source: www.joelonsoftware.com/2002/06/12/strategy-letter-v/

# Strategy Letter V

When I was in college I took two intro economics courses: 
macroeconomics and microeconomics. Macro was full of theories like “low 
unemployment causes inflation” that never quite stood up to reality. 
But the micro stuff was both cool and useful. It was full of 
interesting concepts about the relationships between supply and demand 
that really did work. For example, if you have a competitor who lowers 
their prices, the demand for your product will go down unless you match 
them.

In today’s episode, I’ll show how one of those concepts explains a lot 
about some familiar computer companies. Along the way, I noticed 
something interesting about open source software, which is this: most 
of the companies spending big money to develop open source software are 
doing it because it’s a good business strategy for them, not because 
they suddenly stopped believing in capitalism and fell in love with 
freedom-as-in-speech.

Every product in the marketplace has substitutes and complements. A 
substitute is another product you might buy if the first product is too 
expensive. Chicken is a substitute for beef. If you’re a chicken farmer 
and the price of beef goes up, the people will want more chicken, and 
you will sell more.

A complement is a product that you usually buy together with another 
product. Gas and cars are complements. Computer hardware is a classic 
complement of computer operating systems. And babysitters are a 
complement of dinner at fine restaurants. In a small town, when the 
local five star restaurant has a two-for-one Valentine’s day special, 
the local babysitters double their rates. (Actually, the nine-year-olds 
get roped into early service.)

All else being equal, demand for a product increases when the prices of 
its complements decrease.

Let me repeat that because you might have dozed off, and it’s 
important. Demand for a product increases when the prices of its 
complements decrease. For example, if flights to Miami become cheaper, 
demand for hotel rooms in Miami goes up — because more people are 
flying to Miami and need a room. When computers become cheaper, more 
people buy them, and they all need operating systems, so demand for 
operating systems goes up, which means the price of operating systems 
can go up.

At this point, it’s pretty common for people to try to confuse things 
by saying, “aha! But Linux is FREE!” OK. First of all, when an 
economist considers price, they consider the total price, including 
some intangible things like the time it takes to set up, reeducate 
everyone, and convert existing processes. All the things that we like 
to call “total cost of ownership.”

Secondly, by using the free-as-in-beer argument, these advocates try to 
believe that they are not subject to the rules of economics because 
they’ve got a nice zero they can multiply everything by. Here’s an 
example. When Slashdot asked Linux developer Moshe Bar if future Linux 
kernels would be compatible with existing device drivers, he said that 
they didn’t need to. “Proprietary software goes at the tariff of US$ 
50-200 per line of debugged code. No such price applies to OpenSource 
software.” Moshe goes on to claim that it’s OK for every Linux kernel 
revision to make all existing drivers obsolete, because the cost of 
rewriting all those existing drivers is zero. This is completely wrong. 
He’s basically claiming that spending a small amount of programming 
time making the kernel backwards compatible is equivalent to spending a 
huge amount of programming time rewriting every driver, because both 
numbers are multiplied by their “cost,” which he believes to be zero. 
This is a prima facie fallacy. The thousands or millions of developer 
hours it takes to revise every existing device driver are going to have 
to come at the expense of something. And until that’s done, Linux will 
be once again handicapped in the marketplace because it doesn’t support 
existing hardware. Wouldn’t it be better to use all that “zero cost” 
effort making Gnome better? Or supporting new hardware?

Debugged code is NOT free, whether proprietary or open source. Even if 
you don’t pay cash dollars for it, it has opportunity cost, and it has 
time cost. There is a finite amount of volunteer programming talent 
available for open source work, and each open source project competes 
with each other open source project for the same limited programming 
resource, and only the sexiest projects really have more volunteer 
developers than they can use. To summarize, I’m not very impressed by 
people who try to prove wild economic things about free-as-in-beer 
software, because they’re just getting divide-by-zero errors as far as 
I’m concerned.

Open source is not exempt from the laws of gravity or economics. We 
saw this with Eazel, ArsDigita, The Company Formerly Known as VA Linux 
and a lot of other attempts. But something is still going on which very 
few people in the open source world really understand: a lot of very 
large public companies, with responsibilities to maximize shareholder 
value, are investing a lot of money in supporting open source software, 
usually by paying large teams of programmers to work on it. And that’s 
what the principle of complements explains.

Once again: demand for a product increases when the price of its 
complements decreases. In general, a company’s strategic interest is 
going to be to get the price of their complements as low as possible. 
The lowest theoretically sustainable price would be the “commodity 
price” — the price that arises when you have a bunch of competitors 
offering indistinguishable goods. So:

> Smart companies try to commoditize their products’ complements.

If you can do this, demand for your product will increase and you will 
be able to charge more and make more.

