software is 4 Twenty Ninth International Conference on Information Systems, Paris 00

6 u/software esign in Markets with Oen Source Cometitors develoed in an OS way, where the rovider s revenue comes from comlementary roduct of the OSS; the software is develoed in a closed source way, where revenue comes from both software license and service. The authors demonstrated that when there are more roductive in-house rogrammers and when the initial uality of the software is high, oening source codes may not be beneficial to a firm. On the other hand, oening source codes becomes a viable alternative to closed source only when the involvement of OS community in the roject reaches a critical level. Moreover, OS is referred when rogrammer wage exceeds some threshold, even with highly roductive in-house rogrammers. Lerner and Tirole 00 argued that PRs release their rorietary codes to OS community in the hoe that they can gain more by roviding related services. However, releasing codes could be risky for PRs if the ayoff in the comlementary service segment after the release does not exceed the ayoff if the codes had not been converted to OS, which exlains why the strategy of releasing codes to OS community is often observed in firms that are not major layers in the rorietary segment. Researchers also found that firms may have different incentives subsidizing or suorting OS rojects. Some firms invest in OS develoment if the OSS is comlement to the commercial software or hardware they roduce Schmidt and Schnitzer 003. Bessen 006 investigated why firms contribute to OSS develoment when there is PRS from non-rival firms. The author argued that comlexity of software limits the number of features included in PRS. Under-rovision of features created a market for OS community, which tends to develo more comlex and geekier alications. Firms articiate in OSS develoment for their own needs of software features. The author concludes that OSS extends software market rather than relace PRS. That is why OSS can grow in the resence of a cometing PR, and PRS can coexist with OSS because they cover different market segments. Mustonen 005 investigated when a PR may suort the develoment of substitute OSS. The author showed that this could haen when the suort creates comatibility between the rograms and that the rograms exhibit network effects. So suorting a rival OSS may allow the PRS and the OSS to share the same network. The resulting strong network effect of the PRS, however, is earned at the rice of the PR losing its network of old PRS, and at the cost of roviding suort to the OSS. Lerner and Tirole 00 argued that PR may want to subsidize the OS movement for strategic reasons such as weaken a rival or lessen the deendence on other vendors. Another line of research on OS strategy is related to OS license. Kim et al. 006 examined and comared three software ricing mechanisms: ricing of commercial software, ricing of OS roduct/service in OS dual license model, and ricing of oen source roduct/service in OS suort model. They investigated whether OS models are viable in monooly and duooly setting. They found that OS suort model is viable in the resence of uality asymmetry among cometitors no matter whether the uality of OSS is higher or lower than commercial software. The second stream of research related to this aer concerns the imact of OS movement on PRS design, in articular, on the design of software features. Bitzer and Schroder 007 stated that the uestion of what imact this unusual develoment method OS has on innovation activity in the software sector has received surrisingly little attention thus far. They built a simle economic model and examined the imact of increased cometition on innovation activity of both incumbents and entrants. They found that although incumbent commercial firms claim that technological rogress will slow or even sto as a conseuence of OSS entry, the model shows that it romotes innovation, that is, enterrises choose to increase the technological levels after the emergence of OSS. Bitzer and Schroder 006 argued that the emergence of OSS has raised fears of a otential anti-innovation effect on two main issues. First, the emergence of a no-cost cometitor on the software market raised the uestion of whether commercial enterrise will be able to comete successfully decreasing rofits of commercial software roducers will lower their ability to invest in R& activity, thus resulting in slower technological rogress in the software industry ; Second, an anti-innovative effect of OSS may result if its develoment rocess is less efficient than that of commercially organized software. To examine the legitimacy of OSS s anti-innovation effect, the authors used the release history of Windows and Linux, Internet Exlorer, Netscae s Web browser and Mozilla Firefox, as a otential indicator of technological rogress in software industry. They found that the data and cases resented do not offer evidence of an anti-innovative imact; on the contrary, if anything, the entry of OSS into commercial segments of the market aears to be associated with increased innovation activity. Economides and Katsamakas 006b extended the model develoed by Economides and Katsamakas 006a and analyzed the innovation incentive in systems of two latforms: the OS and the rorietary latform. Comaring vis-a-vis the innovation investment of OS system and PR system, they found that the investment in alication is stronger when the latform is OS. This is because the OS latform is available for free, enabling the alication rovider to set a larger rice and cature a larger rofit than the alication rovider for the rorietary latform. The authors also found that the level of investment in the alication affects the level of investment in latform due to the comlementarities Twenty Ninth International Conference on Information Systems, Paris 00 5

