From michael@ecst.csuchico.edu Tue Feb 4 02:27:07 1992 Return-Path: Received: from cscihp.ecst.csuchico.edu by tigger.cs.adelaide.edu.au with SMTP (5.64+1.3.1+0.50/UA-5.20) id AA21194; Tue, 4 Feb 1992 02:27:04 +1030 Message-Id: <9202031557.AA21194@tigger.cs.adelaide.edu.au> Received: by cscihp.ecst.csuchico.edu (15.11/15.6.R2) id AA05824; Mon, 3 Feb 92 07:58:43 pst From: Michael Perelman Subject: Re: Patents To: gordoni@cs.adelaide.edu.au (Gordon Irlam) (Gordon Irlam) Date: Mon, 3 Feb 92 7:58:42 PST In-Reply-To: <9202031203.AA05970@chook.cs.adelaide.edu.au>; from "Gordon Irlam" at Feb 3, 92 10:33 pm Mailer: Elm [revision: 64.9] Status: RO Patents are just part of the argument. I believe that modern technology is moving in a direction in which the marginal costs of goods is tended toward zero, making them more like public goods. As a result, markets are not a good instrument. -- Michael Perelman Economics Department California State University Chico, CA 95929 Tel. 916-898-5321 916-898-6141 messages E-Mail michael@ecst.csuchico.edu From michael@ecst.csuchico.edu Tue Feb 4 03:47:13 1992 Return-Path: Received: from cscihp.ecst.csuchico.edu by tigger.cs.adelaide.edu.au with SMTP (5.64+1.3.1+0.50/UA-5.20) id AA21286; Tue, 4 Feb 1992 03:46:54 +1030 Message-Id: <9202031716.AA21286@tigger.cs.adelaide.edu.au> Received: by cscihp.ecst.csuchico.edu (15.11/15.6.R2) id AA07729; Mon, 3 Feb 92 09:18:31 pst From: Michael Perelman Subject: Section from Book To: gordoni@cs.adelaide.edu.au (Gordon Irlam) (Gordon Irlam) Date: Mon, 3 Feb 92 9:18:30 PST In-Reply-To: <9202031203.AA05970@chook.cs.adelaide.edu.au>; from "Gordon Irlam" at Feb 3, 92 10:33 pm Mailer: Elm [revision: 64.9] Status: RO I. The Increasing Importance of Information A. If public goods are defined as the products of high overhead, low marginal cost industries, then information is indeed a prototypical public good. Its marginal cost is virtually zero. If the popular wisdom, that we are becoming more of an information economy, is correct, then the tension between the existing system of social and property relations and optimal economic performance should be severe in the market for information. B. How important is information in our economy? According to a widely cited estimate of Marc Uri Porat, in 1967, 25.1 per cent of the US Gross National Product originated with the production, processing and distribution of information goods and services sold on the market. In addition, the purely informational requirements of planning, coordinating and managing the rest of the economy consumed another 21.1 per cent. In other words, workers whose tasks are predominately informational account for almost one-half of the total US labour income (Porat, 1976, p. 1). C. Some researchers find this estimate a bit excessive. The bulk of the estimates for the size of the information sector in the advanced capitalist countries runs from around 25 per cent to 40 per cent of the total economy (see Jussawalla, 1988, p. 23). Given the magnitude of these estimates, many have come to see modern capitalist economies as evolving toward information economies. D. The reaction of the American Express Corporation in 1982, when it was first included in the Dow Jones Industrial Index, symbolized this trend toward an increasing role for information. The company issued a statement that read, '[O]ur product is information .... Information that charges airline tickets, hotel rooms, dining out, the newest fashions, and even figures mailing costs for a travel magazine; information that grows money funds, buys and sells equities and manages mergers; information that pays life insurance annuities ... ' (Schiller, 1988, p. 27). E. Kenneth Arrow once proposed, 'The meaning of information is precisely a reduction in uncertainty' (Arrow, 1979, p. 306). According to this perspective, some activities that are normally counted as information producing should be excluded. For example, estimates of the information sector include advertising and marketing activities as information producing. Some advertising is designed to confuse people in order to get an edge on competitors without serving consumers' needs in any way. Such activities should better be treated as disinformation. This information may charitably be called, 'local information'. It may reduce uncertainty for the firm that benefits from the information, but it may create more uncertainty for other agents. F. The fastest growing major sector of the US economy is sometimes known as FIRE, an acronym referring to Finance, Insurance, Real Estate (see Niggle, 1988). A good deal of the work in this sector produces outcomes that are of dubious or even negative outcomes. Deducting such activities from the information sector would substantially diminish the estimates of the importance of information in our society. G. In addition, some of the apparent growth of the information sector is an illusion that is due to changes in the social division of labour. Jagdish Bhagwati has made much of this effect in his analysis of services. He wrote of the 'continuous process during which services splinter off from goods and goods, in turn, splinter off from services' (Bhagwati, 1984, p. 134). H. Bhagwati's discussion of splintering has obvious implications for the social division of labour although he appears to be unaware of the existing literature on this subject (see Chapter 2). As we suggested in Chapter 2, virtually all work involves the processing of information, but we only tend to take notice of the informational aspects of work when it becomes a specialized occupation. For example today, instead of employing a carpenter to build a house, we first employ an architect to design it. Architects are part of the information sector, but carpenters have never been treated that way, even when they performed design work. I. We might be misled by this example since modern housing requires a much broader range of materials and functions than earlier housing typically did. Think of a primitive hunter and gatherer. In Chapter 1, I argued that such people probably had a greater knowledge of their flora and fauna than a modern biologist did, but the biologist is part of the information sector and the hunter while the gatherer is not. Although hunters and gatherers may not publish their findings in learned journals, they disseminated their information to their society just as surely as a modern biologist. J. Some of the activities, resulting from the splitting to which Bhagwati refers, do not create information. Consider the process of deskilling that we discussed in Chapter 3. In that case, management attempts to restructure work with the intention of reducing workers' power. The shifting of work from the manufacturing workplace to the head office may even represent a loss of information since much of the earlier workers' knowledge is now forgotten. In addition, workers will take measures to resist management's attempt to stake out greater authority, thus creating a need for more monitoring of the sort that we discussed in