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Open Source and Economics: How the Hold Up Problem Explains the Flash Wars

Last year, when we were finalizing an academic paper tracing the history of public software institutions over the last half a century, Flash (s adbe) stood out as somewhat of an exception – a proprietary solution in the web development world otherwise dominated by open source. Flash’s banishment from Apple (s aapl) suggests that this exceptional position may not last much longer. It also highlights one of the main drivers behind open source – the economic phenomenon known as “the hold up problem,” which is a central point in our research.

The surprising aspect of open source is not its existence, but its success. People do things for free all the time. Among other things, there is no shortage of people willing to share their videos on the web. However, despite the availability of free videos, viewers are often willing to pay money to watch films made by professionals. Professional producers of films in turn usually make full use of copyright laws. In contrast, in many software domains, open source solutions are preferred. The important question about open source is therefore not “Why do people contribute to a project like Apache?” but rather, “Why can’t companies create proprietary products that can beat Apache on the market?”

The reason is based on what economists call “the hold up problem.” When a business relies on assets owned by another party, it may become dependent on that party’s cooperation in the future. In this situation, the party with ownership of a key resource may gain the ability to “hold up” its partner, demanding an unreasonably high price. Hold up becomes a problem especially when a business needs to make large capital investments that assume future cooperation from the owner of a complementary asset.

The hold up problem is particularly severe in the IT sector. Building an Internet company on a foundation consisting of proprietary software owned by others is akin to building a house without owning the land under it. When software is sold in binary form, the buyer is subject to hold up by the vendor; if the software needs to be changed in the future, such changes can only be done with the cooperation of the original vendor at the price that the original vendor demands. By relying on open source, a company can invest in developing its product without fear of being held up down the road. Therefore, open source is an economically powerful solution to the hold up problem.

This holds true even when an open source solution is originally not as good as a proprietary alternative. A technology company using an open source solution benefits from being able to make large complementary investments (and reap of the corresponding efficiencies) without fear of hold up. For example, Facebook has relied heavily on PHP in building its products. When PHP didn’t meet their needs, they fixed it.

Programming languages and software development platforms are particularly at risk of hold up. Software written in a particular language is only useful in combination with a programming language interpreter. Such software presents an investment that could easily be lost if its use depends on future cooperation of the owner of the interpreter. For this reason, software development platforms are a niche where open source has been most successful.

Flash is a proprietary software development platform and products built on Flash are at risk of hold ups. The recent attacks on Flash, most notably from Apple, are therefore not surprising. Apple is heavily investing in its iPad ecosystem. If software written for the iPad makes use of Flash, Apple’s ability to profit from its investments would require future cooperation of Adobe. Banishing Flash from the iPad now avoids future hold up. With the recent release of the WebM project, Google (s goog) has joined the campaign to replace Flash with open source alternatives. (Unlike Apple’s alternatives to Flash, WebM promises a fully open source solution for web video).

It may seem ironic that the Flash protest has been instigated by Apple — the owner of one of the most closed development platforms today — but it’s hardly surprising. Actors who control valuable resources often stand to benefit most from the openness of complementary products. It remains to be seen, however, whether Apple’s own closed platform will continue to be successful in the face of open source alternatives.

Michael Schwarz is the principal scientist at Yahoo Labs and Yuri Takhteyev is an assistant professor at the University of Toronto School of Information.

17 Responses to “Open Source and Economics: How the Hold Up Problem Explains the Flash Wars”

  1. ChimChim

    “It remains to be seen, however, whether Apple’s own closed platform will continue to be successful in the face of open source alternatives.”

    Interesting that the paper refers explicitly to the iPad as the platform, yet infers that open source will be a threat to that. Since there is no open source threat to the iPad presently (no Android tablets shipping from major manufacturer), the context seems to be more iOS in general, and the threat from Android.

    However, given the enormous amount of iOS devices in use (phone and media players AND pads), the success of Apple’s closed platform cannot be questioned. (The same could also be said of closed RIM, whose devices also function as phone, readers and media players.)

    A more accurate sentence would have been “will continue to be as successful”. The failure to quantify calls into question the prejudices of the authors, and their accuracy in assessing/applying the “hold up” theory.

  2. I see this as a bit of a contrived argument in the case of Apple and iPad. From a legal standpoint, contracts solve the “hold up” issue and I’m sure that Apple has enough influence in the industry to get some sort of contractual assurance from Adobe in terms of continued support for a significant number of years (longer than we will have iPads around at any rate).

    Besides that, doing a “hold up” is nothing more than mutually assured destruction. If Adobe were to provide Flash on iPad for say, two years, and then pull support afterwards it would damage Adobe’s business as much or more as it would damage Apple — there is no commercial value for Adobe in such a strategy. Adobe benefit greatly from maximum proliferation of Flash platforms because Adobe sell the tools to work those platforms.

    It’s not as if Apple is ever going to be writing the core iPad platform to depend on Flash, at most it will only be third party applications.

    Finally, the real proof that “hold up” is not a key concern for Apple is their approach to Java. Now, remember that Java has at least three independent implementations, and the language specification is completely open so anyone can build a new implementation — yet Apple steadfastly refuse to support Java on any of their mobile devices. Why could this be? The real reason is they don’t want anything that might offer users an alternative way of downloading apps so every Apple user becomes a slave to Apple’s “App Store” and that is why they will not allow any third party language platform no matter how open.

