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For many, software has been a magnificent business. It is the two-hundred-billion-dollar-per-year juggernautD. Kirkpatrick, “How the Open Source World Plans to Smack Down Microsoft and Oracle, and…,” Fortune, February 23, 2004. that placed Microsoft’s Bill Gates and Oracle’s Larry Ellison among the wealthiest people in the world. Once a successful software product has been written, the economics for a category-leading offering are among the best you’ll find in any industry. Unlike physical products assembled from raw materials, the marginal costThe cost of producing one more unit of a product. to produce an additional copy of a software product is effectively zero. Just duplicate, no additional input required. That quality leads to businesses that can gush cash. Microsoft generates one and a half billion dollars a month from Windows and Office alone.F. Vogelstein, “Rebuilding Microsoft,” Wired, October 2006. Network effects and switching cost can also offer a leading software firm a degree of customer preference and lock in that can establish a firm as a standard, and in many cases creates winner-take-all (or at least winner-take-most) markets.
But as great as the business has been, the fundamental model powering the software industry is under assault. Open source software (OSS)Software that is free and where anyone can look at and potentially modify the code. offerings—free alternatives where anyone can look at and potentially modify a program’s code—pose a direct challenge to the assets and advantages cultivated by market leaders. Giants shudder—“How can we compete with free,” while others wonder, “How can we make money and fuel innovation on free?” And if free software wasn’t enough of a shock, the way firms and users think about software is also changing. A set of services referred to as cloud computingReplacing computing resources—either an organization’s or individual’s hardware or software—with services provided over the Internet. is making it more common for a firm to move software out of its own IS shop so that it is run on someone else’s hardware. In one variant of this approach known as software as a service (SaaS)A form of cloud computing where a firm subscribes to a third-party software and receives a service that is delivered online., users access a vendor’s software over the Internet, usually by simply starting up a Web browser. With SaaS, you don’t need to own the program or install it on your own computer. Hardware clouds can let firms take their software and run it on someone else’s hardware—freeing them from the burden of buying, managing, and maintaining the physical computing that programs need. Another software technology called virtualizationA type of software that allows a single computer (or cluster of connected computers) to function as if it were several different computers, each running its own operating system and software. Virtualization software underpins most cloud computing efforts, and can make computing more efficient, cost-effective, and scalable. can make a single computer behave like many separate machines. This function helps consolidate computing resources and creates additional savings and efficiencies.
These transitions are important. They mean that smaller firms have access to the kinds of burly, sophisticated computing power than only giants had access to in the past. Start-ups can scale quickly and get up and running with less investment capital. Existing firms can leverage these technologies to reduce costs. Got tech firms in your investment portfolio? Understanding what’s at work here can inform decisions you make on which stocks to buy or sell. If you make tech decisions for your firm or make recommendations for others, these trends may point to which firms have strong growth and sustainability ahead, or which may be facing troubled times.