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October 6, 2010 / Lukasz Cerazy

Reaping Network Externalities with Open Source

Firms in the services sector are finding it difficult to uphold their intellectual property rights, especially in industries like entertainment, IT, software and telecommunications. The number of patents and other copyrights issued over the last three decades has risen dramatically. This is mainly due to the increased ability of firms to exploit their ideas and knowledge in the marketplace, but also by the fact that the world is turning into a knowledge-based economy where individuals who hold ideas will prosper more than the ones who hold the means of production. However, a serious problem for these firms exist in that not all users respects their rights and endangers their profitability. Ever since the beginning of the Internet Revolution a race has existed between regulators and users in a kind of shadow economy, which has raised many heated debates. This race has produced many new innovations and possibilities predominantly because of its fast pace and high degree of competition. It has also lead to many spill-overs that have been beneficiary to the industries and created positive externalities, so they are not all bad. However, a degree of protection for firms is necessary because they would otherwise be discouraged from engaging in R&D or invest in projects, if they were unable to be rewarded in some way.

The problem is obvious because it is very difficult to control the flow of these products since they are intangible and sometimes invisible. Firms in the service sector suffer from not having possession over their products – only intellectual property rights. Firms in the manufacturing sectors, on the other hand, most often experience both and can therefore operate in the marketplace with a higher degree of control over their products. Furthermore, the service firm’s cost structure forces them to engage heavily in many sunk costs, which they have to cover later – this only gives them an even larger incentive to seek intellectual property rights, perhaps triggering a counter reaction by their users. Monopolising or restricting the distribution and use of their services has also been the preferred tool by firms in these industries for most of the period. In reality though, creative individuals and advanced users continuously find new ways of circumventing restrictions and are outpacing regulators.

Firms are aware of the economics behind their positioning and many have now adopted an inverse strategy. A “if you can’t beat them – join them!” approach. This means letting parts of their product, which often also are the most difficult to control, be free. This has predominantly been the case for IT, software and telecommunication firms. They then only charge for the hardware or subscription, for instance, and let the intangible part be accessible to users. The reason why they are adopting this approach is due to the phenomenon economists call; network externalities. This is an old and well-understood occurrence where the social gain grows with every additional user of the network. Think of it like this: a telephone is not of much use if you are the only one that has one. By applying this strategy firms are able to encourage more users to join their network, increase the gains for the users and in many cases the firm become more profitable. This is possible because the costs are near zero at the margin, meaning that one extra user can join at almost no cost to the firm. There are of course limits to this strategy as users are only inclined to join networks they see benefit in, which are limited. Firms therefore have to reach a critical mass of users or they will never take off the ground. That is why there are very often no more that a handful of networks, which attract a very large part of a given market, usually relying heavily on brand strength. Think of Google, Facebook, Microsoft and the list goes on. These networks become more useful the more users join or use them and they also create compatibility. This is owing to the fact that the demand-curve, unusually, is parabolic and upwards bending before a certain point. This results in two points of equilibrium where the first one is called the point of critical mass and must be reach if a firm is to succeed and the other is the highly profitable point of a big consumer mass with the same level of supply. However, there is a certain lock-down effect once users gather in a network and the barrier to exit becomes greater.

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There is good reason why firms would apply this strategy to try and reach market domination, however, some may loose out even though they are better just because of user’s brand loyalty with a competing firm. There are, however, other opportunities, which include introducing open source software that not only benefits from network externalities, but also significantly increases the pool of developers for their systems. The operating system Linux and the Google’s Chromium are examples of this. Firms then rely on the combined pool of users and developers to evolve the software to what the users themselves think is most necessary for them and reward the best ones. This is evidence that it pays to be a techie. By applying these and similar strategies firms are able to reach a critical mass of users and can become very profitable. So, if you have a business idea that would operate in a virtual market, you now know the basic economics behind it.


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