When IBM designed the PC architecture, they used off-the-shelf parts 
instead of custom parts, and they carefully documented the interfaces 
between the parts in the (revolutionary) IBM-PC Technical Reference 
Manual. Why? So that other manufacturers could join the party. As long 
as you match the interface, you can be used in PCs. IBM’s goal was to 
commoditize the add-in market, which is a complement of the PC market, 
and they did this quite successfully. Within a short time scrillions of 
companies sprung up offering memory cards, hard drives, graphics cards, 
printers, etc. Cheap add-ins meant more demand for PCs.

When IBM licensed the operating system PC-DOS from Microsoft, Microsoft 
was very careful not to sell an exclusive license. This made it 
possible for Microsoft to license the same thing to Compaq and the 
other hundreds of OEMs who had legally cloned the IBM PC using IBM’s 
own documentation. Microsoft’s goal was to commoditize the PC market. 
Very soon the PC itself was basically a commodity, with ever decreasing 
prices, consistently increasing power, and fierce margins that make it 
extremely hard to make a profit. The low prices, of course, increase 
demand. Increased demand for PCs meant increased demand for their 
complement, MS-DOS. All else being equal, the greater the demand for a 
product, the more money it makes for you. And that’s why Bill Gates can 
buy Sweden and you can’t.

This year Microsoft’s trying to do it again: their new game console, 
the XBox, uses commodity PC hardware instead of custom parts. The 
theory (explained in this book) was that commodity hardware gets 
cheaper every year, so the XBox could ride down the prices. 
Unfortunately it seems to have backfired: apparently commodity PC 
hardware has already been squeezed down to commodity prices, and so the 
price of making an XBox isn’t declining as fast as Microsoft would 
like. The other part of Microsoft’s XBox strategy was to use DirectX, a 
graphics library that can be used to write code that runs on all kinds 
of video chips. The goal here is to make the video chip a commodity, to 
lower its price, so that more games are sold, where the real profits 
occur. And why don’t the video chip vendors of the world try to 
commoditize the games, somehow? That’ s a lot harder. If the game Halo 
is selling like crazy, it doesn’t really have any substitutes. You’re 
not going to go to the movie theatre to see Star Wars: Attack of the 
Clones and decide instead that you would be satisfied with a Woody 
Allen movie. They may both be great movies, but they’re not perfect 
substitutes. Now: who would you rather be, a game publisher or a video 
chip vendor?

Commoditize your complements.

Understanding this strategy actually goes a long, long way in 
explaining why many commercial companies are making big contributions 
to open source. Let’s go over these.

Headline: IBM Spends Millions to Develop Open Source Software.

Myth: They’re doing this because Lou Gerstner read the GNU Manifesto 
and decided he doesn’t actually like capitalism.

Reality: They’re doing this because IBM is becoming an IT consulting 
company. IT consulting is a complement of enterprise software. Thus IBM 
needs to commoditize enterprise software, and the best way to do this 
is by supporting open source. Lo and behold, their consulting division 
is winning big with this strategy.

Headline: Netscape Open Sources Their Web Browser.

Myth: They’re doing this to get free source code contributions from 
people in cybercafes in New Zealand.

Reality: They’re doing this to commoditize the web browser.

This has been Netscape’s strategy from day one. Have a look at the very 
first Netscape press release: the browser is “freeware.” Netscape gave 
away the browser so they could make money on servers. Browsers and 
servers are classic complements. The cheaper the browsers, the more 
servers you sell. This was never as true as it was in October 1994. 
(Netscape was actually surprised when MCI came in the door and dumped 
so much money in their laps that they realized they could make money 
off of the browser, too. This wasn’t required by the business plan.)

When Netscape released Mozilla as Open Source, it was because they saw 
an opportunity to lower the cost of developing the browser. So they 
could get the commodity benefits at a lower cost.

Later AOL/Time Warner acquired Netscape. The server software, which was 
supposed to be the beneficiary of commodity browsers, wasn’t doing all 
that well, and was jettisoned. Now: why would AOL/Time Warner continue 
to invest anything in open source?

AOL/Time Warner is an entertainment company. Entertainment companies 
are the complement of entertainment delivery platforms of all types, 
including web browsers. This giant conglomerate’s strategic interest is 
to make entertainment delivery – web browsers – a commodity for which 
nobody can charge money.

My argument is a little bit tortured by the fact that Internet Explorer 
is free-as-in-beer. Microsoft wanted to make web browsers a commodity, 
too, so they can sell desktop and server operating systems. They went a 
step further and delivered a collection of components which anyone 
could use to throw together a web browser. Neoplanet, AOL, and Juno 
used these components to build their own web browsers. Given that IE is 
free, what is the incentive for Netscape to make the browser “even 
cheaper”? It’s a preemptive move. They need to prevent Microsoft 
getting a complete monopoly in web browsers, even free web browsers, 
because that would theoretically give Microsoft an opportunity to 
increase the cost of web browsing in other ways — say, by increasing 
the price of Windows.

