Licensing and Competition for Services in Open Source Software

Transcription

1 Liensing and Cmpetitin fr Servies in Open Sure Sftware Terrene August Rady Shl f Management University f Califrnia, San Dieg Hyduk Shin Rady Shl f Management University f Califrnia, San Dieg Tunay I. Tuna Smith Shl f Business University f Maryland Marh, 2013 Abstrat Open sure sftware is beming inreasingly prminent and the enmi struture f pen sure develpment is hanging. In reent years, firms mtivated by revenues frm sftware servies markets have beme the primary ntributrs t pen sure develpment. In this paper we study the rle f servies in pen sure sftware develpment and explre the hie between pen sure and prprietary sftware. Speifially, ur enmi mdel jintly analyzes the investment and priing deisins f the riginatrs f sftware and f subsequent pen sure ntributrs. We find that if a ntributr is effiient in sftware develpment, the riginatr shuld adpt an pensure strategy, allwing the ntributr t ffer higher ttal quality and apture the higher end f the market while the riginatr fuses n prviding sftware servies t lwer end nsumers. Cnversely, if the ntributr is nt effiient in develpment, the riginatr shuld adpt a prprietary sftware develpment strategy, gaining revenue frm sftware sales and squeezing the ntributr ut f the servies market. In ertain ases an inrease in riginatr develpment effiieny an result in inreased ntributr prfits. Finally, we find that, smewhat unter-intuitively, an inrease in ntributr develpment effiieny an redue verall sial welfare. Rady Shl f Management, University f Califrnia, San Dieg, La Jlla, CA taugust@usd.edu Rady Shl f Management, University f Califrnia, San Dieg, La Jlla, CA hdshin@usd.edu Smith Shl f Business, University f Maryland, Cllege Park, MD ttuna@rhsmith.umd.edu

2 1 Intrdutin As the emplyment f infrmatin tehnlgy in mdern rpratins bradens and evlves, sftware plays an inreasing rle in the effiieny f firms and their ultimate level f mpetitiveness. Cnsequently, implementatin, integratin and st effiieny f sftware seletin is ruial t a mpany s verall infrmatin tehnlgy strategy. Emerging as a respnse t this need, in a field that has been traditinally served by prprietary sftware slutins, pen sure sftware has beme mre prminent in the past deade, and its availability and quality have inreased dramatially. Fr example, prduts and appliatins based n Linux and Apahe sftware initiatives are widely used tday, and many ther pen sure prduts suh as JBss (Java middleware) and MySQL (DBMS) have emerged and generated inreased usage in reent years (Kntzer 2005, Brunelli 2005, and Brersma 2005). Open sure sftware is arguably f mparable r, in sme ases, even higher quality than its prprietary unterparts in terms f tehnial features. But high quality sftware and useful features alne have little value t a business unless it is able t utilize them thrugh a hesive integratin f its systems and business presses and an maintain these integrated systems up and running in a reliable fashin. In fat, integratin is preisely where the pen sure sftware industry has nentrated its effrts in the last deade. 1 Firms realize what matters t ustmers is the trade-ff between the quality f the pen sure sftware slutin and the prie they pay. Due t ustmers needs fr value-added servies, sftware mpanies nw see ptential in harnessing ther develpers ntributins t pen sftware while still maintaining a lurative sure f revenues binded t servies rather than prdut sales (Vane 2009). Tday, while prdut liense sales is the dminant revenue mdel fr sftware firms wh elet t keep their prduts prprietary, integratin, supprt, and nsulting servies have beme the mst widespread and prmising revenue mdel fr firms that hse an pen sure path (Watsn et al. 2008). An imprtant questin that emerges is when wuld it be in a sftware firm s best interest t pursue an pen sure strategy. Strategi nsideratins play an imprtant rle in this deisin. The highest 1 Integratin refers t getting sftware installed n a mpany s servers and integrated with business presses and preexisting infrmatin systems as effetively as pssible t inrease the verall quality f the slutin prvided. Supprt refers t nging maintenane f these integrated systems, frm trubleshting bugs whih arise t effiiently prviding seurity vulnerability pathes and mre. Infrmatin tehnlgy nsulting ften refers t the prvisin f human resures t advise, implement, and deply IT slutins whih may inlude ustm-built appliatins that run n tp f pen sure sftware. Altgether, the integratin, supprt, and nsulting fferings are generally referred t as servies. 1

3 quality servies are expeted t be ffered by the firms wh have invested the mst effrt int the pen sure prjet by ntributing sure de and managing the arhiteture f the sftware. Thrugh their aumulated expertise, these firms have an advantage in the servies market as they an prvide the best integratin with existing systems as well as mst effetively prvide supprt and nsulting. Hwever, with pen sure sftware, firms develpment effrts t imprve quality f integratin and servies an als benefit ther servie prviders. In partiular, beause servie prviders an use publily available sftware dumentatin, servie mdules and utilities written by firms wh have invested in develpment, they an prvide mre effetive integratin and supprt, and thus ffer a higher quality sftware slutin (LaMnia 2005, Virijevih 2005). Cnsidering the effets f suh mplementarities n mpetitin in the market fr integratin and supprt, investments n sftware develpment and building expertise gain additinal strategi imprtane. With pen sure sftware, diverse market envirnments an emerge. In ertain ases, the sftware riginatr assumes the rle f primary develper while subsequent ntributrs undertake useful but relatively minr develpment rles. Red Hat, with its JBss divisin, leads develpment and dminates the servies market fr JBss Appliatin Server, whih is an example f this setting (Kerstetter 2004, Sager 2005, Adamsn 2005). In ther ases, a small firm r rganizatin may riginate a sftware prdut, but a large utside firm leads investment tward the develpment f the sftware prdut, thus making signifiant ntributins even thugh they are subsequent t the riginatr s effrts. Fr example, IBM has ver 700 develpers wrking n pen sure sftware and self-reprtedly plans t invest $1B int develpment and supprt f its prjets in this dmain (Capek et al. 2005). Similarly, HP has ver 2,500 develpers fused n pen sure prjets (Hewlett-Pakard 2007). These mpanies are strngly inentivized by the glbal servies market. In 2007, IBM generated $55.3B frm glbal servies while nly $20B frm sftware (IBM 2007). The strategi interatins between these players determine the final market utme and have an imprtant rle in shaping sftware develpment hie. In this paper, we present a mdel that aptures the enmi inentives fr firms t ntribute t pen sure sftware develpment and then explre the strategi and pliy deisins f a sftware riginatr and regulatrs, respetively. We explre jint develpment and priing equilibria in sftware markets fr bth 2