Chapter 3. K. None the less, information is probably more crucial in our modern society than the widely accepted estimates suggest, but for reasons that have less to do with economics than ecology. Our current methods of production threaten to cause many forms of environmental destruction. We must pin our hopes for avoiding disasters on careful management of our resource base; in other words, public agencies must take measures (or force firms to take measures) to monitor or restrict environmental hazards created by an individualistic profit seeking capitalist society. Consequently, our very survival may depend on the quality of information that we can generate. With this grim concern in mind, just as those who try to protect society from environmental collapse produce vital information, the firms that create the problems might be treated as another case of producing 'disinformation'. L. In summary, modern society may be becoming more dependent upon information. What is more noteworthy than the increasing importance of information is, the greater reliance on information instead of knowledge, in the sense that we discussed in Chapter 1. To the extent that our future welfare depends on the coordination of a multitude of activities (as the threat of looming environmental catastrophes might suggest) we would be better off in an institutional framework that treated information as public knowledge. II. Information as a Public Good A. The need for more widespread knowledge contradicts Hayek's notion that market relations are ideally suited to the discovery and processing of information (see Chapter 2). To begin with, profit seekers ignore everything that does not affect their earnings. Consequently, individuals generally do not have any motives to gather information about, say environmental disruptions. This market defect is well known. B. In addition, even when information is available, the market for information is beset by a fundamental problem that Kenneth Arrow explored in a now classic article. Arrow began with the proposition that, when the typical commodity is placed on the market for sale, it remains unchanged, except for say perishable products. Information is different. It cannot enter into the circuit of capital without undergoing a fundamental change. In this vein, Arrow wrote: C. ##[If] the cost of transmitting a given body of information ... were zero, then optimal allocation would obviously call for unlimited distribution of information without cost ... D. ##[A]ny Information ... should, from the welfare point of view, be available free of charge (apart from the cost of transmitting information). (Arrow, 1962, pp. 614-6) E. Arrow's conclusion is self-evident given the usual mainstream interpretation of our economic order. Unfortunately, theory and reality are moving in two different directions. Information, which was once freely distributed through libraries and government agencies is increasingly becoming privatized (Schiller and Schiller, 1988; Schiller, 1984, pp. 102-3). In the telling phrase of Vincent Mosco, we are evolving from a paper society to what he calls a 'pay-per' society, alluding to the increasingly common practice of selling information. F. The US government has acted as a willing accomplice in this process. For example, B. C. Sullivan has observed: G. ##The role of the Federal Depository Library Program in collecting and circulating government publications is being undermined by the unavailability of those documents. Budgetary constraints have prevented it from acquiring the latest electronic equipment for information delivery .... The government has approved pilot programs in which private contractors manage the electronic filing, processing and dissemination of data that businesses and individuals are required to submit to government agencies .... In sum, the national information supply is an endangered resource. (Sullivan, 1985). H. The US Patent Office is now granting patents on genetic material and even mathematical procedures that are developed at or in conjunction with universities that receive substantial public funds. To make matters worse, the government, after paying for the fixed costs of gathering information, often permits private agents to treat this information as private property (Schiller, 1984, p. 84). I. Arrow explored another problem intrinsic to the market for information in a capitalist society. He explained: J. ##In the absence of special legal protection, the owner cannot, however, simply sell information on the open market. Any one purchaser can destroy the monopoly, since he can reproduce the information at little or no cost. Thus the only efficient monopoly would be the use of the information by the original possessor. This, however, will not only be socially inefficient, but also may not be of much use to the owner of the information either, since he may not be able to exploit it as effectively as others ... K. ##[T]here is a fundamental paradox in the determination of demand for information; its value for the producer is not known until he has the information, but then he has in effect acquired it without cost. (Arrow, 1962, p. 615) III. The Puzzle of Software Pricing A. Much of this book thus far has relied upon a combination of pure theory together with historical examples. Now, it takes a more perilous turn. In order to develop some of the implications of this work, I shall now explore a new and vital industry that is in a state of flux. B. Microcomputer software is one of the most interesting commodities that capitalism has yet devised. In 1978, the US microcomputer software business was non-existent. By 1986, it comprised 14,000 firms, 27,000 products and annual sales of $5 billion (Judis, 1986). The money paid for microcomputer software is expanding at a 50 per cent annual rate according to the Software Publishers Association (Signal Research Report, 1988, p. 6). C. The microcomputer software industry is largely unchartered terrain. The student of this subject is, more often than not, left to turn to the trade journals rather than academic journals that benefit from peer review. As a result, the risk of being proven wrong when analysing such material is far greater than it would be for analysing, say the nineteenth century steel industry. D. My study of the computer software industry leads me to conclusions that are at odds with the conventional view that markets work reasonably well. None the less, I feel that it is important to extend the argument of this book to the software industry. E. Given that capitalist economics regards knowledge as intellectual property, which is marketed as a commodity, consider how the market for knowledge functions. To begin with, since barriers to price flexibility should be expected to exist in sectors where the marginal cost is low (see Chapter 4), the market for information should be especially affected by this problem. Considering the low entry costs in the software industry, the extent of market coordination is enormous. F. To make matters worse, the pricing of computer software, at first glance, seems to defy the conventional wisdom of microeconomics since the demand for computer software frequently has a positive price elasticity; the higher the price, the greater the demand for the product. Numerous software vendors have discovered this phenomenon. A few years ago, Borland International seemed to be the exception that proves the rule. The company, which originally made its reputation by selling high-quality, low cost software, purchased another company named Analytica, which marketed a program called Reflex. Reflex had previously sold only 1200 copies in 9 months when it was priced at $495. At $99.95, Borland sold 100,000 copies in 9 months (Freiberger and McNeill, 1987). G. More recently, Borland has become a vocal exponent of the theory of positive price elasticity. It tripled its price when it revised Reflex. 