7 Organization Theory, Strategy and IS between the alication and the latform. In articular, the marginal benefit of investing in the latform decreases with the level of investment in the alication. Overall, most of the rior research investigate one tye of software in the landscae of OS movement and do not systematically comare software that is different in nature. One excetion is the research by Sen 007. Sen 007 comared the imact of OSS on PR s software usability and ricing decisions for two tyes of software: software with strong network effect versus software with weak network effect. The author found that the two tyes of software markets reveal very different behavior given the entry of OSS. In software markets with low network effect, PR is better off in the resence of cometition from OSS while PR in markets with high network effect is threatened by the resence of OSS. Furthermore, PR has little incentive to imrove the usability of their software in markets with low network effect, while the same strategy may drive PR to exit the market in software market characterized by strong network effect. A Model A Case of MySL I draw on the case of MySL to romote the model. MySL is a oular OS BMS. It is chosen in the case analysis because BMS is in general considered to have high demand for service, and there is serious cometition between OSS and PRS in this software market. These characteristics of BMS are essentially the focus of this study, hence the key elements in the model. Therefore MySL reresents a good case in oint in this study. The comany MySL was acuired by Sun Microsystems in February 00. It was founded in 995 and is headuartered in Sweden today. It has several offices throughout the world with thousands of community members worldwide. MySL is in the list of OSS building blocks called LAMP, reresenting Linux, Aache, MySL and Perl Wittig and Inkinen 004. It is used by Google, Yahoo!, Nokia, YouTube, Amazon and Travelocity among others. MySL has received much attention of both media e.g., Bank 003; Lacy 006; Lawton 007; Tam 004 and academic researchers e.g., ahlander and Magnusson 006; Kim et al. 006; Lerner and Tirole 005; Mustonen 005. Mustonen 005, Wittig and Inkinen 004, Wittig 006, and ahlander and Magnusson 006 reared MySL cases and documented the history, current market osition and business model of MySL. MySL is known not only because of its high growth rate and large volume of installed base, but also because it challenges a high-margin database software category and could reshae the database market as Linux has reshaed the server oerating systems market. In their case study of MySL, ahlander and Magnusson 006 mentioned that the most rominent PRSs that are cometitors of MySL are the databases of Oracle and IBM. Industry analysts reorted that facing cometition from oen-source alternatives, not only Oracle, but also IBM and Microsoft have each lowered their database rices and created low-end bundles aimed at smaller organizations and artners. LaMonica 005 MySL used to use a so-called dual license model: the software is available under both OS license GPL and rorietary license. In 005 MySL introduced the MySL Network described as a subscrition service that rovides udates, alerts, notifications, knowledge base and roduction level suort, that make it ossible for comanies to easily manage hundreds or thousands of MySL servers. The core MySL database remains oen source, but these services are only available to aying customers. MySL s EP of sales commented we are following the Red Hat attern. The subscrition business is growth business for us and that will overtake our OEM business Wittig 006. MySL has been imroving its roduct. In October 005, MySL released version 5.0 which incororated comarable features, such as stored rocedures and triggers, to those of Oracle, IBM and Microsoft. These features were exlicitly outlined by Oracle in 004 to show the inferiority of MySL Wittig 006. With more advanced features released, MySL is ut in more direct cometition with Oracle, IBM and Microsoft. Model Setu I model the cometition between a PR and an OSS in a software market characterized by high demand for suort and service. The PR sells software license and suort service for its rorietary software; the OSS is available for users free of charge; an OS service rovider adots a suort model and sells suort service for the 6 Twenty Ninth International Conference on Information Systems, Paris 00