    On the positive side, jailbreaking your equipment has now been declared legal I believe.

  3. Interesting article but has a MAJOR floor.

    Hold up is not applicable to software development.
    In general, any (good) software product that ages goes through complete rewrites every 3-4 iterations. If you are held up, you iterate sooner. Also, in terms of Web and RIA development, complete re-writes and change in technology components can happen even more often.

    So this “Reasoning” for Apple to drop flash simply does not hold water.
    Grate spin, but get into the real world mate.


  4. Porter identified the “hold up problem” many years ago, as the “vertical competition”, particularly the “bargaining power of suppliers”.

    “Porter’s five forces include – three forces from ‘horizontal’ competition: threat of substitute products, the threat of established rivals, and the threat of new entrants; and two forces from ‘vertical’ competition: the bargaining power of suppliers and the bargaining power of customers.”

    “The bargaining power of suppliers is also described as the market of inputs. Suppliers of raw materials, components, labor, and services (such as expertise) to the firm can be a source of power over the firm, when there are few substitutes. Suppliers may refuse to work with the firm, or, e.g., charge excessively high prices for unique resources.”

    Ex. If you are making cookies and there is only one person who sells flour, you have no alternative but to buy it from him.

  5. “Google has joined the campaign to replace Flash with open source alternatives. (Unlike Apple’s alternatives to Flash, WebM promises a fully open source solution for web video).”

    Yes, that is why Google is bundling Flash Player with the Google Chome browser and supporting it in Android 2.2 / Froyo?

  6. I do not disagree with the principle/thesis of hold-up, but there are some situations where this principle applies and several where it doesn’t.

    Adobe/Flash, clearly is a soft target. Let’s pick on others who seem to defy the hold-up hypothesis.

    Microsoft (windows, office) might sound so “last decade”, but the fact is, Microsoft defies the hold-up hypothesis. Much as we may like Linux and OpenOffice or Google Docs or what-have-you, Microsoft will continue to laugh their way to the bank for a while to come. And why not? Ordinary users do not mind paying and seem to mind the “cost of change” (not dollars, but unfamiliarity).

    Google (as in search) is another telling example of what proprietary software can give you. And what open source cannot. For all it’s seemingly philanthropic tech initiatives, it is the VERY-VERY closed search algorithm that runs the Google gravy train.

    Oracle, SAP in the database world are not exactly known for open source either.

    One could go on and on listing counter examples…

    The only place where open source seems to have created a niche is with the IT aware/geeks or IT-enabled business-men (think mobile handset makers). Linux, Android are there, gcc and the rest of the tools live there, Firefox lives there.

    Also, let’s not conclude that every (consumer electronic) device using Linux is cheaper because it uses Linux (instead of a non-open OS). A number of Linux “merchants” have sprung up over the years, charging device makers AS MUCH AS (or more than!!) closed operating systems for packaging and supporting Linux for their devices. Hold-up = money. Period.

    In any case, the non-geeks of the world do not recognize the hold-up situation with software, just as the average car buyer does not bother about whether he can customize / change the engine or the gears or the air bags. Come to think of it, a more interesting research question would be the popularity (or prevalence) of open source in other industries.

  7. Aspects of this have been well known for some time. Anyone associated with academia in the U.S. is very familiar with government agencies, the U.S. Department of Defense in particular, funding computer science and engineering projects for code that is intended from the beginning to end up in the public open source domain. It’s an important source of funds for research assistants. The word used here is “hostage,” as in not being hostage to code from a company that might not exist next year.

    The Apple/Adobe Flash situation is probably not a good example in this case. Apple exercises strict control over what capabilities third-party apps bring to the iPhone. Flash is not just a media player, but a full platform of its own with the potential to end-run Apple’s control. If Adobe was to cripple Flash sufficiently to satisfied Apple’s concerns, I don’t anyone would be happy with the result.

  8. Mark Hernandez

    Very insightful and well written! I would just ask that EVERYONE be careful of “binary” references such as open/closed.

    The situation Apple and any other company is in is very complex, and each company deals with a large set of tradeoffs and chooses their own particular balance between those tradeoffs.

    Everything is a moving target, and companies must be like an amoeba, constantly moving and changing their “balance of tradeoffs” to adapt to the marketplace which is constantly being broadsided by innovation and competitive counter moves.

    Apple’s “system,” like any other, is neither totally open or closed, but a complex mixture of the two which gives them what they see as their competitive advantage. And it will constantly be morphing.

    Apple is about to broadside the industry again with the new iPod Touch and change the balance of things with the Touch’s FaceTime capability, even though they’ve also published the FaceTime specs for all to use freely, for instance. The amoeba is moving thataway and pulling in one of it’s other sides.

    So please everyone, try to avoid black and white references so we can all contribute to a better understanding of what’s really going on, rather than polarizing each other into camps and then getting sidetracked with binary references and semantics and learning little, except that humans (including people in the tech industry) have a difficult time understanding and discussing complexity.

    Mark Hernandez
    The Information Workshop

    • Narayanan

      Excellent reply to an excellent post.

      Apple was the victim of the holdup issue from MSFT and ADBE amongst others and so they are just covering bases. And as younsay, it is not a black and white situation.