'It is amazing but there is not much price sensitivity in the Mac market', says Philippe Kahn, President and CEO of Borland. 'That is one of the strange things about the market'. 'The market has not taken it very seriously', said Kahn (Parker, 1987). He proudly asserted, 'The product is so powerful that we were told its low price was hurting its credibility' (Flynn, 1987). Borland estimated that, at $279, Reflex Plus will get the notice it deserves. Borland goes further, predicting that higher prices will ultimately benefit users. 'We decided that certain products need more support, and the market has lots of issues besides price', said Kahn (Parker, 1987). H. Kahn's experience is not unique. Automated Reasoning Technologies of Eugene, Oregon sells 'Personal Finances With Lotus', a large collection of templates to run with Lotus 1-2-3. It initially priced its program at $59. Despite good reviews it did not sell well. At $89, sales went up. At $200 it was even more successful. The company concluded 'Setting a price too low can tarnish the image of a product' (Reid and Hume, 1988). I. Why would business be insensitive, or even perversely sensitive, to price? According to Robert Lefkowitz, analyst for Infocorp of Cupertino, California, 'List price is more a statement of position rather than an economic decision' (Ranney, 1985). According to another industry source, 'It's similar to using a consultant. If you are paying 2 consultants $2.50 an hour and $1,000 a day respectively, whose advice are you going to trust more' (Judis, 1986)? J. Tibor Scitovsky first described a similar phenomenon in 1945. He observed: K. ##The habit of judging quality by price, however, is not necessarily irrational. It merely implies a belief that price is determined by the competitive interplay of the rational forces of supply and demand. (Scitovsky, 1945, p. 100; see also Stiglitz, 1987, p. 3) L. This logic anticipates the rational expectations literature in certain respects. For example, Sanford Grossman recently argued: M. ##[O]ne is learning from prices what other people know, and that information is conceivably useful in formulating one's own tastes. At its simplest, this concerns the direct utility that one will obtain from consumption of a good. For example, if one sees that car X retails for more than car Y, then one may infer that car X is worth more to oneself, because one suspects that others have experience with this car. (Grossman, 1981, p. 115) N. Scitovsky went beyond this line of thought. He noted: O. ##The situation is different in markets where new models or new brands are frequently introduced. A new commodity has no traditional price, no past reputation, its quality, therefore is likely to be appraised partly or wholly on the basis of its present price. (Scitovsky, 1945, p. 101) P. In the absence of traditional price levels, software marketers have developed novel methods to determine the appropriate price. For example, Martel Firing, who developed Intuit, an integrated word processor, spread sheet, and file management program tried a variant of this strategy. His small, one person company, Noumena, ran an advertisement announcing its product at an initial price of $50. The ad explained that price would increase by $20 each week until demand would fall off in response to the price. After evaluating buyer response to a price that ranged from $50 to a high of $210, it finally settled on an $89.95 price tag, which stood for two years. Now the program sells for $50 including mailing and sales tax (Ranney, 1985; Needle, 1987). Q. At best, the relationship between price and quality in the software market is erratic. For example, John Judis compared two word processing programs IBM Display Write 2, which sells for $385, and Ann Arbor Software's Textra 3.1A, which costs $29.25. He concluded that Textra is better (ibid.). R. If the various industry observers are correct, business price insensitivity would cast serious doubts upon the efficiency of the market for computer software. Undoubtedly, some of the rhetoric about business' lack of concern about price is self-serving. Not all consumers, not even all business consumers, are insensitive to price. I already mentioned Borland's early experience with Reflex. The sellers of Javelin, a modelling and spreadsheet program, also attempted to compete with price. It first sold for $695, but its publishers could not sell many at that price. They lowered it to $99, then raised it to $199, then lowered it again to $100, upon introducing the more powerful Javelin Plus at $249 (Feldman, 1987). According to Dick Bonzagni, vice president of marketing, Javelin's strategy was to lower the price to $99 only until it sold 10,000 copies with the intention of building up its installed user base (Warner, 1986). S. If the market for computer software displays any regularity, it may be what Scitovsky called, Harrod's law of diminishing price elasticity, whereby the rich are far less concerned with price than those who have less wealth (Scitovsky, 1945, p. 103). Perhaps the general awareness of the basis for Harrod's law explains the popular curiosity about the habits of those wealthy individuals who happen to be unusually frugal. T. The anomalous pricing of computer software is related to the combination of incredible mark-ups with the potentially enormous benefits that computer software promises, although it does not necessarily meet this promise, superimposed on a relative ignorance about the computer software market. A $700 program that could help a firm be more competitive in making presentations for multimillion dollar contracts would be a steal in the eyes of a user regardless of the marginal cost of the program to the vendor. U. A firm could perhaps save money by purchasing a less expensive program. Many publications review computer products, but the reviews are often surprisingly divergent, especially for specialized programs. Much of this lack of unanimity is due to the idiosyncratic needs of the users for most programs. Unless readers have considerable confidence that their own needs coincide with those of a reviewer's, they may not want to purchase a program