8 u/software esign in Markets with Oen Source Cometitors OSS. In the database market, Oracle is the PR, MySL database is the OSS, and MySL is the service rovider for the OS database software. I build the model on the literature of vertical differentiation 3. Following industry ractice, I model the decision making rocess of the layers as a three-stage noncooerative game with no collusion. Stage : Software esign. In software market characterized by high demand for service, an OSS with features is rovided free of charge. A PR chooses number of features/functions for its software after observing. Let, [0, ] where reresents the maximum number of features/functions that can be develoed for a PR to earn a nonnegative rofit. The develoment cost is C 4 where C > 0, and C > 0. Number of features/functions bundled in the software is treated as the PR s decision variable in the first stage because of the following reasons. First, the model is intended to build an integrated framework including both software and subseuent suort service for the software. The software engineering literature reorts that the amount of maintenance service reuired for one software is closely related with the comlexity in software design; more comlex software reuires more maintenance and suort effort 5 e.g., Abreu and Melo 996; Banker et al. 99; Briand et al. 999; Li et al It has been shown that function oint a unit of measurement to exress the amount of business functionality an information system rovides to a user in software is related with comlexity and size of software, hence is related with maintenance effort for the software Banker et al. 99; Swanson and Beath 99. Second, functionality is one of the main evaluation criteria for BMS Wittig and Inkinen 004, which further gives good reason for using the number of functions/features as PR s decision variable in the software design stage. Stage : Software Pricing. PR chooses rice for the PRS develoed in stage. Each consumer acuires one and only one coy of the software from either the OS community or the PR software market is fully covered. denotes the demand for PRS and is determined by,, and the exected value of PRS service and OSS service denoted by A and B resectively. The rest of the market adots OSS. emand for OSS is denoted as o. Stage 3: Service Pricing 6. 3 The literature on vertical differentiation is closely related to the literature on how to describe the differentiation between goods. This uestion has been addressed by Hotelling 99, Chamberlin 95, 96, and Lancaster 966. According to Tirole 9 vertical differentiation is alied to a situation where all consumes agree over the most referred mix of characteristics of goods. A widely-adoted aroach to model vertical differentiation can be found in Tirole 9. 4 C includes the cost to design and develo features and to ensure the uality of the software if PR is an entrant. If PR is an incumbent, reresents the overall number of features bundled in the software; C includes the cost to design and develo the incremental features, the cost to ensure the uality of the software, including comatibility of new features to the system, maintainability, extensibility, robustness, reliability of the software, after including the incremental features. 5 Poor software design may also incur high demand for suort service. However, this may not be of major concern in the case of MySL database and Oracle database. MySL uses a systematic aroach to manage the rocess of software design and develoment and Its database has an easy-to-use interface Wittig and Inkinen 004. In general, OSS has to reach mature stage to be able to comete with an existing PRS. Literature has shown that OSS that reached mature stage is uite comarable with corresonding PRS in terms of uality in software design Wheeler Some PRs offer a bundle of software license and suort contract. Oracle offers searate rices for license and suort. I follow the ractice of Oracle and searate the ricing decision for license and suort into two stages. The result remains the same if I combine stage with stage 3. The result will change if the rice for a bundle with both license and suort is different from the sum of the rices if the two are sold searately. Since bundling is not the focus of this aer, I searate the ricing for license and suort for simlicity. Twenty Ninth International Conference on Information Systems, Paris 00 7