4 pen sure and prprietary sftware strategies. If a firm hses an pen sure strategy, she makes her sure de publily available whih has several effets. First, the sftware reeives a develpment bst as utside ntributrs help write and refine the prdut s sure de, as well as prdue related mdules and utilities. Send, the firm must rely heavily n servies as the primary revenue sure sine her sure de is freely available t users. Third, the availability f sure de makes it easier fr mpetitrs in the servies market t build expertise and imprve the quality f their wn fferings, whih means the riginating firm faes tugher mpetitin in this market. Fr example, a large ntributr suh as IBM an dediate vast resures t the develpment f an pen sure prjet in rder t inrease his mastery f the sftware and imprve his servies pakages. This investment an bth benefit and harm an riginatr perating in an pen sure envirnment. Alternatively, the riginating firm may hse a prprietary ptin, in whih ase the sure de f her prdut remains lsed. In this ase, the firm inurs the entire prdut develpment st alne. On the upside, in additin t ptentially harging fr sftware and integratin servies, the firm retains the ability t harge a prie per eah py f the prdut regardless f whether she prvides the servies aspet. Using this mdel, we study three main issues: First, under bth pen-sure and prprietary liensing strategies, we thrughly examine and identify the equilibrium utmes in a market fr sftware where an riginatr and ntributr invest in develpment and firms mpete fr revenues frm prviding servies. Send, building n this equilibrium analysis, we explre hw sftware develpment effiieny fr bth the riginatr and subsequent ntributrs impats the riginatr s hie f sure de liensing strategy. Third, we study the impliatins f an pen apprah n sial welfare. The U.S. gvernment has reently begun t advate pen sure develpment in ertain irumstanes and, mre imprtantly, ntinues t play a signifiant rle in setting pliy t help inrease the value generated by infrmatin gds in the enmy (Herz et al. 2006). Ardingly, we als study sial surplus, and prvide insights int hw gvernane and pliy an utilize the enmi inentives influened by mpetitin in the sftware servies market t imprve welfare. In essene, what lies at the re f ur paper is the management f tw gds that are mplements, namely the sftware and the integratin and servies prvided fr it. The main trade-ff in this sftware 3

5 liensing deisin with servies is as fllws: the riginatr an either develp a prdut alne and be able t harge fr the sftware herself in return (prprietary strategy), r she an pen up the sure de t utside ntributrs t share the burden f investment in develpment but rely nly n servies and integratin inme fr revenue, albeit with pssibly higher quality f sftware and servies thanks t the effrts f the ntributr firm (pen sure strategy). There are a number f fatrs that play ritial rles in determining the best liensing strategy suh as the relative effiienies f the riginatr and the ntributr firms, and apabilities f the firms reaping benefits frm eah thers sftware develpments. Cntributr effiieny is a duble-edged swrd fr the riginatr. When the ntributr is strng in develpment effiieny and utilizing develpments t imprve quality, it an pay ff fr the riginatr t pen the sure de sine this an result in signifiantly inreased ttal sftware and servie quality at little st t the riginatr. Hwever, a strng ntributr an als be a frmidable mpetitr that an steal signifiant market share. The riginatr has t balane these tw fatrs when making her liensing deisin. We find that if the riginatr is suffiiently effiient in develpment, her liensing deisin mainly depends n her ability t harness the ntributr s develpment t imprve quality: if the riginatr is adept at imprving the quality f her sftware/servie pakage by utilizing the ntributr s develpment, then an pen sure strategy is ptimal, therwise the riginatr is better ff keeping the sftware prprietary. We find that an inrease in riginatr develpment sts an in fat derease the riginatr s servie prie and inrease the ntributr s servie prie. This urs beause dereased riginatr develpment effiieny redues riginatr effrt in investment and inreases differentiatin between the riginatr and the ntributr s fferings. Cnsequently, the ntributr an be better ff by inreasing his effrts in develpment, quality and prie. We als shw that inreased ntributr effiieny an unexpetedly derease welfare. This result an manifest when the ntributr is highly effiient beause if the riginatr pens up the sure de, the riginatr an be squeezed ut f the servies market as the ntributr uses his develpment effiieny and strategi priing t pen up a large gap between the verall attrativeness f his ffering and that f the riginatr. In suh irumstanes, the riginatr may instead hse a prprietary strategy, whih results in lwer sftware and servie quality and dereased welfare. 4

6 2 Literature Review One f ur key researh gals in this paper is t explre the enmi inentives f the develpers and firms prduing pen sure sftware. One primary questin is why d develpers ntribute t a prjet withut being paid fr their effrt, at least by traditinal means. In the existing literature, researhers have empirially substantiated the existene f intrinsi mtivatins suh as intelletual stimulatin and mmunity building as well as extrinsi mtivatins suh as jb market signaling and being paid t ntribute (see, e.g., Lerner and Tirle 2002, Hars and Ou 2002, vn Krgh and vn Hippel 2006, Rberts et al. 2006, Iansiti and Rihards 2006). Hwever, t ur knwledge, n study has investigated a theretial mdel that expliitly strutures the real mnetary inentives and revenue sures f the firms that ntribute t pen sure prjets fr prfit under market mpetitin. We fus n these inentives, whih emerge thrugh the market fr servies. Reently, the market fr servies has been regnized as a pwerful extrinsi mtivatin fr develpers ntributins t pen sure sftware (see, e.g., Raymnd 1999, Lerner and Tirle 2002, Lerner and Tirle 2005a, Capek et al. 2005). The servies market has the ptential t generate signifiant revenues fr ntributrs wh invest in pen sure develpment. One reasn is due t the existene f many indiret methds t apture a sftware prgram s sale value whih refers t its value as a salable mmdity (Raymnd 1999). Lerner and Tirle (2005a) nte that fr-prfit firms suh as IBM whih ffer servies that are mplementary t pen sure sftware have largely benefited in their nsulting businesses. Watsn et al. (2008) suggest that the ntemprary send-generatin pen sure (OSSg2) mpanies that generate the bulk f their revenues frm servies have the mst prmising business mdel in the pen sure dmain. Our paper ntributes t the pen sure sftware literature by frmally analyzing the impat f the servies market n the inentives f riginatr and ntributr firms as prfit-seeking entities. When ne turns t the mtivatins f firms that prfit frm pen sure, revenues generated by prviding implementatin, integratin and ther related servies turn ut t be a signifiant fatr. Iansiti and Rihards (2006) empirially demnstrate that large IT vendrs suh as IBM and Orale invest in pen sure sftware develpment prjets that prvide r mplement revenues frm appliatins and servies 5

