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.