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A short essay about value in software. Conclusion: CIOs and government need to take a very good look at free software for desktops and other generic software.

What makes value in software? Value in anything is what people are prepared to pay for it. There are lots of ways this gets set. For something unique, an irreplaceable painting by an old master, say, the value is typically set by auction. Or take a new car – you can often shop around for deals for your chosen model, but the price is pretty much set by the manufacturer. Manufacturers control the price, but if they set it too high they risk going out of business because there is competition between different manufacturers and models. This means that the price of a new car shouldn’t go too much above the costs to manufacture, distribute and sell the car – except maybe at the high end where manufacturers can get away with a premium for the brand name.

Another example is a piece of government stock. That’s a piece of paper (actually, the paper itself has been done away with but the principle is the same) that says that the government will pay its owner certain sums of money on certain dates. Because government stock directly converts to money over a period of time, its quite easy to work our what the price should be – you just figure out what you think interest rates are going to do over that time and get your calculator out.

Some goods have a ‘secondary market’, or a way of trading them after the goods have first been sold by their manufacturer. For cars, that’s the used-car trade. Of course, a used car is not the same as a brand new one – people are prepared to pay a premium for a new one. And used cars of the same model and vintage might fetch different prices if they were in different conditions – high versus low kilometres, stained upholstery versus showroom condition etc. Financial instruments like government stock have a thriving secondary market, partly because ‘used’ stock is just the same as any kind. It’s all the same, or fungible in the jargon of financial markets. Its quite different in the market for old masters. The number of people who can afford to spend millions on a painting is quite small, and trades don’t happen very often, but most importantly every painting is different so its hard to set a price for one based on the another.

The availability of a secondary market encourages people to buy a good in the first place. If you don’t like driving old cars, you want to be certain that you will be able to sell the new car you have your eye on today in a couple of years time, and get a fair price for it. And in financial markets, having a secondary market is so essential that it has its own name – liquidity.

What does this tell us about software? Let’s look at the similarities. Is software unique, like a painting? Some is, usually software that is written by or for a big corporate for its own use. Millions get spent on this, and sometimes the developments fail to meet expectations. Custom software is often very costly, although this doesn’t have to be the case. But a lot of software is fungible, in that all copies of the same piece of software are the same. Desktop software like Windows or Microsoft Office fall into that category. Even so, there mostly isn’t a secondary market for fungible software. That’s because the software supplier doesn’t grant you ownership of the software – they sell you a licence, and the terms of the license often prevent you from selling the software on. So, the pricing of software is unaffected by a secondary market.

What drives the pricing of desktop software? Unlike physical goods, software has upfront development costs but very little cost of producing each copy. So the traditional cost-based model that we use for, say, cars doesn’t apply. The competition for Microsoft Office, say, is mainly from the free OpenOffice, although the (also free) Google Docs, which runs on Google’s servers rather than on your computer, is getting some attention. Another paid alternative is Apple’s iWork suite which goes for a lot less than Microsoft Office but only runs on Apple hardware. So, the price of Microsoft Office is staying high despite the availability of free competition. That’s a neat trick, and its achieved mainly through the fear of re-training costs and incompatibility. Incidentally, its why Office is available for home users at a far lower cost than it is for commercial users.

But, the question for those of us who use software is: what drives the price? And, how can we justify using software with any kind of price tag in today’s environment when free software is available? That’s particularly a question for CIOs as they see their budgets slashed in the recession. And it’s very relevant to government, which buys an enormous amount of desktop software – so much so that it tries to negotiate specific government wide deals with the main vendors, in an attempt to control its software costs.