on the strength of a review or two. The problem is that potential users cannot fully understand the strengths and weaknesses of a program until they have the opportunity to 'kick the tyres' themselves. Finally, the search for the appropriate program might cost more than any possible savings that a firm could enjoy by purchasing cheaper, but more effective products (see Stigler, 1961). V. Given this situation, contemporary software firms attempt to gain a market presence through intensive promotional efforts, which are more effective in creating profits than perfecting the product. In the process, much of the potential of the computer technology is lost. IV. Computer Software as a Public Good A. Within Arrow's logic, computer software is an ideal public good. Once produced, software code costs virtually nothing to duplicate. One can even read Arrow's analysis of the economics of information as an economic justification for the piracy of computer software; that is, software piracy, generously interpreted, approximates the price structure that pure neo-classical economics implicitly recommends, assuming that software vendors are marketing nothing more than the information embodied in the program. B. The development costs of a business application program for a microcomputer run at about $4 million, roughly the same as many commercial phonograph recordings. Software prices generally exceed the prices of phonograph records by a significant amount, sometimes by thousands of dollars. C. Now consider how low the marginal cost of computer programs is. According to Business Week, the actual materials cost of a $700 program, including disks and the manual, are less than $15. Marketing and R&D can represent 30 per cent of the total retail price. Toll free customer support lines can cost $20 per customer. Even with lavish marketing expenses, computer software can bring pretax margins of 20 to 40 per cent (Anon., 1987). D. Doug Clapp gives an even more modest estimate of the costs of computer software: $10.40. His figure includes the cost of disks ($2.20), royalties ($3), packaging ($3), manuals ($1.50), labour and even the labels ($0.20). Clapp is also assuming that the program is being shipped on the more expensive 3.5 inch diskettes (Clapp, 1986). E. After the software company sells its product, the retailer adds on another substantial mark-up. WordPerfect's average wholesale cost is $158. Its list price is $495. Street prices range between $388 and $455 (Radigan, 1987). Profits in the industry can be so bounteous that they led W. E. 'Pete' Peterson, executive Vice President of WordPerfect Corporation to chortle 'we're making so much money that if we went public, shareholders would want to cut out our salaries' (Bulkeley, 1987). F. Software companies sometimes justify their high prices by the alleged costs imposed by piracy, although high prices make piracy a more tempting alternative to the outright purchase of programs. G. To be sure, software firms generally exaggerate the losses that they suffer from piracy. Industry sources estimate the number of bootleg copies of major programs in the millions. Supposedly 2.5 million unauthorized copies of Lotus 1-2-3 exist. The respective numbers of unauthorized copies for DBase and WordStar are supposedly five and three million respectively (Anon., 1988b). According to another industry source, 'the actual loss to software developers from piracy is relatively small; ... software innovation is thriving, unaffected by copying; ... the whole piracy issue is rapidly declining in importance as the software industry matures' (Woods, 1985). H. Currently, many software companies willingly incur significant costs to send sample disks gratis to acquaint potential customers with their products. Many alleged pirates saved firms such expenses by 'sampling' programs to see if they are worth purchasing later. The vast majority of these supposedly 'stolen' copies remain unused after the pirate spends a couple of hours trying them out. Perhaps this reasoning explains why InfoCorp reports that micro software sales exceeded $5 billion this year, while piracy cost software developers only $60 million (presumably pretax) in 1984 (Woods, 1985). More importantly as we shall see, pirates perform a great service for the developers by introducing the program to a wider audience. I. A few years ago, many software houses took great pains to thwart pirates by copy protection, creating an artificial cost of transmitting information. The intent was to make software more unlike public goods. Ironically, copy protection makes the program even more like a pure public good from the perspective of the vendor because the extra programming involved in copy protection adds to the fixed cost of production rather than the marginal cost. J. Copy protection has largely disappeared. These schemes diminished the utility of programs to all users, legitimate and otherwise. Since copy protection usually involved major inconveniences for purchasers of the program, a groundswell of consumer resistance built up. Once consumers balked at purchasing programs with copy protection, this method of ensuring that software companies could collect rents fell into disuse. K. Software vendors impose other costs on the economy in order to protect the value of their commodity. For example, they routinely hide their code so that potential competitors cannot take advantage of their programs. This tactic may help purveyors of software collect rents, but it cripples the potential usefulness of some programs. For example, Wordstar had what were called patches, openings into the program that allowed users to write their own code to perform specialized tasks. Many of these patches were eventually incorporated into the program as it was sold. More modern programs allow users to write macros, which are mini-programs, to make the product more effective, but when users are denied access to the original code that makes up the program, macros tap only a limited part of the program's potential. L. The software industry restricts the potential usefulness of its products in an even more blatant respect. Economists understand that a monopolist will profit by distorting the array of quality and variety of their product even though such behaviour reduces social welfare relative to the imaginary ideal of perfect competition (see Besanko, Donnenfeld and White, 1987, p. 743; White, 1977; Maskin and Riley, 1984). Software marketers are no exceptions. In order to create an artificial range of quality, they actually spend money to disable some features of their product. M. Similar behaviour among computer hardware manufacturers is rarer although IBM did go to the expense of installing special circuitry to make their infamous PC-Junior unable to match the performance of its PC line. Earlier, the developers of the original PC line chose the 8088 chip rather than the more powerful 8086 because the corporate headquarters would never allow the computer to be built with the 8086, which might threaten the existing IBM line of computers (see Chposky and Leonisis, 1988, pp. 23-4). N. Software companies have also taken pains to undermine each others' efficiency through complex strategies of copyright and patents. As a result, the legal costs of producing software are soaring. The Wall Street Journal reported on the case of Paul Emmerich, President of CadTrak Corp, a six person company in San Mateo, Ca. This company takes in almost $5 million in licensing fees for a method he found for moving a cursor around on a graphics screen. 