Creative Destruction

Sunday, February 11, 2007
What Would Schumpeter Think Of Open Source?

If “theories of the firm” are really “theories of relational contracting” per Smith and King (2007),1 then contracting is really the raison d’etre of the Free Software movement. This also aligns with the Coase-ian answer to “Why is there any organization?” (Coase, 1937).2

In “Coase’s Penguin: Linux and the Nature of the Firm,” Benkler (2002)3 maps Coase’s ideas on this new phenomenon. The instinctive reaction is — of course, open source organizations are “organizations” in the way Katz and Gartner mean (1988)4, and, of course, open source licenses are “contracts” in the way Smith and King (2007) imply. Does it follow that open source organizations are a natural evolution of capitalism? Is open source a legitimate heir of capitalism in the Schumpeterian sense? Is open source an entrepreneurial activity?

A typical open source organization is a coalition of spatially dispersed collaborators held together by two kinds of glue — an intangible glue that could be best described as a pastiche of moral, anti-establishment, self-aggrandizing sense, and a definite, legally binding, contractual glue. There are not many physical assets belonging to this organization — a charter, guiding principles or bylaws, and an article of incorporation along with a server or two to provide web-presence are usually about all by way of infrastructure. The web or email list server is also usually a shared or donated item of infrastructure with a definite sense of communal ownership. If the organization is mature enough, there might be periodic meetings or user-conferences that may bring together the members and users of the organization held via Internet Relay Chat (IRC) or Voice-over-Internet Protocol (VoIP). The legal organization itself is usually very tiny relative to the user-base. And, while the legal contract is binding, it rarely is enforceable. The organization has no physical presence, and while it is as ubiquitous as the availability of network access, it is usually governed by the laws of the land where it is incorporated.

Many newer and looser open source organizations may not even be registered or incorporated. A developer might decide to put out his or her work as an open source project under one of the many readymade and popular open source licenses. If other developers and users download, use, and contribute back to the project, it might take on a new life that may range from anywhere between a very loose, rag-tag collection of members to a more formal, registered and incorporated legal entity. Otherwise, it might just die a natural death through low subscription, underuse, neglect and abandonment.

All this is very different from what McKelvey (1980)5 envisioned when he talked of organizations. In the traditional world, organizations are firms, they have a brick-and-mortar presence, a physical mailing address, and many other characteristics such as a phone line, a receptionist, and assets. If the firm is situated in more than one physical locations, typically each location is subject to the laws of the jurisdiction it falls within.

As described by Katz and Gartner, McKelvey notes four major properties of organizations: the structural properties of resources and boundaries and process-based properties of intentionality and exchange. Katz and Gardner focus on organizations that are not yet organizations, that is, they don’t yet exist in a form that is traditionally recognizable as an organization.

Why do Firms Develop?

Efficient Markets Theory says that given everything else being equal, those who are capable of providing goods and services at the lowest possible cost already do so. Once the floor is reached, differentiation can only take place by providing something extra beyond the stated goods or services. In such an environment, one would expect that individual, self-employed independent operators would contract with each other to do business. Firms can develop only when an individual hires another individual on a “permanent” basis, but in an efficient market, there would be no reason for anyone to do so.

So, why do “firms” develop at all? Firms develop because the cost of doing business solo and outsourcing help becomes more than hiring the help in-house. There are many different costs to using outside labor, even if that labor is the “cheapest.” These costs are termed as “transaction costs.” Firms develop to lower the transaction cost of doing business. Firms keep on growing as long as hiring continues to lower the transaction cost. The size of a firm reaches an equilibrium when their is a balance between the cost of using in-house labor versus outsourcing the work to someone outside.

While outside the firm it is the price that determines production through a “series of exchange transactions on the market,” there are no such transactions within the firm. Instead, there are the coordinators or the managers who direct production. So, why is there such organization in the first place?

Well, firms could emerge because people want to work under others, and they would do so for lower pay. But this would be contrary to the tendency to be one’s own master. Firms could also emerge if people desired to have others work under them. But that would imply that those who want to control would be willing to accept lower pay for the privilege of doing so. Firms could also arise if the commodities they produce are preferred over commodities produced by non-firms. But firms are found even where this is not true. The real motivation to forming firms is to reduce transaction cost. There is cost associated with using the price mechanism itself. Cost of negotiating separate contracts for each transaction can also become onerous. While not eliminated, such costs are greatly reduced in the case of a firm, as contracts are not required of its employees for every single task.

Of course, there is still a contract, the employment contract — the employee basically agrees to follow orders, within limits, for a certain remuneration. Length of the contract can also lead to expenses. A longer term contract is preferable to several short term contracts because of the costs involved. So, it is to lower these market costs that a firm emerges. It is believed that the entrepreneur or the manager will be able to get production at a lower price than the market, and can always revert back to the markets if she fails to do so. Per Coase, “A firm, therefore, consists of a system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur.” A firm will continue to expand until the cost of doing work within the firm will become equal to or more than the cost of getting the same work done outside. This is the capitalistic process.

Creative Destruction

Joseph Schumpeter railed against those who misunderstood capitalism in his view. He contended that the theorists of monopolistic and oligopolistic competition might suggest that capitalism is unfavorable to achieving maximum performance in production. According to Schumpeter, capitalism is evolutionary. It is a form or method of economic change and is never stationary. He said, “The process of industrial mutation incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” This, according to Schumpeter, was the process of “Creative Destruction,” and it is an essential fact of capitalism.