7 they prvide. Watsn et al. (2008) pint t the fat that JBss ntributed 85%, 95%, and 60% f the ttal effrt tward JBss AS, Hibernate, and Tmat, whih are its three leading pen sure prduts, and the majrity f JBss s revenues me frm its prvisin f servies. Further, fr mst pen sure prjets, althugh there may be many independent, small servie prviders, the majr ntributrs t develpment (ther than perhaps the riginatrs) are a small number f firms prminent in the speialty (Mkus et al. 2000, Kgut and Metiu 2001, Kh and Shneider 2002, Kuk 2006). Based n these empirial bservatins, ur paper fuses n the mtivatins f firms bth in develpment and mpetitin, aunting fr prfitmtivated ntributin inentives via a market fr servies. A majr questin we study in ur setting is whether a sftware riginatr shuld hse t make her prdut prprietary r pen sure. Related t this questin, Lerner and Tirle (2005b) predit prprietary prjets that seem less likely t sueed may be turned int pen sure prjets but will als fae lwer aeptane by the pen mmunity. Gaudeul (2004b) finds that prprietary strategies are favred when develper wages are lsely balaned with their sts. Using a dynami mdel f priing and investment, Haruvy et al. (2008) study the prblem in the ntext f an exgenus mplementary prdut r servie n the pen sure path. Additinally, several papers lk at diret mpetitin between pen sure and prprietary firms (e.g., Gaudeul 2004a, Bessen 2006, Casadesus-Masanell and Ghemawat 2006, Lee and Mendelsn 2008, Zhu and Zhu 2012). In this paper, unlike these existing studies, we fus n the mpetitin in the servies market fr a given sure de strategy. Our paper thus ntributes t this literature by explring the riginatr s strategy f whether t preed with an pen sure r prprietary strategy in nsideratin f the market fr servies. 3 Mdel A sftware riginatr determines whether t pursue a prprietary r pen sure sftware liensing strategy, whih we dente with ρ {P, O}. Thrughut the paper, we use supersripts P fr prprietary and O fr pen sure t indiate the liensing strategy. After the liensing deisin, the riginatr invests in the 6

8 design and develpment f the sftware prdut. A sendary firm, the ntributr, may hse t put frth effrt t invest in develpment and inrease the quality f the sftware slutin. 2 We dente the riginatr with subsript and the ntributr with subsript. In ur mdel, we fus n a prfitmtivated riginatr and a prfit-mtivated ntributr wh intend t generate revenues frm ffering sftware integratin and ther servies t nsumers. It is als imprtant t nte that there are typially ther ntributrs t pen sure sftware that d nt have mmerial mtivatins. These ntributrs have nn-strategi mtivatins suh as hbbyism, altruism, and idealism. One an inrprate these nn-strategi ntributins frm the pen sure sftware mmunity as an exgenus, randm additive mpnent in the quality f the sftware and servie fr all prviders, but this simple arithmeti shift wuld nt alter the nature f the insights r the results frm the mdel. In rder t keep the mdel simpler, we will nt inrprate this mpnent in ur mdel and analysis and, instead, maintain fus n ntributrs with strategi mtivatins. After purhasing r deiding t use the sftware, a nsumer needs t have the sftware installed and integrated, i.e., btain servie, fr it t beme usable and the nsumer t derive value frm it. The value derived frm sftware usage fr a nsumer depends n many fatrs inluding prdut features, reliability, integratin with business systems and presses, and supprt. In turn, the quality (and hene the value t the nsumer) f features suh as integratin and supprt depends n the prvider f the servie. A servie prvider firm with mre expertise, better utility and supprt tls, and preparatin prvides a higher quality servie. Eah firm that prvides servie and integratin essentially ffers its wn level f servie quality, and the verall value a nsumer derives frm using the sftware depends n the firm it ntrats t prvide integratin and servie (see Raymnd 1999 and Farber 2004, amng thers). A firm may imprve its expertise and ttal quality by investing effrt in these areas. Therefre, althugh under bth liensing strategies bth firms share the same sftware prdut, beause f the ptential differene in servie qualities, the ttal quality f the ffering f a firm, whih we define as the mbined quality f the sftware used and the servie prvided by that firm, an differ between the tw firms. We dente the 2 Nte, fr simpliity, we inlude a single large ntributr in the mdel. Further, in the market we study, ntributins are extremely nentrated amngst very few ntributrs (see, e.g., Mkus et al. 2000, Kh and Shneider 2002, Kuk 2006), and it is ften the ase that a single large ntributr emerges t mpete against the riginatr and tgether dminate the market s strategi interatins, as in the ase f Apahe Gernim. 7

