10.1 Introduction

Learning Objectives

After studying this section you should be able to do the following:

  1. Understand how low marginal costs, network effects, and switching costs have combined to help create a huge and important industry.
  2. Recognize that the software industry is undergoing significant and broadly impactful change brought about by several increasingly adopted technologies including open source software, cloud computing, and software-as-a-service.

For many, software has been a magnificent business. It is the two-hundred-billion-dollar-per-year juggernaut (Kirkpatrick, 2004) that placed Microsoft’s Bill Gates and Oracle’s Larry Ellison among the wealthiest people in the world. Once a successful software product has been written, the economics for a category-leading offering are among the best you’ll find in any industry. Unlike physical products assembled from raw materials, the marginal cost to produce an additional copy of a software product is effectively zero. Just duplicate, no additional input required. That quality leads to businesses that can gush cash. Microsoft generates one and a half billion dollars a month from Windows and Office alone (Vogelstein, 2006). Network effects and switching cost can also offer a leading software firm a degree of customer preference and lock in that can establish a firm as a standard, and in many cases creates winner-take-all (or at least winner-take-most) markets.

But as great as the business has been, the fundamental model powering the software industry is under assault. Open source software (OSS) offerings—free alternatives where anyone can look at and potentially modify a program’s code—pose a direct challenge to the assets and advantages cultivated by market leaders. Giants shudder—“How can we compete with free,” while others wonder, “How can we make money and fuel innovation on free?” And if free software wasn’t enough of a shock, the way firms and users think about software is also changing. A set of services referred to as cloud computing is making it more common for a firm to move software out of its own IS shop so that it is run on someone else’s hardware. In one variant of this approach known as software as a service (SaaS), users access a vendor’s software over the Internet, usually by simply starting up a Web browser. With SaaS, you don’t need to own the program or install it on your own computer. Hardware clouds can let firms take their software and run it on someone else’s hardware—freeing them from the burden of buying, managing, and maintaining the physical computing that programs need. Another software technology called virtualization can make a single computer behave like many separate machines. This function helps consolidate computing resources and creates additional savings and efficiencies.

These transitions are important. They mean that smaller firms have access to the kinds of burly, sophisticated computing power than only giants had access to in the past. Start-ups can scale quickly and get up and running with less investment capital. Existing firms can leverage these technologies to reduce costs. Got tech firms in your investment portfolio? Understanding what’s at work here can inform decisions you make on which stocks to buy or sell. If you make tech decisions for your firm or make recommendations for others, these trends may point to which firms have strong growth and sustainability ahead, or which may be facing troubled times.

Key Takeaways

  • The software business is attractive due to near-zero marginal costs and an opportunity to establish a standard—creating the competitive advantages of network effects and switching costs.
  • New trends in the software industry, including open source software (OSS), hardware clouds, software as a service (SaaS), and virtualization are creating challenges and opportunity across tech markets. Understanding the impact of these developments can help a manager make better technology choices and investment decisions.

Questions and Exercises

  1. What major trends, outlined in the section above, are reshaping how we think about software? What industries and firms are potentially impacted by these changes? Why do managers, investors, and technology buyers care about these changes?
  2. Which organizations might benefit from these trends? Which might be threatened? Why?
  3. What are marginal costs? Are there other industries that have cost economics similar to the software industry?
  4. Investigate the revenues and net income of major software players: Microsoft, Google, Oracle, Red Hat, and Salesforce.com. Which firms have higher revenues? Net income? Which have better margins? What do the trends in OSS, SaaS, and cloud computing suggest for these and similar firms?
  5. How might the rise of OSS, SaaS, and cloud computing impact hardware sales? How might it impact entrepreneurship and smaller businesses?


Kirkpatrick, D., “How the Open Source World Plans to Smack Down Microsoft and Oracle, and…,” Fortune, February 23, 2004.

Vogelstein, F., “Rebuilding Microsoft,” Wired, October 2006.


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