Open Sourcing as a Profit-Maximizing Strategy for Downstream Firms

This paper characterizes and explores a corporate strategy in which downstream firms collaborate to develop open substitute designs for proprietary hardware they would otherwise purchase from upstream suppliers. This strategy centrally involves the downstream firms distributing design costs over multiple downstream firms—a strategy that is routine to producers selling to multiple downstream firms but which has been in the past typically not practical for coalitions of downstream firms. Today, downstream firms find it increasingly feasible to codesign products they may all purchase because of two technological trends. First, computer-aided design/computer-aided manufacturing and other design technologies are lowering downstream firms’ costs to develop designs for purchased hardware inputs. Second, better communication technologies are lowering the costs of doing such projects collaboratively, even among large groups of downstream customer firms. Downstream firms collaborating to develop a design for a hardware input they can all purchase could in principle choose to protect their design as a club good. However, opening up collaboratively created designs to free riders can increase the profits of the contributing firms for several reasons we explore and model. Important among these is that free revealing draws free riders away from purchases of proprietary software or hardware to customer-developed free substitutes. This “scale-stealing” mechanism reduces the markets of upstream suppliers of competing proprietary inputs. In the case of hardware only, free riders also contribute to reducing the average manufacturing costs of the open hardware by increasing purchase volumes and so creating increased economies of scale. Resulting reduced unit purchase costs benefit downstream firms contributing to the free design as well as free riders.