'Mr. Emmerich scans computer ads and treks through trade shows, hunting for unwitting violators. After four days at the giant Comdex show in Las Vegas last fall, he says, he 'picked up 10 or 12 new infringers' that he can sue (Bulkeley, 1989). O. The firms that CadTrak sues do not knowingly copy its discovery. They come upon it independently. Still, one might try to stretch the usual case for patents by arguing that patents somehow have encouraged people such as Mr Emmerich to innovate. This defence does not hold water in the case of Berkeley Limited Partnership, which settled a suit with IBM in February 1989 after accusing IBM of patent infringement. As its name might suggest, Berkeley Limited Partnership has its roots in the world of finance, not software. This firm began with the purchase of a patent at a bankruptcy sale by a Washington, DC lawyer. Berkeley claims that its patent covers some basic software operations that are found in almost every personal computer and word processing program (ibid.) P. The use of the courts to extract rents can cripple the production of innovative software. Jeffrey Tarter, editor of SoftLetter, a Cambridge, Mass. newsletter, said that such lawsuits can overwhelm a small software developer 'if it's a matter of challenging seven or eight patents every time you do software and fighting with lawyers' (ibid.). Q. Software companies contend that most of the glaring deficiencies of the software industry are inevitable, claiming that, without the lure of profit made possible by protecting the vendors' intellectual property, the programs would never be written in the first place. Others that are familiar with the software industry insist that the corporate culture is incompatible with the sort of creativity that good programming requires. R. In fact, the majority of the major software houses either began as or became software brokers rather than software creators. For example, Microsoft was a tiny company. Its fortunes soared when it won a contract to supply IBM with the DOS operating system; however, Microsoft originally purchased DOS from Seattle Computer, an even tinier software house, for a mere $50,000 in 1980. In comparison, Microsoft's revenues for system software in 1985 were $75 million. Seattle Computer won some relief later when it successfully sued Microsoft and was awarded $925,000 (Watt, 1986a; 1986b). S. Micropro, which markets Wordstar, hired a programmer, Rob Barnaby, who claims that he wrote most of the code for Wordstar while working for another company, IMSAI. Barnaby's programme was a masterful tour de force, packing a full blown word processor into a 64k CP/M machine. According to John Judis, 'when Barnaby, repelled by Micropro International's corporate culture, quit, the firm's team of programmers were unable to master and improve Barnaby's code' (Judis, 1986). With the emergence of the IBM, Micropro merely ported Wordstar over from the 8 bit CP/M world rather than rewriting it to take advantage of the more powerful 16 bit environment. T. Lotus Corporation suggests another failure of the corporate culture. In John Judis' words: U. ##Lotus followed its brilliant 1-2-3, developed by a single programmer, Jonathan Sachs, by a succession of high-priced, complex and team-produced duds, including Symphony and Jazz. (ibid.) V. Mitch Kapor, founder of Lotus, described the change from 'a small band setting out on a grand adventure' to 2300 people. Kathie Payne, one of the eight public-relations chiefs that Lotus has had in its short history recalled the early days of the company, 'That was the perfect balance, because you had a company with a lot of soul'. She lamented, now 'its all yuppie and no hippie' (Bulkeley, 1988). As a result of these changes in the company, despite its huge cash reserves, the financial press has begun to question Lotus's long-term future (Bulkeley, 1988). W. We should also note that, only in the case of Lotus among these three examples did the programmer reap significant rewards from the marketing and distribution of the program. V. Software as a Meta-Public Good A. Recall that a pure public good was distinguished by the fact it had a zero marginal cost. In the case of a radio signal, one person can receive it without detracting from the consumption of others. Computer software might be called a meta-public good. Let me elaborate on what I mean by a meta-public good. As in the case of a pure public good, the marginal cost of the good is zero. What distinguishes a meta-public good from a pure public good is the fact that each additional user confers a benefit on the other users. Consequently, the cost per unit of benefit from a meta-public good would not just decline as the number of users increased; it would decline exponentially. B. Consider how software qualifies as a meta-public good. By itself, complex software code is usually relatively useless for most people. Very few major computer programs are so transparent, so user friendly, that an inexperienced person can run them without some sort of assistance. The typical user of the typical program requires considerable information about how to use it. C. The knowledge about computer software comes in several forms. First, manuals, books or even on-line help assists the user. Second, software houses can supply direct support about bugs, updates, undocumented features, as well as special applications programs. Finally, other users can lend a helping hand. These users represent a significant positive externality, which is known as a user base (see Katz and Shapiro, 1985; 1986; Farrell and Saloner, 1986). D. As more and more people learn how to use a program, this knowledge becomes more commonplace. Consequently a new user has an easier time discovering what to do with the program. The user base has other advantages. The first versions of a computer program are often spotty. Early adopters of programs act as guinea pigs. They commonly encounter frustrations that can cost them a great deal of time, stress and much, much more. Some of them will notify the supplier about problems in their product. In the process they do a great service in showing the vendor how to improve the program. The larger the installed user base is, the greater the possibility for discovering bugs and even new applications. E. The existence of an installed user base for commercial software encourages people to contribute to the value of the program. In part, the user base creates a market for add-ons that make the program more useful. For example, when