Optimal software design and pricing in the presence of open source software

Open source software (OSS) has become an increasingly threatening competitor to traditional proprietary software. In this paper, we study the competition between proprietary and OSS by considering consumer’s taste difference using a Hotelling model. In particular, we seek to answer how commercial software vendors should optimally set the price and design its product. Our analysis suggests that the optimal strategy of the commercial firm is dependent on consumer’s fit cost and the positioning (design) of open source software. Specifically, we find that if the OSS is targeted to consumers with extreme requirements, the commercial firm should serve only a proportion of the entire population and the commercial firm’s profit is maximized. Furthermore, our analysis shows that the social welfare is maximized when open source software targets more specialized users. Further, In the presence of positive network externalities, the commercial firm enjoys greater profit when there’s positive network effect. However, the commercial firm’s profit is not monotonically increasing or decreasing in network intensity.