9 ttal quality fr the riginatr by Q and the ttal quality fr the ntributr by Q. The ttal quality f the ntributr firm s ffering benefits at a ertain rate frm the effrt invested by the sftware riginatr tward develpment f the prdut. Furthermre, if the prdut is pen sure, the ntributr s additinal develpments are available t the publi, s in that ase, the ttal quality f the riginatr s ffering als benefits frm the ntributr firm s effrts. Therefre, a sftware and related servies marketplae with the pssibility f pen sure liensing has an interesting harateristi: The riginatr and the ntributr are mplementary t eah ther in imprving the ttal quality f the sftware and servies while they als mpete against eah ther in the marketplae fr prviding these servies. The sftware pliy hsen by the riginatr (i.e., prprietary r pen sure) hanges the inentives fr these tw firms and therefre influenes their strategi hies f effrt invested in the sftware. There is a ntinuum f nsumers wh have hetergeneus preferenes n the ttal quality f a mplete sftware slutin they reeive. We mdel this nsumer type harateristi as unifrmly distributed, θ Θ = [0, 1] where θ dentes a speifi nsumer s sensitivity t quality r type. A nsumer with type θ btains value θq, if she ntrats with the riginatr and θq if she ntrats with the ntributr. The riginatr selets an effrt in develpment e IR + and inurs a quadrati nvex st f effrt β e 2 /2. Similarly, the ntributr invests effrt e IR + at a st β e 2 /2 subsequent t the riginatr s investment deisin. Effrt in pen sure develpment amunts t labr and resures, and, partiularly in the sftware industry, firms exhibit signifiant variatin in size and wrker abilities, as well as differenes in the shadw pries f wrker time and resure availability fr any given prjet. Therefre, β and β are in general different and firms demnstrate hetergeneity in this dimensin (see, e.g., Oi 1983). Nte that, fr the riginatr, e refers t the additinal effrt in develpment f the sftware beynd the base amunt required fr the release f the sftware in the minimal aeptable frm. As we mentined abve, depending n the sftware pliy deisin (O r P ) a firm s ffering will be psitively impated by ther firms investments in publily available pen sure de, servie supprt mpnents, utility ntributins, and infrmatin. Under an pen sure pliy (i.e., fr ρ = O), the ttal quality ffered by the riginatr depends nt nly n her wn effrt e O but als n the effrt exerted by the ntributr suh that Q O = s O e O + s O e O. Similarly, the ttal quality fr the ntributr depends 8

10 n the riginatr s effrt and is given by Q O = s O e O + s O e O. The parameters s O ij > 0, i, j {, }, indiate the effet f firm j s effrt n firm i s ttal quality. The magnitudes f effiients s O ij are largely determined by the partiular sftware prdut market and the nature f the riginatr and ntributr firms. These effiients have a substantial enmi and strategi signifiane. Their relative magnitudes are ritial in determining the inentives f the firms t put effrt int the sftware beause a firm s mpetitr benefiting frm her effrt at a high rate may urb her inentives t bear the sts f exerting that effrt. Further, the relative magnitudes f these effiients between prprietary and pen sure pliies may als affet the riginatr s liensing pliy. As we will see mre learly in the fllwing setins, these effiients will play an imprtant rle in determining the utme and the results. Under a prprietary strategy, nsumers wh purhase the prdut an hse t use the riginatr s servies r ntributr s servies. Sine the sure de is lsed under this strategy, the ntributr s effrt des nt reate returns tward the riginatr s quality mpnent, s P = 0. Nte that s P is related t the benefit that the riginatr an btain frm develper effrt. Under the prprietary strategy, it is harder fr the riginatr t garner develper effrts t her advantage. Fr example, Mirsft may try t implement ertifiate prgrams t nurture new sftware. Sme ntributrs may invest their effrts t earn the ertifiates. Hwever, it is nt diretly related t enhaning the sftware quality nr t inreasing Mirsft s servie quality. Cnsequently, s P is lse t 0. 3 Further, the lsedness f the sure de limits the ntributr s ability t imprve his wn quality fatrs and related fferings, i.e., s P < s O. We nsider s P = s O t be nstant and independent f the riginatr firm s strategy. In rder t make a fair mparisn between the prfitability f the tw business mdels, we hld this speifi parameter nstant and islate the main effets that help eah mdel t perfrm relatively better. 4 In summary, fr the prprietary ase, Q P = s P e P and Q P = s P e P + s P e P. Nte that fr simpliity in analysis, we assume that the riginatr is apable f better harnessing her wn effrts in develpment t imprve quality than the ntributr an, i.e., s O > s O and s P > s P. In many ases it is reasnable t expet that a sftware riginatr an d this beause as the reatr f the sftware, she is likely t have fundamental knwledge 3 Tehnially, it is nt required that s P = 0 in rder t establish ur results. 4 It is mathematially nt a prblem t relax this speifiatin, and all f ur results wuld ntinue t hld if we allwed this parameter t be apprpriately nstrained t math desired settings. 9

11 and expertise as well as ntrl f the prjet diretin, enabling her t better leverage her wn effrts. Cnsumers usage deisins are made in the last stage. Under a prprietary strategy, the riginatr sets a prie fr the prdut p P and a prie fr her servies p P, while a ntributr nly sets a prie fr his servies ffering p P. Under an pen sure strategy, the priing f integratin and servies still urs (p O and p O ), but the prdut prie is zer (p O = 0). Fr simpliity, thrughut the paper, we assume that the st f prviding servie fr the firms is zer. In the prprietary ase, a nsumer with type θ hses ne f the fllwing: nt use the sftware prdut, purhase bth the prdut and servies frm the riginatr, r purhase the prdut frm the riginatr while btaining servies frm the ntributr. Her net payff frm eah atin is given by V P (θ) = Q P θ p P p P if purhased and servie is ntrated with the riginatr ; Q P θ p P p P if purhased and servie is ntrated with the ntributr ; 0 if nt purhased. (1) Under an pen sure strategy, the riginatr frges revenues frm prdut sales while fusing n the servies market. In this ase, the nsumer s net payff is given by V O (θ) = Q O θ p O if servie is ntrated with the riginatr ; Q O θ p O if servie is ntrated with the ntributr ; 0 if nt used. (2) The mplete sftware and servies ttal qualities (Q P and Q O, and Q P and Q O ) differ under eah sure de strategy due t varying investment inentives as well as ertain quality rss-effet parameters s P ij and s O ij differing fr the tw sure de strategies. In summary, the timeline fr ur mdel is as fllws: 1- The riginatr hses a liensing strategy, ρ {P, O}, either making the prdut prprietary r pen sure. 2- The riginatr invests in develping the sftware, e. 10