So, what does “Creative Destruction” do? Schumpeter (1950)6 said, “We are dealing with an organic process, analysis of what happens in any particular part of it, say, in an individual concern or industry, may indeed clarify details of mechanism but is inconclusive beyond that. Every piece of business strategy acquires its true significance only against the background of that process and within the situation created by it. It must be seen in its role in the perennial gale of creative destruction; it cannot be understood irrespective of it or, in fact, on the hypothesis that there is a perennial lull.” The only thing constant about capitalism was change as even the best system today is likely to become second to something better tomorrow. In capitalism, organizations grow through change. Even those organizations that seem to be monopolies are constantly changing even though they would seem to have little motivation for change. For example, Walmart continually seeks to keep prices low by innovations in supply-chain; Target differentiates itself from Walmart through perceived style; and even so, upstarts such as iTunes can gain competitive advantage and become their own monopolies. Emerging companies are able to strike established monopolies through competition from new commodity or technology, or through the new source of supply, or via a new type of organization.

Open Source As “Creative Destruction"

Steven Weber (2004)7 contends that open source, “Is a way of organizing production, of making things jointly.” As such, it is a threat to existing monopolies that either embrace innovation or die. An open source organization has process (intentionality and exchange) and structure (resources and boundaries), and as such, is no different from the emerging organizations studied by Katz and Gartner (1988).

In Coase’s world an organization comes to be when the transaction cost of doing business as an organization is less than the transaction cost of doing business as an individual. The entrepreneur hires help to assist her in carrying out tasks that would otherwise detract her from her primary value production activity.

In the open source world there is no traditional business. The product of open source is bits not atoms. Distance, or spatial distribution, increases the cost of transactions, therefore inventions that could overcome this barrier would tend to increase the size of the firm. Coase hypothesized that telephone and telegraph would reduce the cost of organizing spatially. That is exactly what the internet did. Knowledge is indivisible and irreducible, and since computing technology is founded on networking technology, distance dispersion is immaterial in this revolution. Petersen and Rajan (2000)8 claim so in “Does Distance Still Matter? The Information Revolution in Small Business Lending.” Since the traditional transactional cost is minimal, and the work is divisible, the open source organization exists to procure assistance directly in the production of value which, in this case, is usually a software, but could also be data produced by the software. This shift from bits to atoms and from the need for proximity to spatial independence strikes at the very “foundations of how markets and democracies have coevolved for almost two centuries.” (Benkler, 2007).9

Recent years have seen the rise of a few newer models of organizations — there are the completely virtual organizations, and there are the hybrid organizations that have both virtual and physical presence. The division between the two, however, is less clear-cut as it might be assumed. Even most virtual organizations, that is, those that conduct all their customer-facing business almost exclusively virtually, typically utilize physical warehouses or distribution centers, especially if they are dealing in physical goods. The hybrid organizations are usually one hundred percent physical organizations that branched out into online commerce. So, we have primarily virtual organizations that acquire physical assets necessary for functioning, and we have primarily brick-and-mortar organizations that now have online storefronts.

Just as firms are formed to reduce inefficiency, they engage in contractual relationships to reduce uncertainty because uncertainty also leads to inefficiency. We conclude that open source organizations are indeed organizations. This idea is reinforced by the system of contractual agreements within which these organizations exist. They offer their products, services, and infrastructure via contracts that determine how these offerings will be used. The contracts determine how these organizations relate to other individuals and organizations.

Large cooperative software projects such as Linux under the General Public License (GPL) can force cooperation. Given a piece of Free Software, everyone can study the (modifiable) source code and make improvements. One can decide to keep secret the improved version and distribute it in an unmodifiable binary form or one can share the improved version in a modifiable source code form. If everyone defects, then it is likely that many are probably making exactly the same improvements, and that would be very inefficient. By forcing cooperation, a contract such as GPL makes is illegal to distribute only the unmodifiable form, including any changes made, thus reducing inefficiency. Since no one can defect from without breaking a legal contract, rival parties cooperate and share in the improvements made by the everyone.

Economic landscape seems to undergo a trajectory of chaos, routine, and crisis which is not unlike the “paradigm shift” in science described by Kuhn (1996)10 that occurs in three stages — pre-science (chaos), normal science (routine work), and revolutionary science (crisis). Creative Destruction could be seen as a fundamental part of the structure of economic revolutions.

  1. Smith, D. G., & King, B. G. (2007). Contracts as Organizations. Univ. of Wisconsin Legal Studies Research Paper.
  2. Coase, R. H. (1937). The Nature of the Firm. Economica, 4, 386–405.
  3. Benkler, Y. (2002). Coase's Penguin, or, Linux and The Nature of the Firm. The Yale Law Journal, 112, 369–446.
  4. Katz, J., & Gartner, W. B. (1988). Properties of emerging organizations. Academy of Management Review, 13, 429–441.
  5. McKelvey, B. (1980). Organizational Systematics. Berkeley: University of California Press.
  6. Schumpeter, J. (1950). Capitalism, Socialism and Democracy (New York, Harper Torchbooks). New York, Harper Torchbooks.
  7. Weber, S. (2005). The Success of Open Source. Harvard University Press.
  8. Petersen, M. A., & Rajan, R. G. (2000). Does Distance Still Matter? The Information Revolution in Small Business Lending.
  9. Benkler, Y. (2007). Wealth of Networks. Yale University Press.
  10. Kuhn, T. (1996). The Structure of Scientific Revolutions. University Of Chicago Press; 3 edition.