9 Organization Theory, Strategy and IS As discussed in revious Section, software ost-sale service rovides additional value to software users. In this stage, PR chooses service rice s for the PRS and a service rovider secializing in OSS determines the service rice s o for OSS. I normalize service cost er customer to zero, so that service rice is the rofit margin. PRS users urchase service from PR and OSS users urchase service from OSS service rovider if their net surlus of urchasing the service is ositive. For the same tye of buyers defined in the next aragrah, I assume service is of higher value to buyers if the software urchased in stage is more comlex, that is, the software is bundled with more features/functions. This is reasonable because if software is simle and easy to use, users do not have much need for technical suort; while if software is comlicated or users lack exerience in using it, technical suort becomes much more imortant to kee the software running and to udate the software to tonotch condition. Following this logic, I denote the gross value of service for PRS and OSS by and corresondingly where. > 0. Consumer Preference. Consumers are uniformly distributed in a unit suare where the two axes reresent their taste for software features and service resectively 7. For examle, consumers located at, have the highest valuation for software features and service; consumers located at, 0 have the highest valuation for software features but lowest valuation for service. Consumers know their tye about software design at the beginning of stage, but get to know their tye about service only after they consume the software, i.e., at the end of stage. This is because consumers tye for service is closely related with consumers exerience with the software. If the software runs smoothly, they may find less value of the service. If they have difficulty with the software, they may have greater need for the service. As a result, when consumers select software in stage, they use the exected surlus they anticiate to derive from the service as art of the inut. The Euilibrium I start with the last stage to solve the model. Stage 3. Consumers utility is θ - s if they urchase PRS service and θ - o s if they urchase OSS service. θ reresents consumers tye about service and is uniformly distributed over the interval [0,]. emand for service o s o s o s, s is for PRS service and OSS service corresondingly. PR s roblem at this stage is to maximize his service rofit determined by s s. OSS service rovider maximizes his rofit determined by o s o s. Proosition. The euilibrium service rice and the conseuential service market coverage satisfy o o s, s, s, s for PRS and OSS corresondingly. o Clearly, service roviders for PRS and OSS are monooly in their individual service market; hence each of them covers half of the service market and rices service at half of the service value to obtain monoolistic service rofit. Stage. Incororating the above results into stage, I derive consumers exected net gain of using PRS service and OSS service resectively. 7 This aroach is commonly used in modeling consumer references in two dimensions. Consumers tastes for software features and service are assumed to be indeendent from each other because their relationshi could be deendent on consumers secific reuirements for the software, their technical caabilities and rior exerience with similar roducts. Therefore, the relationshi between them could be ambiguous. Customers with high valuation for software features may have low or high valuation for service; the same alies to customers with low valuation for software features. Twenty Ninth International Conference on Information Systems, Paris 00

10 u/software esign in Markets with Oen Source Cometitors Twenty Ninth International Conference on Information Systems, Paris 00 9 ' ', ' ' d B d A o s s o s s θ θ θ θ Consumers exected utility of choosing PRS is θ-+a. θ reresents consumers tye about software features and is uniformly distributed over the interval [0, ]. θ- reresents utility from consuming the software and A reresents exected utility of adoting PRS service. Consumers exected utility of adoting OSS is θ+b. Let >, demand is o, for PRS and OSS corresondingly. PR s ayoff at stage is π π software + π service where., service software s s π π PR s roblem at stage is to max + π Proosition. The euilibrium PRS rice and the corresonding software market share satisfy o , 6 6 3,. Proosition shows that given the setu of this model, PR gains larger market share than OSS in software market characterized by high demand for service as long as both the PRS and the OSS stay in the cometition. Stage. PR s objective at stage is to max C + π where and are determined as in roosition. To make the roblem tractable, following Thatcher and Pingry 004, I assume C a and let b and b, where a > 0, and b 0. Proosition 3. If, b b b where b and b are the roots of a uadratic function +3b -64ab-5a 0, PR s ayoff function is uasi-concave. The euilibrium number of features bundled in PRS satisfies a b b b b b b The sufficient condition for > is < /a. Substituting into the exressions of and secified in roosition and into the exressions of s and s o secified in roosition, I derive the euilibrium PRS rice and market share, and service rices for PRS and OSS. Findings and Managerial Imlications PRs have initial market ower in majority of software markets e.g., Windows and Linux; Oracle BMS and MySL BMS, hence their PRS has higher market share and more software features than OSS initially. Following this market situation, I assume <. Besides, this assumtion is consistent with the situation in the BMS market. MySL s imortant target market is unsohisticated users who do not need all the features of Oracle database and MySL rovides a basic, but good-enough roduct Wittig and Inkinen 004. If, PR will have zero demand. The condition will be checked later.