12 3- Knwing whether the sftware is prprietary r pen sure and having bserved the riginatr s effrt in sftware develpment, e, the ntributr deides whether t ffer servies fr the sftware and hw muh t invest in further develpment, e. 4- The riginatr bserves whether the ntributr is in the market and, if s, the ntributr s level f sftware develpment. 5- Bth firms simultaneusly prie their fferings, i.e., the riginatr and the ntributr set their pries fr servies, p ρ and p ρ, respetively, fr ρ {O, P }. In additin, if the prdut is prprietary, the riginatr sets the unit prie fr the prdut, p P, simultaneusly as well. 6- Eah nsumer hses whether t use the prdut and frm whih firm t purhase servies. The market lears. 4 Sure Cde Strategies 4.1 Prprietary Strategy In the mmerial sftware industry, firms have traditinally pursued prprietary strategies whih use prdut revenues t reup sftware develpment sts and generate return n investment. Crpratins suh as SAP, Orale, and Mirsft have develped leading sftware prduts in their respetive markets, and all have hsen t keep their prduts sure de mstly lsed and generate revenues frm selling liensed pies. Hwever, as we als disussed abve, in rder t derive full benefits frm using the sftware, nsumers als need t spend mney and resures t prure integratin and supprt. Sftware riginatrs wh hse t develp their sftware as a prprietary prdut typially ffer these servies as well. Furthermre, servie fferings need nt neessarily be made separate but may be bundled with the prdut itself. By adpting a prprietary strategy, the riginatr makes a strategi hie t nt permit sendary develpers t ntribute t r build upn the re debase f the prdut. Althugh the firm typially ffers Appliatin Prgramming Interfaes (APIs) that permit seletive extensins t sftware funtinality, 11

13 ustm de written fr an API is ften user-speifi and limited in ptential spe. By pting fr the firm s servies pakage, a user benefits in several ways. First, by develping and managing the sftware prdut, the firm has aumulated expertise whih it an leverage t prvide a higher quality slutin t the ustmer. Send, the firm an adapt its sftware prdut t inlude speifi funtinality requested by lients, and, further, this funtinality an be built int the prdut fr future releases whih then require less maintenane f ustm de by users. In this setin, we investigate hw an riginatr sets pries fr her prdut and servies and hses investment in verall quality at the prdut develpment stage. We haraterize the ptimal prfits btainable using a prprietary strategy and use it as a benhmark fr mparisn t the utme under pen sure Cnsumer Market Equilibrium Given the effrt levels, e P and e P, and pries, p P, p P and p P, eah nsumer f type θ hses whm t ntrat in rder t maximize her net payff given in (1) whih reflets the hies fr btaining servies. The haraterizatin f equilibrium nsumer behavir is symmetri, dependent n whether the riginatr r ntributr ffers a higher ttal quality. In either ase, the pries are hsen suh that ne f the fllwing utmes urs: (i) n nsumer uses the sftware; (ii) nsumers purhase the prdut frm the riginatr, and all f them elet t be servied by the firm ffering a higher ttal quality; (iii) nsumers purhase the prdut frm the riginatr, and all f them elet t be servied by the firm ffering a lwer ttal quality; and (iv) nsumers purhase the prdut frm the riginatr, and they further segment suh that lwer (higher) types elet t be servied by the lwer (higher) quality firm. 5 Figure 1 illustrates these regins f the nsumer market equilibrium. Beause f symmetry, the figure fuses n the ase where the riginatr is the quality leader, i.e., Q P > Q P. When the riginatr s servie prie is suffiiently lw mpared t the ntributr s servie prie, the riginatr s servie is a mre attrative ffer as her prie is lw fr her quality level mpared t the prie/quality ffering f the ntributr. In suh a ase, every nsumer wh purhases the prdut will prefer t get servies frm the 5 The mplete mathematial haraterizatin f the nsumer market equilibrium and these regins is given in Lemma OS.1 in the nline supplement. Fr ease f expsitin, tehnial statements f all lemmas and prpsitins, as well as their prfs, are plaed in the nline supplement. 12

14 riginatr, i.e., the ntributr is squeezed ut f the market. If the ntributr s servie prie is lwer, then nsumers with a strnger preferene fr quality, i.e., thse with higher θ values, still prefer t ntrat with the riginatr fr servies, while ertain nsumers with lwer θ values will nw hse t aquire the ntributr s servies; fr them, the ntributr s prie will be mre attrative than the riginatr s, better justifying the quality f his servie ffering as an be seen in panel (b) f Figure 1. Finally, if the ntributr s servie prie is suffiiently lw mpared t that f the riginatr s, all nsumers will find purhasing servies frm the ntributr t be mre attrative than purhasing servies frm the riginatr. In this ase, nsumers will either nt use the sftware r btain servies frm the ntributr after purhasing the sftware. The nsumer market struture that results fr this ase is illustrated in panel () f Figure Cnsumer Market Priing Next, we present and disuss the nsumer market priing equilibrium taking the develpment effrt levels fr the riginatr and the ntributr as fixed. Given their respetive effrt levels, e P and e P, in the priing stage f the game, the firms mpete in the servies market by setting their servie pries t maximize their prfits taking eah ther s pries as given. The Nash equilibrium utme f this stage f the game yields the equilibrium servie pries dented by p P (e P, e P ) and p P (e P, e P ), whih are funtins f the effrt levels the firms hse earlier in the game. The fllwing prpsitin desribes hw the riginatr and ntributr set pries in equilibrium. Prpsitin 1 Given the effrt levels f the riginatr and ntributr, the equilibrium sftware and servies priing utmes are haraterized as fllws: (i) If the riginatr is the quality leader, she sets the sftware prie as a mnplist and pries her servies at st suh that she is the nly firm atively serviing nsumers in equilibrium. The ntributr is fred ut f the market. (ii) If the ntributr is the quality leader, then the riginatr adjusts the sftware prie refleting the ntributr s effrt level, and she prvides a disunt t users wh pt t nsume her servies. 13

