Abstract: Technology platforms, such as Microsoft Windows, are the hubs of technology industries. We develop a framework to characterize the optimal two-sided pricing strategy of a platform firm; that is, the pricing strategy toward the direct users of the platform as well as toward firms offering applications that are complementary to the platform. We compare industry structures based on a proprietary platform (such as Windows) with those based on an open source platform (such as Linux), and analyze the structure of competition and industry implications in terms of pricing, sales, profitability, and social welfare. We find that, when the platform is proprietary, the equilibrium prices for the platform, the applications, and the platform access fee for applications may be below marginal cost, and we characterize demand conditions that lead to this. The proprietary applications sector of an industry based on an open source platform may be more profitable than the total profits of a proprietary platform industry. When users have a strong preference for application variety, the total profits of the proprietary industry are larger than the total profits of an industry based on an open source platform. The variety of applications is larger when the platform is open source. When a system based on an open source platform with an independent proprietary application competes with a proprietary system, the proprietary system is likely to dominate the open source platform industry both in terms of market share and profitability. This may explain the dominance of Microsoft in the market for PC operating systems. 

Insights: (a) Competition between Linux and Windows is best understood as competition between two platforms "fighting" for both users and applications. (b) Cross-side network effects are important determinants of platform strategies. (c) An open source platform does not imply profit destruction in software industry; counterituitively, an open source platform may lead to higher total industry profits, as the proprietary applications sector of an industry based on an open source platform may be more profitable than the total profits of a proprietary platform industry. (d) In the long-term, the variety of applications at equilibrium is larger when the platform is open source and not proprietary. (e) The current dominance of Microsoft Windows in PC operating systems can be explained by the larger variety of applications and complements available currently for Windows -- this does not mean it will continue for ever [Goto (d)].

Keywords: networks, network effects, network externalities, complements, systems, open source software, technology platforms, software industry structure

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