Subject: Re: Option & Software Pricing
From: Laurent GUERBY <laurent@guerby.net>
Date: Sun, 07 Aug 2005 16:39:31 +0200

On Mon, 2005-08-01 at 15:20 +0900, Stephen J. Turnbull wrote:
> >>>>> "Laurent" == Laurent GUERBY <laurent@guerby.net> writes:
> 
>     Laurent> http://www.onlamp.com/pub/a/onlamp/2005/07/21/software_pricing.html
> 
> Interesting, but the model is almost pessimally bogus.  It assumes
> that value = price, which is true at the margin, but false (ie, an
> underestimate of value) for almost all purchasers.[1]  Furthermore,
> for many software products which are purchased in exactly quantity one
> (1), this underestimate can be arbitrarily large for *all* purchasers.

The only section of the text where I spot a value / price swing is the
following:

<<
When I informally polled enterprise software buyers about what they
would pay for software given that they wouldn't be able to buy any
maintenance for it (as a middleman, I'd be selling that to somebody
else), the universal response was that they would pay much less than the
license--implying that the option to buy maintenance was clearly a
significant fraction of the price. It is also the case that people
expect software maintenance prices to be subject to change. Certainly,
it has been the historical record that large software companies do
change their pricing on maintenance occasionally--sometimes
substantially.
>>

It only assume that relative change in value is related to relative
change in price, which is quite different than flat price = value.
Then the author talks only about price of different items and combined
items trying to get again a relative picture. May be I missed a
paragraph in error, could you quote it?

> More important (and this is a mistake that finance experts make all
> the time when they stray into economics), the policy discussion simply
> ignores the effect of licensing and pricing on _supply-side_
> incentives.  But that's what the whole argument is about! (except for
> the irredeemably greedy on both sides who merely want something for
> nothing).

Well given that this is the first paper where I see software support
issues just even mentionned, I'd say it's quite good just for that
point. 

Software supply-side papers just plain ignore support supply-side
economics, which are shown to be of great importance (see this article
and the previous one about I mentionned about "software stinks") and
support quality and pricing is completely destroyed by the proprietary
software model which implies monopoly on support.

Plus FOSS has shown monopoly incentive strength is extremely weak in a
very large part of the software domain.

>     RL> For the open source movement, perhaps a better way to position
>     RL> the change that OSS is making is this: we're converting
>     RL> warrants on future maintenance and enhancements into options,
>     RL> which means that instead of having a sole supplier (warrants),
>     RL> we have created a third-party market (options) of these
>     RL> derivatives.
> 
> *chuckle*  If that wording doesn't scare CTOs off of OSS, nothing
> will!  (Last I heard, CTOs and CFOs were natural enemies. :^)
> 
>     RL> How capitalistic is that?
> 
> Do CTOs care about "capitalism"?

CTOs number one priority is support quality, so yes legal monopoly rules
that push support quality towards zero are an area where CTO would
love a bit more capitalism/competition.

> Footnotes: 
> [1]  The idea underlying the arbitrage model of option pricing (aka
> Black-Scholes) is that for derivatives of financial assets, it _does_
> make sense to assume that the only real good is money[sic], all
> traders are risk-neutral and monotone in money, and that volatility is
> objective.  Those three assumptions mean that _all_ traders have the
> same preferences for the option, and if the price is "wrong", the
> option will be untradable (either everybody wants to sell it, or
> everybody wants to buy it).
> 
> That does not sound like a software maintenance contract to me!

All derivative traders see bid/ask prices on the derivative market, then
they try to figure what those price mean and inverted bid/ask volatility
and the B&S framework gives them some insight about what the price mean
(Bloomberg screens show price, volatility and deltas for listed options
for example). But then, no two traders agree on volatility level (or
wider model issue), that's why there's a derivative market and no
untradable options (where did you get that idea from? :).

I agree that a simple B&S model is very weak to get insight in
software and support prices, but by adding default risk and
some transaction cost I think you could get more information at the cost
of more model work...

Laurent