enough users become interested in adopting a particular program, people will write books or develop new programs that enhance the productivity of that program. Commercial magazines will publish information on how to make the program more useful. Another response is probably more important than these commercial activities. User groups organize to share information about programs. Their newsletters assist people both within and outside of the formal user groups. F. Because of the strategic importance of establishing a wide user base, early software pirates did a great service to companies, such as Micropro, the vendor of Wordstar, which became almost a standard for word processing among users of CP/M and early IBM compatible computers. The pirates unwittingly created a large installed user base that encouraged others to pay hundreds of dollars for the program. G. The role of users' experience in winning a position as the industry standard can be vital, since no evidence exists for the existence of any mechanism to ensure that the superior products become the standards. The initial success of the IBM PC is a case in point. In short, the net effect of a large user base is to create a rent that the vendor of the program can capture. H. The importance of an installed base is not limited to the software industry. David and Bunn's lively analysis of the struggle over the standard for generating electricity dramatically demonstrates the importance of winning a predominate user base in an industry in which neither alternative had yet achieved clear, technical superiority (David and Bunn, 1988). I. The market for recordings offers an example that is closer to the software market. The recording industry complains about the threat of the availability of inexpensive methods for copying recordings. Indeed, record prices seem to have fallen as a response to the competition from unauthorized duplication. None the less, much copying of tapes and records actually increases the value of records and tapes (Morris, 1988). J. For example, Warner Communications surveyed people who made tapes at home to find out why they made their recordings. They found that many people merely wanted to make copies for their car or office. Others just enjoyed making copies. Some of the sample were creating programs as if they were commercial disk jockeys. Others were trying to preserve the quality of their records. Some of the people who were surveyed were just determining if they wanted to purchase the records. All of these motives worked to increase the value of the record. Perhaps most importantly, unauthorized taping increases the awareness of the music in a way that is comparable to the expansion of the installed user base of a computer program (Morris, 1988). K. A few software companies do behave in an exceptional manner, which makes the market for computer software perform more like the markets that neo-classical economics postulates. For example, some software developers offer extensive customer support. In the process of working with their customers, they can gain significant insight into possible improvements in their own product. This assertion even holds for well developed programs. L. In some cases, the installed base might create excess inertia: The larger the installed base, the more difficult it may be to get people to try alternative programs. However, many computer users enjoy experimenting with new techniques. In any case, the greatest cause of inertia in harnessing the potential of microcomputers is undoubtedly the prohibitive cost of purchasing new programs. M. In conclusion, the more people that adopt a program, the more valuable it becomes. As a result, correcting for the quality or the effectiveness of a program, the cost per unit would decline exponentially as the number of users increases. Firms that market software can charge more money for their programs because of the externalities, such as those that user groups and secondary software producers create. N. Economists have long recognized how such externalities can develop out of the cumulative spillover effects of a seemingly small number of independent decisions. For example, in discussing why industries tend to cluster around a specific location, Alfred Marshall wrote, 'When an industry has chosen a locality for itself, it is likely to stay here long: so great are the advantages which people following the same trade get from near neighborhood to one another' (Marshall, 1920, p. 271). O. From the standpoint of those that sell computer software, the installed user base creates a similar or even more powerful bandwagon effect (Arthur, 1985). People want to take advantage of the expertise that develops around a user base. As more people become enthusiastic about a program, additional users will become encouraged to adopt it. In the process, the program will improve, thereby confirming their initial instincts. P. Given this characteristic of the software industry, standard economic theory suggests that social welfare is improved by subsidizing users, bringing price in line with marginal cost, which is approximately zero. In fact, the case for subsidies is far stronger for computer software than for typical examples of public goods. VI. Other Options for Software Creation A. Writing before the age of microcomputers, Stephen Breyer also argued that certain kinds of knowledge should properly be treated as public goods rather than intellectual property: B. ##It is not unfair to finance through taxes the creation of works that benefit not only those who buy them but also many other members of society as well .... The practicality of administering such a system -- when restricted to works of particular social value -- is suggested by the fact that many governments and other institutions now award such grants and prizes. In the United States the amount of such support is large when compared to the total revenue that scholarly, technical, or scientific writers receive from copyright royalties, and even in the case of literary works it is significant. (Breyer, 1970, p. 287) C. I am convinced that Breyer's insight holds for the computer software industry. D. In the early days of microcomputers, the typical computer user was a skilled programmer. When such a person wanted to solve a problem, he or she merely wrote a program. These programs were often freely shared with other users, either personally or through formal user groups. E. Even after a commercial microcomputer software market emerged, some of the developers marketed their programs as 'shareware' rather than selling them as commodities. They distributed their programs gratis to people who would freely download them from computer bulletin boards. Some of these developers eventually turned their programs into commercial successes by requesting that people send them a fee if the product would turn out to be useful. Because of the absence of marketing and distribution costs, some of these programs earned far more than their creators ever dreamt. For example, Andrew