11 Organization Theory, Strategy and IS Comarative analysis of the euilibrium is resented in a two-by-two framework in Table. Table reorts how the imact of OSS differs on software market characterized by low demand for service versus on software market characterized by high demand for service. The findings are summarized in the following roositions. Table : Comarative Analysis 0 No OSS > 0 With OSS b 0, software market with low demand for service,,,, a 6a a 6a b > 0, software market with high demand for service 3 b a 6 b 3b, as in roosition 3 b b, b + 6 Proosition 4. In software market characterized by low demand for service, when < /a, a. OSS does not have an effect on the otimal number of features develoed in cometing PRS. The otimal level of features in PRS remains at the threshold value /a; b. PRS is riced lower after the entry of cometing OSS; c. PRS remains the same market share after the entry of cometing OSS. The results reorted in Proosition 4 are consistent with findings in rior literature that examines software market with low demand for service. For examle, Bitzer and Schroder 007 built a simle economic model to examine the imact of increased cometition due to OSS entry on innovation activity of both incumbents and entrants. They found that entry of OSS romotes innovation, that is, enterrises choose to increase the technological levels after the emergence of OSS. Bitzer and Schroder 006 emirically found suort for the roosition in Bitzer and Schroder 007. Note that although art a in Proosition 4 does not show an increase in PR s investment in software feature after the entry of OSS, it does not conflict with the findings in rior research. This is because the investment decision in my model Stage refers to service-demand-imroving investment in software feature. PR may invest in other innovation activities in resonse to the entry of OSS, which may lead to an increase in its overall technological level. Proosition 5 9. In software market characterized by high demand for service, when is less than a threshold 0,, a 3 < < + b a. The euilibrium number of features in PRS satisfies a 6 where the uer bound is the euilibrium number of features in PRS when there is no OSS; PR lowers the euilibrium number of features as OSS includes more features. When exceeds the threshold but is less than /a, the euilibrium number of features in PRS is at the highest level. When exceeds /a, PR is driven out of the market. b. PRS is riced lower, but with larger market share when there is OSS than when there is no OSS. Part a of roosition 5 imlies a magnetic henomenon in the design of PRS with high demand for service that is not observed in the design of software with low demand for service. Figure illustrates the magnetic henomenon. When the number of features in OSS is below a threshold value, the otimal number of features in PRS with high demand for service is higher than the number of features in the cometing OSS; the higher the number of features in the OSS, the lower the number of features in the PRS. This situation resembles one in which 9 Proof of roosition 5 is based on the right continuity roerty of PR s ayoff function at 0 and by taking derivative of first and second order condition of the ayoff function at otimal with resect to. Comlete roofs of all roositions are available uon reuest. 0 Twenty Ninth International Conference on Information Systems, Paris 00

12 u/software esign in Markets with Oen Source Cometitors the osition of R is attracted to that of OSS. If the osition of OSS exceeds the threshold, the design of PRS is laced at the maximal distance away from the osition of OSS as if the two reelled one another, that is,. Figure : A Magnetic Phenomenon in the esign of PRS with High emand for Service This henomenon can be exlained by the leverage of market share effect and strategic effect discussed in the literature of roduct differentiation Tirole 9. According to Tirole 9, strategic effect and market share effect reresent cometing firms roduct choice. The strategic effect dominates the market share effect when firms target their roducts at a maximal difference to avert intense cometition; the market share effect dominates the strategic effect when firms target their roducts more closely to obtain a larger market share. It has been shown that in general, the strategic effect dominates the market share effect; hence firms tend to adot the strategy of maximal difference. My findings suggest that in software market characterized by high demand for service, PR s software design strategy deends on the features in cometing OSS: there is a threshold in the number of features in OSS, below which the market share effect dominates, and above which