15 (a) Only the riginatr is ative in the market V (θ) N Purhase Purhase sftware and servies frm the riginatr Cnsumer net payff frm purhasing the sftware and getting servies frm riginatr: V (θ) = (s P ep + sp ep )θ pp p P V (θ) 0 N Purhase p P +p P s P ep +sp ep 0 1 p P +p P s P ep +sp ep N Purhase Purhase sftware and get servies frm the ntributr Purhase sftware and get servies frm the riginatr p P pp (s P sp )ep +(sp sp )ep Purhase sftware and get servies frm the ntributr 1 Cnsumer net payff frm purhasing the sftware and getting servies frm ntributr: V (θ) = (s P e P + s P e P )θ p P p P (b) Bth the riginatr and ntributr are ative in the servies market V (θ) () Only the ntributr is ative in the servies market θ Cnsumer net payff frm purhasing the sftware and getting servies frm riginatr: V (θ) = (s P ep + sp ep )θ pp p P Cnsumer net payff frm purhasing the sftware and getting servies frm ntributr: V (θ) = (s P e P + s P e P )θ p P p P θ Cnsumer net payff frm purhasing the sftware and getting servies frm ntributr: V (θ) = (s P e P + s P e P )θ p P p P Cnsumer net payff frm purhasing the sftware and getting servies frm riginatr: V (θ) = (s P e P + s P e P )θ p P p P θ 0 p P +p P 1 s P ep +sp ep Figure 1: The nsumer market equilibrium under a prprietary strategy when the riginatr has higher ttal quality. The ntributr sets a servie prie abve st that mirrrs the riginatr s disunt, and bth firms atively servie nsumers in equilibrium. Part (i) f Prpsitin 1 states that if the riginatr s servie is f higher quality than the ntributr s then the ntributr annt mpete with the riginatr in the servies market beause the riginatr will prie the prdut t maximize revenue frm sftware sales, while setting her servie prie t zer t squeeze the ntributr ut f the servies market. As a nsequene, she essentially ffers a bundle f prdut and servie as a mnplist and sets the ttal prie f the bundle at the mnply prie. At these prie 14

16 levels, the ntributr is fred ut f the market mpletely, sine in rder t gain any psitive market share, she has t prie her integratin servie ffering belw st, i.e., belw zer, whih wuld result in lsses. Therefre, the ntributr is effetively fred ut f the market. On the ther hand, if the ntributr is the quality leader fr servies, then he has an advantage with the high valuatin nsumers (i.e., high θ nsumers) ver the riginatr. Part (ii) f Prpsitin 1 states that in this ase, in equilibrium, the riginatr hses t share the servies market with the ntributr, utilizing the high quality f the ntributr s servies t bst sales f her sftware prdut at the high end f the market. At the same time, she sets her servie prie negative t maintain prie pressure n the ntributr wh is ffering high ttal quality, whih helps t inrease revenues frm the prdut amng thse wh prefer t purhase servies frm the ntributr Determinatin f Develpment Effrt Levels Using the equilibrium utme fr prdut and servie pries prvided in Prpsitin 1, we an analyze the equilibrium effrt investment levels fr the tw firms. Given the effrt f the riginatr (e P ) and using the equilibrium prie expressins haraterized in the prf f Prpsitin 1, we an derive the ntributr s prfit as a funtin f his effrt level, e P. 7 Frm this funtin, ne an bserve that given the riginatr s effrt level, if the ntributr s effrt level is suffiiently lw, the riginatr is the quality leader; whereas, when the ntributr puts suffiient effrt in develpment, he bemes the quality leader. As a best respnse t the riginatr s effrt level, the ntributr hses an effrt level t maximize his prfit, and the fllwing prpsitin summarizes the slutin t the deisin prblem he faes. Prpsitin 2 Given the riginatr s effrt level e P > 0, the ntributr s best respnse effrt level e P (e P ), and the resulting nsumer market equilibrium is haraterized as fllws: There exists a ritial 6 By part (ii) f Prpsitin 1, it is in the riginatr s best interest t enfre that nsumers wh purhase the servie frm her and enjy the disunt, indeed get the servie frm her. This wuld prevent higher valuatin nsumers, wh prefer the ntributr s higher quality servie, frm purhasing servie frm the riginatr just t get the disunt and t atually have servie perfrmed by the ntributr. S, the agreements are set t be binding in that by ntrating with the riginatr fr the servie, ustmers agree t being servied exlusively by the riginatr. This is naturally enfreable by mnitring the sure f servie fr eah ustmer. This infrmatin is verifiable eletrnially as well as in persn beause servie wrk is typially nging. 7 The full lsed frm expressin fr the ntributr s prfit as a funtin f his effrt level is given in equatin (OS.19) in the nline supplement. 15

17 threshld value, ē > 0, where 8 (i) If the riginatr s effrt level is less than ē, then the ntributr s investment in develpment level is psitive and the ntributr bemes the quality leader in the market with bth firms atively serving segments f the nsumer market; (ii) If the riginatr s effrt level is abve ē, then the ntributr des nt invest in develpment and remains ut f the market. If the riginatr s effrt level is small, then the ntributr has an pprtunity t leapfrg the riginatr s quality by investing heavily in develpment and bringing t market a servies pakage preferred by higher valuatin nsumers. When the riginatr s develpment effrt level is lw, the ntributr seizes this pprtunity, and bemes the quality leader. On the ther hand, if the riginatr puts suffiient effrt int develpment, then the ntributr faes very different prspets. In this ase, his effrts will nt yield suffiient returns t ver his sts, s, his best respnse is nt t invest in develpment at all. Cnsequently, the riginatr is the quality leader and bemes the sle firm atively serving the nsumer market. Prpsitin 2 desribes hw the ntributr respnds t feasible effrt investments by the riginatr. Utilizing this haraterizatin, in partiular the mathematial haraterizatin detailed in the nline supplement, we next examine hw the riginatr then hses her effrt level e P t maximize her wn prfit Π P. Substituting the ntributr s effrt best respnse funtin and the equilibrium pries, we an write the riginatr s prfit as a funtin f her effrt level e P. 9 Studying this funtin, ne an see that if the riginatr des nt invest suffiiently in the sftware, i.e., e P ē where ē is as given in Prpsitin 2, then as we have seen abve, the ntributr puts substantial effrt and bemes the quality leader. In this ase, if the ntributr is effiient enugh in develpment (lw β ), the riginatr als benefits frm his effrts. In this ase, the riginatr s prfit in fat inreases as β dereases. On the ther hand, if the riginatr makes a suffiiently large investment in the sftware, i.e., e P ē, then, by Prpsitin 2, the ntributr 8 The lsed frm mathematial expressin fr ē as well as the investment levels fr the ntributr are given in the prf f this prpsitin in the nline supplement. 9 The full lsed frm expressin fr the riginatr s prfit as a funtin f her effrt level is given in equatin (OS.20) in the nline supplement. 16

