Open Source Commentary from Navica's CEO, Bernard Golden

June 2006

In This Issue

• Andy Kessler on Open Source Elasticity of Demand

• Navica News

This month's newsletter takes as its inspiration a chapter from a recent book, Just One Thing (John Wiley and Sons, 2006), a collection of essays organized by a well-known investment writer, John Mauldin (you can learn more about Mauldin and sign up for his very enjoyable weekly newsletter here).

Mauldin asked a number of colleagues to write a chapter containing the single best investment idea they knew. While all of the chapters are thought-provoking, I'd like to focus on one essay by Andy Kessler. Kessler is a former investment analyst, venture capitalist, and hedge fund operator, who has written a couple of fascinating books discussing his career on Wall Street (Wall Street Meat) and the history of technology (How We Got Here).

Andy Kessler on Open Source Elasticity of Demand

Kessler begins his chapter describing a near-disastrous hike up Mount Washington one clear sunny day -- that quickly turned into a cold, wet trudge surrounded by impenetrable fog. He was saved that day by moving from one signpost to another, depending upon each to lead him to the next without any complete path in view. Investing, he says, is much like that dangerous hike -- that significant returns depend upon incremental decisions based upon the limited visibility available at any moment -- because if you stand in clear sunshine the view is available to everyone.

However, he has carried a set of guidance with him throughout his career -- guidance that has directed his investment philosophy throughout, consistent no matter what the individual investment decision of the moment happened to be.

Kessler writes that his entire investment career has been built on two insights:

Elasticity (lower cost creates its own huge markets)
Intelligence moves out to the edge of the network

To wit: As computer chips get cheaper, use of them goes up; and, those chips get put in increasingly-powerful devices that operate on the outer boundaries of the network. Simple, eh?

Applying these insights made Kessler's clients (and Kessler himself) very wealthy as he invested in companies that grew because of increased demand for chips or for products that incorporated those increasingly powerful chips.

The Internet is a testament to Kessler's second insight. The original communications network -- the telephone system – is a network of central intelligence and dumb peripherals. All new functionality needs to be developed and delivered by the network owner – the phone company – but also, crucially, needs to be envisioned and invented by the network owner as well. As a former phone company employee, I can testify that telecom companies are excellent operators, but run a bit short on imagination and creativity.

By contrast, the Internet is quite simple. It does not attempt to deliver or even dictate what applications run on it; it merely seeks to guarantee packet delivery via best effort. The Internet allows, even demands, end user imagination to create new applications. It does not attempt to forecast what will communicate via its network; it instead supports the ability of new applications to operate across its connections.

It's easy to see the results of the dumb but faithful network. Just to name a few: a painful restructuring of the publishing and media industries; many new entertainment options available via services like Tunes, delivering digital payloads to mp3 players (intelligent devices hanging off the edge of the Internet); efficiencies wrung out of processes by businesses desperate to respond to the market entrance of a globe's worth of competitors.

Naturally, all of these trends are made even more powerful by Kessler's other insight: elasticity. As the price of these edge devices has dropped (and the cost of bandwidth served up by the dumb network has dropped as well; after all, it uses chips too), demand and use has skyrocketed.

Kessler is mostly a hardware guy (he was a chip analyst during his Wall Street days). I'd like to explore how his two insights apply to software; specifically, what they mean in a world of open source software.

It's often difficult to appreciate just how radical the price/performance improvement of digital goods is. Humans are very capable of observing and understanding gradual change: we note how a company's earnings increase 10% year over year; we see that our new car gets 15% better mileage than our previous six-year-old one; we understand that a one-hundredth of a second improvement in the 100 meter world record is a significant accomplishment.

But trying to understand the year-on-year doubling of digital processing power (or, the halving of price for the same performance, to take the inverse of Moore's Law) is mind-boggling to most humans. Today's $1000 Intel chip will cost $500 next year. Only $250 the year after that. Less than a dollar in ten years. As a species, we're just not set up to comprehend that scale of improvement.