Flugelman, who began this 'shareware' concept as 'an experiment in economics', found that he had to hire people to handle the checks that flooded his office from users of his PC-Talk communications program (Getts, 1988, p. 184). F. The success of shareware in establishing a user base can provide a foundation for a commercial market. For example, after three years of successfully distributing ProComm, a well-written communications program, by bulletin boards, 55,000 individuals and firms had voluntarily sent it their $50 registration fee. Because of the positive reputation of this program the developers began to retail their program through retail outlets (Asbrand, 1988). Building on this user base, they were able to gross a half million dollars per quarter (Getts, 1988, p. 184). In some major firms, experienced in the use of shareware, have been able to convince management to adopt these programmes because they were superior to commercial products selling for ten times as much as the shareware fee (see Pontine, 1989). G. The shareware market lies somewhere between a commercial market and a system designed to distribute a public good. The major objection to treating software as an outright public good, is the claim that nobody would produce it. In fact, the microcomputer software market was begun by people who were willing to put their time and energies into the production of a public good. After all, almost everyone who used these programs knew the names of the people who wrote them. Such recognition can motivate people as surely as financial rewards can so long as the person is not left in squalor and destitution. H. One group that is building on this ideal is the Free Software Foundation of Cambridge, Massachusetts, which is in the process of developing its GNU operating system. GNU is intended to be an alternative to UNIX, the proprietary operating system of AT&T. In contrast to UNIX, which is oriented toward a commercial mission, GNU is decidedly anti-commercial, even though its product may well be superior to UNIX. I. Richard Stallman has expressed the philosophy behind GNU in his GNU Manifesto, which he distributes by electronic mail. I can do no better than cite from this document to give the flavour of the possibilities of this experiment. The GNU Manifesto exudes the excitement evoked by the prospect of working on major computer projects with other like-minded programmers, free from the hierarchical pressures of the commercial world. The Manifesto reads: J. ##If anything deserves a reward, it is social contribution. Creativity can be a social contribution, but only in so far as society is free to use the results. If programmers deserve to be rewarded for creating innovative programs, by the same token they deserve to be punished if they restrict the use of these programs ... K. ##Extracting money from users of a program by restricting their use of it is destructive because the restrictions reduce the amount and the ways that the program can be used. This reduces the amount of wealth that humanity derives from the program. When there is a deliberate choice to restrict, the harmful consequences are deliberate destruction. L. ##The reason a good citizen does not use such destructive means to become wealthier is that, if everyone did so, we would all become poorer from the mutual destructiveness. This is Kantian ethics; or, the Golden Rule. Since I do not like the consequences that result if everyone hoards information, I am required to consider it wrong for one to do so. Specifically, the desire to be rewarded for one's creativity does not justify depriving the world in general of all or part of that creativity .... M. ##Restricting copying is not the only basis for business in software. It is the most common basis because it brings in the most money. If it were prohibited, or rejected by the customer, software business would move to other bases of organization which are now used less often. There are always numerous ways to organize any kind of business. N. ##Many programmers are unhappy about the commercialization of system software. It may enable them to make more money, but it requires them to feel in conflict with other programmers in general rather than feel as comrades. The fundamental act of friendship among programmers is the sharing of programs; marketing arrangements now typically used essentially forbid programmers to treat others as friends. The purchaser of software must choose between friendship and obeying the law. Naturally, many decide that friendship is more important. But those who believe in law often do not feel at ease with either choice. They become cynical and think that programming is just a way of making money .... O. ##For more than ten years, many of the world's best programmers worked at the ArtificialIntelligence Lab for far less money than they could have had anywhere else. They got many kinds of non-monetary rewards: fame and appreciation, for example. And creativity is also fun, a reward in itself. P. ##What the facts show is that people will program for reasons other than riches; but if given a chance to make a lot of money as well, they will come to expect and demand it. Low-paying organizations do poorly in competition with high-paying ones, but they do not have to do badly if the high-paying ones are banned. Q. ##In the long run, making programs free is a step toward the post-scarcity world, where nobody will have to work very hard just to make a living. People will be free to devote themselves to activities that are fun, such as programming, after spending the necessary ten hours a week on required tasks such as legislation, family counseling, robot repair and asteroid prospecting. There will be no need to be able to make a living from programming. R. Stallman offers a number of suggestions of ways that programmers could make a living within a market economy, even if all software were free. These include a voluntary tax paid by computer purchasers, earning a wage by adapting software to specific machines, and support funded by users groups. S. Why would programmers behave in a way that appears to be so altruistic? To begin with, producing for the market generally requires programmers to sacrifice their individual identity. One recent study of the subject concluded that software that is produced for sale 'must be produced by an industrial manufacturing process'. The article continued, 'Only by relinquishing personal control over the deliverable product ... can individual developers guarantee the integrity of the project they are working on .... individual freedom becomes taboo' (Bernstein and Yuhas, 1989, pp. 40-1). T. Given this situation, David Levy, a prominant libertarian economist who generally supports market solutions, understands that markets might not be appropriate for scientific work. He pointed out that people involved in scientific pursuits enjoy the acclaim of the scientific comunity for their successes. This recognition amounts to a signficant nonpecuniary incentive for good work (Levy 