18 is ut f the market, and the riginatr an beme the mnplist. Cnsidering and mparing these utmes, the riginatr determines the amunt f effrt t put int sftware develpment that maximizes her prfits. Her deisin, hinges n the develpment effiieny f the ntributr, β. We first examine a ase where the ntributr is highly effiient in develpment. The fllwing prpsitin desribes hw the riginatr ptimally leverages suh an effiient ntributr. Prpsitin 3 If the ntributr s develpment sts are lw, i.e. if β is suffiiently small, then, in equilibrium, bth the riginatr and the ntributr are ative in the servies market and the ntributr is the quality leader. Only nsumers with types in the range [ 1 2, 1] purhase the sftware. The riginatr serves the nsumers with types in [ 1 2, 2 3 ] and the ntributr serves thse with types in [ 2 3, 1]. If the ntributr is st-effiient in develpment, then the riginatr invests a relatively small amunt, whih enurages the ntributr t invest effrt in the sftware and apture the high end f the nsumer market. This benefits the riginatr beause greater investments by the ntributr will als make the riginatr s sftware prdut and servie fferings mre attrative t ustmers whih, in turn, bsts her revenue. As a result, in this regime, the riginatr enables the ntributr t put in suffiient effrt t beme the quality leader and atively serve the higher valuatin (i.e., high θ) ustmers. Likewise, the riginatr nt nly prfits frm sftware sales but als shares the servie market by serving a lwer valuatin segment f the nsumer ppulatin. Next, we examine the ppsite ase in whih the ntributr is highly ineffiient in his st f effrt tward sftware develpment. Under a prprietary strategy, a st-ineffiient ntributr ffers limited value t the riginatr. As a result, the riginatr prefers t beme the sle prvider in the servies market; we frmally establish this result in the fllwing prpsitin. Later, we will see that a ntributr with similar harateristis is leveraged quite differently under an pen sure strategy. Prpsitin 4 If the ntributr s develpment sts are high, i.e. if β is suffiiently large, then in equilibrium nly the riginatr is ative in the servies market. Only nsumers with types in the range [ 1 2, 1] purhase the sftware and servies frm the riginatr. 17

19 When the ntributr is nt very effiient, it is stly fr the ntributr t put in signifiant effrt, and it bemes muh easier fr the riginatr t push him ut f the servies market. Cnsequently, the riginatr invests substantial effrt in sftware develpment, whih in turn disurages the ntributr t make any investment in the sftware; essentially, the ntributr des nt enter the market. That is, a sftware riginatr wh faes an ineffiient ntributr will hse t invest heavily and apture the entire servies market. 4.2 Open Sure Strategy As an alternative t the traditinal prprietary strategy, a sftware riginatr firm an adpt an pen sure strategy in whih the sure de is pened t ther entities suh as develpers and users. One f the re features f the Open Sure Definitin is that the sure de f the sftware prdut must be made available (Car 2006). As a business mdel, there are many signifiant advantages t an pen apprah whih leverages the knwledge and resures fund in an pen mmunity. The riginatr s st f develpment is lwer sine she an benefit frm the ntributins f ther develpers tward bth imprving the sftware and writing utilities and ther supprt de helpful in integratin and maintenane f the prdut. In an pen apprah, the sure de is made freely available in whih ase harging fr the base sftware prdut itself is nt feasible. Hwever, beause nsumers value servies, firms generate the bulk f their revenues by prviding integratin, supprt, and nsulting Charaterizatin f Cnsumer Market Equilibrium Similar t Setin 4.1, we will start by explring the nsumer market equilibrium, and we will rll bak the slutin t effrt levels and liensing strategy subsequently frm there. Given the effrt levels, e O and e O, and pries, p O and p O, eah nsumer f type θ Θ hses whm t ntrat with in rder t maximize her net payff given in (2) whih reflets the hies she has fr btaining servies. The haraterizatin f nsumer behavir in equilibrium is ne again symmetri, dependent n whether the riginatr r ntributr ffers a higher ttal quality. Further, the fur utmes desribed at the beginning f Setin are als all feasible under an pen sure strategy. Figure 2 illustrates the nsumer market 18

20 V (θ) V (θ) V (θ) (a) Only the riginatr is ative in the servies market N Purhase 0 p O s O eo +so eo N Purhase 0 p O s O eo +so eo N Purhase Purhase servies frm the riginatr Purhase servies frm the ntributr Purhase servies frm the riginatr p O po (s O so )eo +(so so )eo Purhase servies frm the ntributr 1 Cnsumer net payff frm purhasing servies frm the riginatr: V (θ) = (s O e O + s O e O )θ p O Cnsumer net payff frm purhasing servies frm the ntributr: V (θ) = (s O e O + s O e O )θ p O θ (b) Bth the riginatr and ntributr are ative in the servies market () Only the ntributr is ative in the servies market Cnsumer net payff frm purhasing servies frm the riginatr: V (θ) = (s O e O + s O e O )θ p O Cnsumer net payff frm purhasing servies frm the ntributr: V (θ) = (s O e O + s O e O )θ p O θ 1 Cnsumer net payff frm purhasing servies frm the ntributr: V (θ) = (s O e O + s O e O )θ p O Cnsumer net payff frm purhasing servies frm the riginatr: V (θ) = (s O e O + s O e O )θ p O 0 p O s O eo +so eo 1 θ Figure 2: The nsumer market equilibrium under an pen sure strategy when the riginatr has higher ttal quality. equilibrium as is fully mathematially haraterized in Lemma OS.2 in the nline supplement fr the ase when the riginatr is the quality leader, i.e. Q O > Q O. If bth firms set their pries t high, n nsumer will buy servies and hene n nsumer will hse t use the sftware. If either the ntributr is priing t high r if the riginatr is priing lw enugh t make her servies mre attrative than that f the ntributr fr all nsumer types, then all purhasing ustmers ntrat with the riginatr as is illustrated in panel (a) f Figure 2. On the ther hand, if neither firm s prie is t high and the riginatr s prie is nt t lw t drive the ntributr 19

