A few weeks back, Glyn Moody wrote a column discussing why there were no “billion dollar open source software companies,” in response to a discussion he had with Redhat’s CEO (Redhat is in the $750 million range):

He said that he did think that Red Hat could get to $5 billion in due course, but that this entailed “replacing $50 billion of revenue” currently enjoyed by other computer companies. What he meant was that to attain that $5 billion of revenue Red Hat would have to displace software that currently costs $50 billion. Selling $50 billion-worth of software — even if it only costs $5 billion — is somewhat hard, which is why it will take a while to achieve.

I immediately knew I wanted to write up something about it, as it reminded me of a point I’ve been wanting to discuss for a while. But I got busy with some other things, and in the meantime, a bunch of other folks picked up the ball and ran with it — and each time they did, they added something different to the conversation, which gave me more to think about before writing up this post. Matthew Aslett pointed out that this is leading many companies to adopt hybrid models while Stephen O’grady pointed out that the question was really irrelevant. Katherine Noyes, over at LinuxInsider highlighted many other points that people brought up as a part of the discussion. It’s all a very interesting read, though none really hit on the two key points that Glyn’s original column got me thinking about:

1. There absolutely are billion dollar open-source companies, but they’re not pure play open source companies. But that’s okay, because a “pure play” open source company is like a record label trying to focus on just selling music. You’re in the wrong business — trying to sell infinite goods — so of course the direct profits should be limited.
2. The lack of billion dollar pure play open source software companies is a sign of a working efficient economy. In fact, billion dollar pure play open source companies would be a sign of a market failure.

On that first point, I would argue that tons of companies are, actually, billion dollar open source companies: Google, IBM, Facebook and many others, for example, all rely heavily on open source software and are valued at well over a billion dollars. It’s unlikely that any of the three would be anywhere near what they are today without open source software. It’s just that all of these companies were smart enough not to be in the bad business of selling an infinite good. Instead, they all looked for ways to use an infinite good — for free — to make something scarce massively more valuable. With Google it was user’s attention and all of the information out on the web. With IBM it was services to support enterprise technology. Even Redhat, the company that kicked off this discussion, really makes its money from services and expertise.

Arguing about the profits directly attributable to pure play software sales of open source software is like only counting CD/digital download sales and claiming that’s the “music business.” It’s not. It’s the recording industry.

But the more interesting and more important point is about the lack of billion dollar pure play open source software companies is the fact that this is a sign of a strong, healthy and efficient marketplace. Even if you go all the way back to your Adam Smith, you would know that when you have a company making outsized profits, competitors will enter that market. That’s the nature of a free market, and it tends to lead to efficiency, innovation and (most importantly) consumer surplus.

I’m reminded of various studies on modern societies without intellectual property protections (or with very weak intellectual property protections) that often saw thriving and highly competitive industries in those areas. One area that has been particularly interesting to me lately is looking at various countries that did not have patent coverage for pharmaceuticals, but then were forced into it. If you look at the pharma industry in those countries, you see the same story almost every time. Without patents, the industry is thriving with many, many different firms (sometimes hundreds). Yes, a percentage of these firms are certainly pure “copycat” firms, but the ones at the top are not. However, after patent protection is introduced (often with the claim that it will help investment, help competition and help innovation), the exact opposite occurs. Instead, many, many firms either go out of business or are gobbled up by large multinational conglomerates. The overall profits increase to those conglomerates, but the innovation and social welfare declines.

This is, of course, exactly what Adam Smith saw nearly two and a half centuries ago. If you give companies monopolies, they will take monopoly profits, but those monopoly profits come at the expense of innovation and consumer benefits.

So, giant billion dollar companies in markets — especially markets of infinite goods — suggests a market inefficiency of some sort. The lack of such pure play billion dollar companies is a good thing. It means the market is acting as it should, and being more efficient and creating greater economic benefit to the wider market. And this goes back to a point that Glyn makes in his original column:

I think this is the first time I’ve heard someone as senior as Whitehurst admit something rather profound: that open source solutions save money for customers by doing away with the fat margins for existing computer companies — and thus shrink the overall market. Opponents of open source like to paint this as “value destruction” that takes money “out of the economy” — as if free software went around burning down offices and warehouses.

What they fail to grasp is that the 90% savings do not just vanish like the smoke from those supposed conflagrations. That money is still in the economy, it’s just spent on other items: free software allows people to use their hard-won money for things other than operating systems, office suites and applications. In developing countries, for example, it might mean more funds available for education or health.

And that’s exactly the point. When a market is made more efficient, that actually spreads throughout other areas and helps consumer surplus, economic growth and the rest of the world benefit. Automobiles and airplanes “shrunk” the railroad market, but opened up massive new markets. The end result was a much bigger economy and greater economic opportunity and consumer surplus. Automated telephone dialing “shrunk” the telephone operator business, but opened up massive new efficiencies, leading to advancements like the internet itself. And that created massive economic efficiencies and growth and consumer surplus.

So, just as we shouldn’t worry about the lack of “billion dollar” pure play open source software firms, we should also not fall sway to the complaints of companies who are being disrupted by these models, about how all that money they make is somehow “disappearing” if the government doesn’t come in and protect their business model. What’s actually happening is all that money is being put to more efficient use. Unfortunately, it’s rare to see politicians or business leaders who actually understand this simple, but important fact, and it leads them to propping up legacy businesses, which actually slows down innovation, economic growth and consumer surplus.

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