The puzzle of open source software explained in economic terms

How do we explain the craze behind open source technology? And why did it gain so much importance? Why do companies spend so much resources developing a platform and then simply license it out for others to modify and distribute? To understand all these, we need to understand the concept of overall market widening.

Economics teaches us that perfect competition is the best scenario for the common market. In a perfect competition, consumers have all the choices they need and they make the final call. If you are a new player in the industry, you can easily enter the market without any barriers to entry. In short, it is win-win.

However, the common perception is that existing players in a market do not desire that someone new comes in. This is because whenever someone new enters a perfectly competitive market, they will end up taking profits from the existing market. Individual profit margins will deteriorate. In the vast majority of cases, this is true.

But what happens when an industry is new or nor fully formed yet? Let us say that a new niche has been identified and there are only three of you serving that niche. It is a great place to be in if you simply look at profit margins, since customers do not have a choice due to a lack of supply. But then, what about demand? How do you really grow your customer base when the vast majority of people don’t even know you exist?

It is here that the concept of welcoming competitors comes into play. When you welcome competitors in by reducing the barriers to entry, you ensure that the overall market grows, and you grow along with it. With this, you manage to increase your revenues despite the fact that your competition just went up. This is why open source developers license their software almost for free.