Question

Software has historically been an artificially scarce good-it is nonrival because the cost of replication is negligible once the investment to write the code is made, but software companies make it excludable by charging for user licenses. But then open-source software emerged, most of which is free to download and can be modified and maintained by anyone. a. Discuss the free-rider problem that might exist in the development of open- source software. What effect might this have on quality? Why does this problem not exist for proprietary software, such as the products of a company like Microsoft or Adobe? b. Some argue that open-source software serves an unsatisfied market demand that proprietary software ignores. Draw a typical diagram that illustrates how proprietary software may be underproduced. Put the price and marginal cost of software on the vertical axis and the quantity of software on the horizontal axis. Draw a typical demand curve and a marginal cost curve \((M C)\) that is always equal to zero. Assume that the software company charges a positive price, \(P,\) for the software. Label the equilibrium point and the efficient point.

Short answer

Answer: Part a: The free-rider problem in open-source software development occurs because individuals can use or modify the software without contributing to its development, which may lead to a lower overall investment in the project. This can impact the quality of the software in different ways, as a lack of funding could lower the quality, while the collaborative nature might improve it. The free-rider problem does not exist in proprietary software because companies charge for licenses, funding development and improvements. Part b: Proprietary software may be underproduced where the charged price is above the marginal cost, which is equal to zero. The difference between the equilibrium point (point E) and the efficient point (point A) represents underproduction, as there is unsatisfied demand at a lower price. The efficient allocation of resources occurs at point A, where the price matches the marginal cost.

Step-by-step solution

Part a: Discussing the Free-Rider Problem in Open-Source Software

The free-rider problem can occur in the development of open-source software because individuals can benefit from using or modifying the software without contributing financially or by improving the code. This might lead to a lower overall investment in the development of the software, as there is no incentive to pay for a product that can be used for free. The effect on the quality of open-source software could vary. On the one hand, the lack of revenue might lead to fewer resources being invested in the project's development, resulting in a lower quality product. On the other hand, the collaborative nature of open-source software could lead to a larger number and diversity of contributors, who can provide different ideas and skills to improve the software's quality. This free-rider problem does not exist for proprietary software because companies like Microsoft or Adobe charge for user licenses, making their software products excludable. By charging for the software, the developers generate revenue that is used to fund further development and improvements to the software, ensuring a continuous increase in quality.

Part b: Diagram Illustrating How Proprietary Software May Be Underproduced

In order to represent graphically how proprietary software may be underproduced, we will draw a diagram with the price and marginal cost of software on the vertical axis and the quantity of software on the horizontal axis. 1. Draw the demand curve, which will slope downwards from left to right, showing that the quantity demanded decreases as the price increases. 2. Draw the marginal cost curve, which will be a horizontal line at zero, representing the negligible cost of replicating software once it is developed. 3. Label the price charged by the software company as \(P\) on the vertical axis. Draw a horizontal line from this point to intersect the demand curve. Label the intersection point as equilibrium point (E). 4. Label the efficient point (where the demand curve intersects the \(MC=0\) curve) as point A. The underproduction of proprietary software is represented by the difference between the equilibrium point (E) and the efficient point (A). At point E, the price of the software is above the marginal cost, meaning that there is an unsatisfied demand for the software at a lower price. Point A represents the efficient allocation of resources, where the price corresponds to the marginal cost.

Key concepts

Free-Rider Problem

In the world of open-source software, the free-rider problem can become a significant issue. This problem occurs when individuals benefit from resources or services without paying for them. When applied to open-source software, it means people use or improve software without contributing back, financially or through development efforts.
Because open-source software is freely available, users often download and use it without supporting its development. This might lead to fewer resources for improvement, potentially affecting quality.
However, open-source projects can benefit from diverse volunteer contributions from around the world. Many people contribute to such projects out of interest or a desire to improve the software. This can sometimes result in high-quality products, but it's not always reliable without a steady source of support.
By contrast, proprietary software companies, like Microsoft or Adobe, don't face this problem. They charge fees for using their software, ensuring they have the revenue to reinvest into development, maintain quality, and offer support or updates.

Proprietary Software

Proprietary software is developed by companies who retain ownership and rights over the software. Users must purchase licenses to use it. This model allows companies to generate revenue continuously, which is vital for sustaining and improving their products over time.
Unlike open-source software, proprietary solutions typically maintain exclusivity. Companies use the revenue from sales to fund research and development, ensuring the software stays competitive and updated. Their products are supported by dedicated teams, contributing to higher, more consistent quality.
Ultimately, the proprietary model ensures steady resources for improvement and innovation, providing an incentive for companies to keep advancing their offerings.

Marginal Cost

Marginal cost in software development represents the cost of producing one additional unit of software. For most software products, especially digital ones, this cost is nearly zero once the software is developed.
This is because after the initial investment in creating the software, distributing additional copies requires negligible cost, such as bandwidth or storage. This is true for both open-source and proprietary software.
In economic theory, the ideal pricing aligns with the marginal cost. However, proprietary software companies usually set prices above the marginal cost to recover initial development investments and sustain their businesses.

Demand Curve

The demand curve illustrates the relationship between the price of a product and the quantity demanded by consumers. Generally, it slopes downwards, indicating that as the price decreases, the demand increases.
In software, especially open-source, the demand can be high because these products are usually available for free. For proprietary software, the demand curve helps companies decide on pricing strategies that maximize revenue.
When a company prices software above the marginal cost, they may not produce at a point where demand equals supply, leading to underproduction. This becomes evident when drawing the demand curve against a horizontal marginal cost line (zero). While proprietary software companies aim for maximum profit, they might miss the efficient allocation where price equals marginal cost. This inefficiency represents an opportunity for open-source solutions to fulfill unmet demand.