21 ut f the market then the tw firms share the servies market, with the ntributr serving the lwer end f the user ppulatin. This nsumer market struture an be seen in panel (b) f Figure 2. Finally, if the ntributr s prie is suffiiently lw and the riginatr s prie is suffiiently high, then despite the riginatr having the higher quality, all ustmers wh use the sftware prefer t ntrat with the ntributr and the riginatr is ut f the market. This an be seen in panel () f Figure 2. The utme fr the ase when the ntributr is the quality leader has exatly the same struture exept the rles fr the riginatr and the ntributr are reversed Priing in the Cnsumer Market Given their respetive effrt levels, e O and e O, in the last stage f the game, the firms mpete in the servies market by setting their respetive pries t maximize their prfits taking eah ther s pries as given. The Nash equilibrium utme f this final stage game yields the equilibrium servie pries dented by p O (e O, e O ) and p O (e O, e O ), whih are funtins f the effrt levels the firms hse in the earlier stages. The fllwing prpsitin desribes hw the nsumer priing equilibrium emerges and shapes up the market (full mathematial haraterizatin f the pries are given in the prf f the prpsitin in the nline supplement). 10 Prpsitin 5 Given the effrt levels f the riginatr and ntributr, the equilibrium sftware and servies priing utmes haraterize the market as fllws: (i) If either the riginatr r ntributr serves as the quality leader, then bth firms are ative in the servies market, eah serving a psitive mass f the nsumer ppulatin. The equilibrium pries swith symmetrially when the rle as quality leader is reversed. (ii) If neither firm serves as quality leader (i.e., they ffer equivalent ttal quality), then the firms engage in Bertrand mpetitin whih gives rise t bth firms priing at st in equilibrium. Prpsitin 5 presents an interesting statement: When the firms servie qualities are nt equal, in equilibrium, the riginatr and the ntributr set pries suh that bth firms serve a psitive market share 10 Part (i) f Prpsitin 5 refers t the similar equilibrium utme as in Gabszewiz and Thisse (1979). Please see the nline supplement fr mre n the tehnial haraterizatin f this equilibrium. 20

22 f the nsumer ppulatin. That is, in equilibrium, amng all pssible regins demnstrated in Figure 2, nly the utme illustrated in panel (b) where bth firms partiipate in an ative duply with psitive market shares, an emerge. Fr eah firm there is always sme benefit f setting a small, psitive prie t apture a prtin f the lw end f the nsumer ppulatin, and hene, nne f the firms an fre the ther ne ut f the market. As a nsequene, in equilibrium, the firms settle t a shared ligplisti market. On the ther hand, if the firms qualities are equal, then they engage in Bertrand style mpetitin that drives their equilibrium pries dwn all the way t their st f prviding servie, whih is zer Equilibrium in Investment Effrts in Develpment Using the equilibrium utme fr servie pries presented in Prpsitin 5, we an nw analyze the equilibrium in effrt investment levels fr the tw firms. Given e O and substituting the equilibrium servie pries, we an write the ntributr s prfit as a funtin f his effrt investment level. Further, we an fully haraterize the best respnse funtin f the ntributr. We prvide the mplete, detailed expressins fr his prfit funtin and his ptimal effrt level e O (e O ) in Lemma OS.3 in the nline supplement and summarize them in this setin. If the riginatr is able t benefit frm the ntributr s effrt better than the ntributr an himself (i.e., if s O s O ), r if the ntributr s effrt level e O is smaller than a threshld, then the riginatr is the quality leader. Otherwise, the ntributr is the quality leader. Further, in bth ases, the ntributr s prfit funtin is stritly nave in his wn effrt e O fr any given riginatr s effrt level e O. The ntributr s effrt investment level ritially depends n tw fatrs, namely (i) hw strngly the riginatr an benefit frm develpment effrts t imprve her ttal quality and (ii) the riginatr s effrt level. First, if s O s O, then Q O = s O e + s O e Q O = s O e + s O e, i.e., the riginatr is the quality leader fr all effrt levels e, e 0. In this ase, the ntributr hses an effrt level t bst his wn quality and aptures a lwer segment f the market while the riginatr serves the tp tier f the market. A similar situatin arises when the riginatr puts in a signifiant amunt f effrt in develpment. In suh an instane, the riginatr s quality is t high and even if the ntributr an exeed the riginatr s quality by investing suffiient effrt, it des nt pay ff fr him t d s; nsequently, e O is small and 21

23 an even be zer, again resulting in the riginatr being the quality leader. Hwever, when the riginatr annt benefit frm her wn effrt as effiiently (i.e., when s O is suffiiently small), r when the riginatr s effrt level is lw, the ntributr faes a dilemma: Putting in substantial effrt an make him the quality leader in the market but it uld als benefit the riginatr, wh needs the extra develpment effrt frm the ntributr t bst her wn quality. On the ther hand, the ntributr may put frth a lwer effrt level and remain the quality fllwer. In suh ases, the ntributr has t hse between ne f these ptins and an even hse t invest n effrt and beme the lwer quality servie prvider in rder t nt benefit the riginatr at all. As a result, the ntributr mpares his ptins and hses the ne that maximizes his prfit. Using ur haraterizatin f the ntributr s ptimal effrt level e O (e O ) as a best respnse t the riginatr s effrt level e O, we an turn attentin t the riginatr s effrt investment prblem. Based n her wn effrt level, the riginatr faes tw separate pssibilities. First, she may hse nt t invest muh effrt in develpment and let the ntributr beme the quality leader. Send, she may hse t invest a substantial effrt and mpete as the quality leader. Eah f the tw ases imply a different prfit urve fr the riginatr rrespnding t these tw different effrt regins. The riginatr then hses her ptimal effrt level within eah regin, and subsequently selets the ptimal effrt that maximizes her prfit mparing thse tw regins. The resulting utme again hinges n the develpment effiieny f the ntributr. The fllwing tw prpsitins haraterize the equilibrium utme under an pen sure sftware liense. Prpsitin 6 If the ntributr s develpment sts are lw, i.e. if β is suffiiently small, then, in equilibrium, the ntributr bemes the quality leader. In this ase, if the ntributr ability t benefit frm his wn effrt (s O ) is suffiiently lwer that the riginatr s ability t benefit frm that effrt (s O ), then the riginatr invests n effrt in develpment beynd the minimal release f the sftware, i.e., e O = 0. Otherwise, the riginatr invests a psitive effrt in develpment. The ntributr serves the tp segment f the market and the riginatr serves a middle segment. An illustratin f hw equilibrium deisins are made in the ase f Prpsitin 6 (fr small β ) is 22