(My argument is even more shaky because it’s pretty clear that Netscape 
in the days of Barksdale didn’t exactly know what it was doing. A more 
likely explanation for what Netscape did is that upper management was 
technologically inept, and they had no choice but to go along with 
whatever scheme the developers came up with. The developers were 
hackers, not economists, and only coincidentally came up with a scheme 
which serves their strategy. But let’s give them the benefit of the 
doubt.)

Headline: Transmeta Hires Linus, Pays Him To Hack on Linux.

Myth: They just did it to get publicity. Would you have heard of 
Transmeta otherwise?

Reality: Transmeta is a CPU company. The natural complement of a CPU is 
an operating system. Transmeta wants OSs to be a commodity.

Headline: Sun and HP Pay Ximian To Hack on Gnome.

Myth: Sun and HP are supporting free software because they like 
Bazaars, not Cathedrals.

Reality: Sun and HP are hardware companies. They make boxen. In order 
to make money on the desktop, they need for windowing systems, which 
are a complement of desktop computers, to be a commodity. Why don’t 
they take the money they’re paying Ximian and use it to develop a 
proprietary windowing system? They tried this (Sun had NeWS and HP had 
New Wave), but these are really hardware companies at heart with pretty 
crude software skills, and they need windowing systems to be a cheap 
commodity, not a proprietary advantage which they have to pay for. So 
they hired the nice guys at Ximian to do this for the same reason that 
Sun bought Star Office and open sourced it: to commoditize software and 
make more money on hardware.

Headline: Sun Develops Java; New “Bytecode” System Means Write Once, 
Run Anywhere.

The bytecode idea is not new — programmers have always tried to make 
their code run on as many machines as possible. (That’s how you 
commoditize your complement). For years Microsoft had its own p-code 
compiler and portable windowing layer which let Excel run on Mac, 
Windows, and OS/2, and on Motorola, Intel, Alpha, MIPS and PowerPC 
chips. Quark has a layer which runs Macintosh code on Windows. The C 
programming language is best described as a hardware-independent 
assembler language. It’s not a new idea to software developers.

If you can run your software anywhere, that makes hardware more of a 
commodity. As hardware prices go down, the market expands, driving more 
demand for software (and leaving customers with extra money to spend on 
software which can now be more expensive.)

Sun’s enthusiasm for WORA is, um, strange, because Sun is a hardware 
company. Making hardware a commodity is the last thing they want to do.

Oooooooooooooooooooooops!

Sun is the loose cannon of the computer industry. Unable to see past 
their raging fear and loathing of Microsoft, they adopt strategies 
based on anger rather than self-interest. Sun’s two strategies are (a) 
make software a commodity by promoting and developing free software 
(Star Office, Linux, Apache, Gnome, etc), and (b) make hardware a 
commodity by promoting Java, with its bytecode architecture and WORA. 
OK, Sun, pop quiz: when the music stops, where are you going to sit 
down? Without proprietary advantages in hardware or software, you’re 
going to have to take the commodity price, which barely covers the cost 
of cheap factories in Guadalajara, not your cushy offices in Silicon 
Valley.

“But Joel!” Jared says. “Sun is trying to commoditize the operating 
system, like Transmeta, not the hardware.” Maybe, but the fact that 
Java bytecode also commoditizes the hardware is some pretty significant 
collateral damage to sustain.

An important thing you notice from all these examples is that it’s easy 
for software to commoditize hardware (you just write a little hardware 
abstraction layer, like Windows NT’s HAL, which is a tiny piece of 
code), but it’s incredibly hard for hardware to commoditize software. 
Software is not interchangable, as the StarOffice marketing team is 
learning. Even when the price is zero, the cost of switching from 
Microsoft Office is non-zero. Until the switching cost becomes zero, 
desktop office software is not truly a commodity. And even the smallest 
differences can make two software packages a pain to switch between. 
Despite the fact that Mozilla has all the features I want and I’d love 
to use it if only to avoid the whack-a-mole pop-up-ad game, I’m too 
used to hitting Alt+D to go to the address bar. So sue me. One tiny 
difference and you lose your commodity status. But I’ve pulled hard 
drives out of IBM computers and slammed them into Dell computers and, 
boom, the system comes up perfectly and runs as if it were still in the 
old computer.

Amos Michelson, the CEO of Creo, told me that every employee in his 
firm is required to take a course in what he calls “economic thinking.” 
Great idea. Even simple concepts in basic microeconomics go a long way 
to understanding some of the fundamental shifts going on today.