the strategic effect dominates. However, in software markets with low demand for service, the strategic effect always dominates the market share effect. The intuition of PR s choice between market share effect and strategic effect is straightforward. PRs have three otions when determining number of features in resonse to OS entrant: decrease, increase or remain number of features in the software. For PRS with high demand for service, when the number of features in OSS is below a threshold, decreasing number of features in the PRS will decrease software rice and customers valuation for service, but the loss of margin is comensated by larger demand for software as well as for service. So the market share effect dominates the strategic effect and PR s otimal resonse is to lower number of features. When OSS is ositioned closer to PRS, the loss of margin in software and service exceeds the benefit of market share effect. It is otimal for PR to lay the high-end game, that is, only focus on customers that value large number of features. Hence the strategic effect dominates the market share effect. However, this strategy does not work for PRS with low demand for service. For this software category, the benefit of market share effect is not strong enough to cover the loss of margin in software license because the margin in service is zero. As a result, PR s otimal resonse is to remain the same number of features. An imortant imlication of Proosition 5 is that in software markets characterized by high demand for service, when OSS is not very sohisticated PR could introduce more basic version of their software in resonse to the growth of OS counterarts. This imlication is very much inline with industry ractice. In the BMS market, IBM, Oracle and Microsoft have each lowered their database rices and created low-end bundles aimed at smaller organizations and artners. LaMonica 005a Oracle released a low-end, free but rorietary edition of its database in October 005, suosedly as a reaction to the growing cometitive ressure from low-end oen source databases. LaMonica 005b Andrew Mendelsohn, senior vice resident of Oracle s server technologies division, commented on this move: There is definitely a market there for low-end databases and a demand. And we want them to be using Oracle and not MySL or SL Server Exress. LaMonica 005b The strategic handling of market share effect and strategic effect can also be used to exlain PRs OS strategies. Two common OS strategies emloyed by PRs are: subsidize OS rojects by having their emloyees working on these rojects or making their PRS comatible with OSS e.g., IBM, HP, SAP, Oracle, Siemens; and submit their rorietary roducts to the OS community e.g., IBM submitted its database Cloudscae to Aache; BEA, Comuter Associates and Sun also donated their PRS to OS community. Researchers in general believe these strategies rovide PRs with the strategic advantage to hurt rivals or the oortunity to rofit through comlementary roducts or services. My finding shows that market share may be additional benefit that drives PR s behavior. Both releasing codes and making PRS comatible with OSS hel PRs gain larger market share by Twenty Ninth International Conference on Information Systems, Paris 00

13 Organization Theory, Strategy and IS attracting users of OS roducts. For examle, by making its BMS comatible with Linux, Oracle effectively attracts Linux users to their roducts run on Linux. The finding of PR s ricing strategy art b in Proosition 5 is also consistent with industry ractice. For examle, BEA Systems reorted in its annual reort of 007 that cometitive ressures and oen source availability of functionally cometitive software could reuire us to reduce the rice of our roducts and related services. Some analysts believe that MySL gave Oracle s cororate customers more rice bargaining ower than in the ast desite the lack of functionality of MySL comared with Oracle database Wittig and Inkinen 004. The results resented in Proositions 4 and 5 allow me to comare the imact of OSS on market structure of two categories of software markets: software with high service demand and software with low service demand. The finding imlies that OSS will be stronger in terms of market share in markets with low demand for service than in market with high demand for service; PR gains larger market share in software market characterized by high service demand than in market with low service demand. These hold true so long as OSS is not very advanced. The results are consistent with Economides and Katsamakas 006a. They found that a vertically integrated rorietary system rorietary latform and alications to the latform are rovided by one firm has a larger