On the other hand, we can see the evidence of Moore's law daily, as yesterday's luxury good becomes today's middle class trophy, and within a few years is a freebie thrown in with a gasoline fillup. This is Kessler's price elasticity – as price decreases, demand explodes.

What then to make of a digital good – open source software – that never rides down the cost reduction curve? Open source starts its elasticity journey at the point most goods only reach after years of existence -- free. It never has a period of only being available to the wealthiest segment of a society because of high price.

The theory of price elasticity tells us free software will inevitably generate a boom of use. With price no barrier to software implementation, demand for software will skyrocket. And, indeed, that is what is happening.

The first stirrings have been seen in the nascent Software-as-a-Service industry. Most of the companies delivering SaaS use open source software throughout their infrastructure. By building upon open source components, they deliver mainstream business applications at an attractive price point and make them available to entire new sectors of the economy.

And, of course, the so-called "Web 2.0" has been enabled through the use of open source software. Open source has allowed these Web 2.0 companies to build their initial offerings for just a few hundred dollars; the ones that have caught on have been able to scale their infrastructure cheaply by leveraging open source.

So we can already see the price elasticity of open source software at play in these offerings. However, I don't think Saas and Web 2.0 represent more than the initial, faint evidence of the impact open source's elasticity will have. Why is that?

SaaS, when you strip away the gee-whiz of “The End of Software,” is really nothing more than vanilla business software operating in a remote data center. SaaS delivers bog-standard business applications at the end of an Internet connection.

And Web 2.0 is essentially consumer diversions – great ways to share photos or post funny videos. Free entertainment -- fun, but hardly economically earth-shaking.

At the end of the day, both SaaS and Web 2.0 represent some organization delivering functionality to users; in other words, a central entity imagining and creating a service it believes end users will want. Put more bluntly, in these initiatives, open source has been used to implement a smart network.

Kessler's second insight – a dumb network facilitates smart devices -- also applies to open source software. His formulation focuses on hardware devices, but there's no reason we can't think of open source-enabled organizations attached to the network as a type of “smart device.”

Instead of a special purpose piece of hardware providing specific functionality, organizations can take advantage of open source to create specific functionality using the Internet as a playing field to operate upon.

Open source software, because of its low cost, offers opportunities for organizations to create special-purpose applications. Because open source is free, organizations are more likely to experiment with it, developing new applications that could never be justified in a world of proprietary, costly software. When the first step in dreaming up a new application is going through the process of budgeting, capital allocation, and purchasing, it's natural that the only applications that ultimately get built are those with the best justification, the clearest use, and the most immediate payback – a scenario designed to ensure that the only systems that get approved are those that offer incremental improvement to existing processes.

Open source, on the other hand, removes most of those institutional barriers to application creation. Open source supports application experiments, offbeat initiatives, and quirky visions – in other words, it underpins just the sort of creative endeavors that lead to non-incremental results.

Kessler's two insights indicate that open source software will engender an explosion of creativity for end users. The ultimate elasticity it delivers via free digital distribution will set the stage for an enormous increase in software use. And, as organizations use free software to develop new, unheard-of, undreamed-of applications, we'll see the rise of the “organization as edge device” offering specialized functionality to audiences/users for whom today's generic solutions are inadequate.

Of course, Kessler applied his insights to a very special end: making a boatload of money for himself and his investors. It's safe to say that open source's unique characteristics will provide those kind of returns -- and more.

My prediction is that the true economic impact of open source will be seen not in the reduced stock prices of proprietary vendors or even in the acquisitions of open source software companies. The biggest economic impact of open source will be in the new applications that spring into being, enabled by open source price elasticity and new "edge of the network" organizations.

Navica News

You can hear me speak at these upcoming events:

June 16, 9:00 a.m.: Burton Group Catalyst Conference. Presentation topic: "Open Source ROI: The Real Story"