Two-Sided Competition of Proprietary vs. Open Source Technology Platforms and the Implications for the Software Industry

It is found that, when the platform is proprietary, the equilibrium prices for the platform, the applications, and the platform access fee for applications may be below marginal cost, and demand conditions that lead to this are characterized.

Abstract

Technology platforms, such as Microsoft Windows, are the hubs of\ntechnology industries. We develop a framework to characterize the\noptimal two-sided pricing strategy of a platform firm; that is, the\npricing strategy toward the direct users of the platform as well as\ntoward firms offering applications that are complementary to the\nplatform. We compare industry structures based on a proprietary platform\n(such as Windows) with those based on an open source platform (such as\nLinux), and analyze the structure of competition and industry\nimplications in terms of pricing, sales, profitability, and social\nwelfare. We find that, when the platform is proprietary, the equilibrium\nprices for the platform, the applications, and the platform access fee\nfor applications may be below marginal cost, and we characterize demand\nconditions that lead to this. The proprietary appiications sector of an\nindustry based on an open source platform may be more profitable than\nthe total profits of a proprietary platform industry. When users have a\nstrong preference for application variety, the total profits of the\nproprietary industry are larger than the total profits of an industry\nbased on an open source platform. The variety of applications is larger\nwhen the platform is open source. When a system based on an open source\nplatform with an independent proprietary application competes with a\nproprietary system, the proprietary system is likely to dominate the\nopen source platform industry both in terms of market share and\nprofitability. This may explain the dominance of Microsoft in the market\nfor PC operating systems.