market share than OS system if there is a relatively large demand for the rorietary alication, a large transition cost for the oen source latform and a relatively small demand for alication of the oen source latform. The intuition is that in software markets with high demand for service, PR has the advantage of maniulating software design and otimizing ricing for both software and service. OS service rovider however does not have as much influence on the design of OSS as the influence PR has on its own software. This disadvantage of OS suort rovider leads to smaller market share of OSS in markets with high demand for service than in markets with low demand for service. To certain extent this resembles the case of an integrated system rorietary system including software and service versus a disintegrated system OS system. Interestingly although MySL CEO Marten Mickos believed that eventually Oracle, Microsoft, and IBM would realized that MySL could be a threat to their database business, my model shows that if MySL does not have full control on the develoment of MySL database, and is not able to align its develoment objective with the objective of MySL database OS develoers, it will not dominate the market of BMS. Proosition 6 0. PRS with high demand for service has more features and larger market coverage than PRS with low demand for service regardless of whether there is OSS. Proosition 6 is intuitive. In software market with high demand for service, PR can derive higher margin selling service by increasing the number of features. The sueriority of this tye of PRS in terms of features hels increase demand for corresonding service, which in turn imroves the exected value consumers can derive from urchasing the software. Naturally, market coverage for PRS with high demand for service is higher. Proosition 7. a. OSS hurts PR s ayoff in both tyes of software markets. When OSS is sufficiently advanced, PR is driven out of the market. b. PR of software with high demand for service has higher ayoff than PR of software with low demand for service regardless of whether there is OSS. Proosition 7 is very intuitive. Part a imlies that cometing with OSS in the same market is ultimately a bad strategy for PR. In the long run, PR has to find a way to cooerate with OS community. Conclusions OSS has become rominent in many categories of software. I investigate how the rise of OSS influence software market structure and PR s software design strategy. In articular, I examine how the imacts of OSS differ between software market characterized by high demand for service and by low demand for service. I found 0 Proof of roosition 6 is straightforward, hence is omitted. Proosition 7 can be roved by studying the direct effect of and b on PR s otimal ayoff. Twenty Ninth International Conference on Information Systems, Paris 00

14 u/software esign in Markets with Oen Source Cometitors that when there is cometition between OSS and PRS, PRS is riced lower because of the entry of OSS. OSS have larger market share in markets with low demand for service than in markets with high demand for service. PR s software design strategy in resonse to OSS differs between software with high demand for service and software with low demand for service: PR s software design demonstrates a magnetic henomenon for software with high demand for service, the urose of which is to increase software market share, which further romotes higher revenue in service; this magnetic henomenon is not found in software with low demand for service. An imortant imlication of the findings is that in software markets characterized by high demand for service, when OSS is not very sohisticated PR could introduce more basic version of their software in resonse to the growth of OS counterarts. This imlication is very much inline with the ractice in the market of BMS. The aer has limitations. Some characteristics of software, such as network effect and switching cost effect, are not considered in the model. Network effect and switching cost may revent users from adoting OSS or switching to OSS even if the OSS is riced at zero. This exlains to some extent why some PRS remains its dominance while cometing OSS rovides similar features and functionalities free of charge. There are several directions of future research. The model could be evaluated using rimary data source collected through survey or interview whereas in this aer it is evaluated mainly with secondary data. Another direction of future research is to conduct case analysis for other OSS and comare PRs strategic resonse to the cometition of OSS in different software markets. Twenty Ninth International Conference on Information Systems, Paris 00 3