1988). U. Other less utopian sounding methods to stimulate the development of software are feasible. For example, the government could sponsor the production of software. After all, the computer itself would not be in existence today without the enormous federal subsidies that launched that industry. V. True, if the government offered to pay all those who volunteered to write software a healthy salary, without controlling for the quality of the product, many people without any interest in producing software would be inclined to take advantage of the opportunity. However, the government could enlist user groups to administer a contest for the development of particular types of software. They could draw up specifications and offer a prize to the winners of the contest (see Nalebuff and Stiglitz, 1983). The US Department of Defence sponsors similar contests although that agency's selection process is coloured by financial and political motives that all too often mar the outcome (see Lichtenberg, 1988). Nalebuff and Stiglitz noted such participants in state sponsored contests or tournaments for software development would have incentives to co-operate, making information flow more easily (Nalebuff and Stiglitz, 1983, p. 40). W. In conclusion, since the marginal cost of computer software is negligible compared to the cost, microeconomic theory suggests that it should be treated as a public good. In the present state of affairs, the market for software fails to capture anything near the full potential of the computer. Even if computer software were not treated as a public good, firms that market software should not be able to collect rents for the externalities, such as those that user groups and secondary software producers create. These externalities are not due to the firms' efforts or skill in creating a program. X. Software companies that do not want to produce public goods have an alternative. They can offer their products on the market at their marginal cost. The firm will not recover the fixed cost of the developing the program, but it can make up these losses by selling support for the program rather than the program itself. Support is a service with a relatively high marginal cost and a low fixed cost. Y. In effect, firms can create a market for their support by providing users with high quality software. Just as a computer program makes the hardware more productive, so to does support make the software more valuable. For example,the Visicalc program made the early Apple II computers valuable to a more general group of users and Appleworks extended the life of the Apple II line, so too can support for the user add to the value of the program. Freely distributing the program is an excellent strategy to create the demand for such support. Where support represents a major emphasis of software developers, piracy would be irrelevant. The vendor, rather than, or perhaps in conjunction with informal user groups, would serve as a vehicle for the transfer of information about the program. Of course, other firms could compete in the market for supporting software, but those firms, lacking in the experience of building a program from the ground up, would be unlikely to dislodge the firm that supplied the program. Z. As things stand today, with a few notable exceptions, firms over-charge for their programs and leave the user to get support from other users, either directly or by reading computer publications published by third parties (Bunnell, 1988). Or even worse -- some firms charge a very steep fee for service contracts, after selling the program for a high price. Some exceptions do exist. For example, WordPerfect provides extensive free support to their customers. It employs a staff of 400 to answer telephone calls from customers who require support (Lunt, 1988). AA. Obviously, companies that control the software industry will resist the sort of changes that I am suggesting. Fortunately, there are some exceptions. One computer software developer, Neil Larson the author of Maxthink, the program with which I am now organizing this work, says that he spends most of his working day talking to customers who call with suggestions about how to improve his program. Customers tell him of novel applications that they have invented for his program. Many of these, he could not have envisioned himself. As a result of these interchanges, he has been able to improve his program and even to move into entirely different areas of software development. AB. Unfortunately, the Maxthink approach is exceptional. One industry source complained, 'The irony is that high prices are necessary only to support large publishing companies that have been built on high prices. There is no reason why the $1.75 million in gross profits generated by a $50 product wouldn't be enough for a good level of advertising and support' (Green, 1985). VII. Conclusion A. The fast-changing computer software industry is bound to evolve in ways that nobody today can foresee. Perhaps something can pressure software producers to make their programs more like public goods; however, current trends seem to suggest a decisive trend toward consolidation. Those programs that revolutionized computer software either came from small, innovative companies or were written by hobbyists. The current market structure is not conducive to replicating these successes. B. People who follow the microcomputer industry today commonly say that the improvements in hardware have outstripped improvements in software. For the most part, the typical microcomputer does today what it did several years ago -- only faster. If our world is to take advantage of the possibilities of new information technology, then we must create an institutional structure that promotes its development. -- Michael Perelman Economics Department California State University Chico, CA 95929 Tel. 916-898-5321 916-898-6141 messages E-Mail michael@ecst.csuchico.edu From michael@ecst.csuchico.edu Sun Feb 2 04:13:12 1992 Return-Path: Received: from munnari.OZ.AU by tigger.cs.adelaide.edu.au with SMTP (5.64+1.3.1+0.50/UA-5.20) id AA17824; Sun, 2 Feb 1992 04:13:10 +1030 Received: from uunet by munnari.oz.au with UUCP (5.64+1.3.1+0.50) id AA14238; Sun, 2 Feb 1992 04:44:49 +1100 (from michael@ecst.csuchico.edu) Received: from cscihp.ecst.csuchico.edu by relay1.UU.NET with SMTP (5.61/UUNET-internet-primary) id AA00766; Sat, 1 Feb 92 11:37:10 -0500 Message-Id: <9202011637.AA00766@relay1.UU.NET> Received: by cscihp.ecst.csuchico.edu (15.11/15.6.R2) id AA09376; Sat, 1 Feb 92 08:37:07 pst From: Michael Perelman Subject: Patents To: gordon@cs.adelaide.edu.au Date: Sat, 1 Feb 92 8:37:06 PST Mailer: Elm [revision: 64.9] Status: RO Gordon, I am interested in your ideas. I introduced some similar ways of approaching patents on a book that I just patented: Information, Social Relations and the Economics of High Technology. -- Michael Perelman Economics Department California State University Chico, CA 95929 Tel. 916-898-5321 916-898-6141 messages E-Mail michael@ecst.csuchico.edu