Interoperability in the Digital World:
Open Standards, Open Source, Property Rights and Markets

Grand Hotel Duomo
Milan, Italy
February 11, 2005

Theme

A premise in discussions of the highly interactive and interdependent industries of the digital age is that competition among firms can take the form of:

• Competition over setting a standard (e.g., Betamax vs. VCR), in which case the winner of the race gets a strong, though perhaps temporary, advantage, and may even take the whole market, until rival technologies catch up or leapfrog it;

• Competition within a framework established by a common standard (e.g., CD recording format), in which case numerous companies produce comparable products.

• A hybrid, in which either: (1) the company that wins the standards race then sets up a common framework within which numerous companies compete. (e.g., VCR again; Qualcomm & CDMA), OR (2) A company wins a standards race because it opens a standard up to other companies and thus makes it attractive (Windows vs. OS2).

While some companies at some times still pursue an exclusive-control-and-use-of-the-standard strategy (e.g., Apple iPod), and should have every right to do so without government meddling, many have become skeptical that this approach is workable as a matter of everyday business practice.

The problems with a strategy of retaining exclusive control are:

• The familiar observation that no matter you work, most of the smart people in the industry work for someone else, and if they are all frozen out they have strong motivation to find a way to beat you;

• The corollary to the smart-people point -- a company wants to enlist outsiders in producing complements to its products that will enhance their value;

• An exclusive-control strategy often requires a company to develop expertise across a wide range of functions, whereas it may be most efficient for each firm to focus on limited core functions;

• The network effects, low-cost connectivity, and technological convergence characteristic of the Internet enhance the importance of interoperability;

• The ethos of the digital world places great value on openness and interaction;

• Companies fear that success with an exclusive-control strategy will trigger a political counter-reaction that will strip the practitioner of the fruits of any victory.

In consequence, digital age companies are seeking a middle ground between exclusive control and total openness. They need hybrid models that will permit significant interoperability by making any particular business's systems open to interconnection with the systems developed by other businesses, but that at the same time allow innovative businesses to be rewarded for investment and risk-taking.

One route to openness and interoperability assumes that property rights must be decreased, via, for example, open source software (or other open source IP), cutting back on patentability, or other "open equals free" devices. This school may even advocate government mandates of open source or other interconnection mechanisms.

This approach recognizes only half the problem, the need for openness, while ignoring the need to maintain incentives for innovation and investment. In practice, the approach may also frustrate interoperability because its very openness encourages tweaking and forking, which can result in version proliferation and incompatibility.

A superior route relies on the creativity of private companies acting within free markets, with governments playing their classic role of defining/enforcing property rights and protecting the integrity of the market. In this approach, the business world is free to develop its own route(s) to interoperability and openness, relying on standard-setting processes, contracts, and property rights.

In our view, the second route is clearly preferable, because it takes accounts of both sets of needs, and it is in fact happening.

The purpose of today's session is to describe and analyze these developments, focusing on a few major points:

• The development of effective standard-setting mechanisms is a fascinating case study in the creativity of private institutions

• Standard-setting organizations (SSOs) have become more aware of the impact of intellectual property rights on standards and on individual companies (e.g., Rambus; Unocal). Many SSOs are revisiting their policies on the use and disclosure of proprietary technology to be sure that the rules are clear and the incentive structures in order.

• The process involves considerable creativity in the development, definition, and adaptation of property rights. One perspective on the process is that the concerned companies, interacting with the standard-setting organizations, are redefining and improving property rights, adapting them to the changing technology. The basic mechanism of adaptation consists of contract terms, but some of the most important of these (e.g., "commercially reasonable") are left sufficiently vague so that they can be regarded as references to community norms more than strict contract terms.

• Overall, the situation is one in which institutional mechanisms and property rights are being developed from the bottom up -- by the people involved -- rather than delivered from the top down. (Some historical analogies would the Law Merchant of the Middle Ages, or Water and Mining Law in the American West of the 19th Century).

It is crucial that law and policy makers look hard at what the people in the arena are doing, and adapt law and policy to business culture and business necessities, rather than the reverse.

The purpose of the day is to explain how we reached these conclusions.