Thursday, November 23, 2006

Crossing the Curve

One can buy a decent home PC system for $330 (Dell Dimension E521, checked 11/23/06). Windows Media Center systems start at $360.

The cheapest Windows Vista operating system will retail for $200 (“Home Basic”). An upgrade is $100. (Summary on GMSV.) The Vista replacement for Windows XP Home (“Windows Vista Home Premium”) is $240; an upgrade $160.

PC hardware prices have been steadily coming down for years. Home PCs used to cost $1,500; then $1,000; and now well below $500. The price of Windows has stayed constant.

We’re close to the long-expected inflection point where the Windows operating system costs more than the PC hardware it runs on. It’s an inflection because I expect that hardware prices will continue to drop, while Microsoft will continue to try to maintain the price of the operating system. Microsoft argues that new software features will keep the price of hardware constant, since users will need more fancy systems; I’m not persuaded. Software functionality increases linearly, while hardware price/performance drops exponentially.

The implications are significant. As hardware becomes a smaller and smaller part of the package price, there will be downward pressure on the price of the operating system. If Microsoft cannot resist this, it will erode Microsoft’s mythical profit margins.

Open source software will increase the pressure. As hardware becomes essentially free, the attractiveness of a free operating system grows. Linux is quietly making progress on the desktop. While Linux-on-the-PC is still only geek amusement, the user experience is steadily improving. Its market share growth could be as rapid and substantial as that of Firefox. I’m hearing more and more anecdotes about Ubuntu. For example, take this user report about switching from Windows:
“I installed the Ubuntu Linux 6.10 (Edgy Eft) distribution that I downloaded and burnt to CD on my desktop. Wow. That’s all I can say - Wow. Ubuntu installed like a dream in less than 30 minutes, and everything just worked. My wireless card worked, power management worked, and the DVD burner worked with no tweaking, fidgeting, or fussing.”

Apple’s model looks increasingly attractive. It knows how to make money selling hardware. It sells what Tren Griffin calls “software in a box.” (Bill Gurley got the idea from Tren.) It can flex its system price below the combined software + hardware price in the PC ecosystem, putting pressure on both hardware vendors and Microsoft. Apple has the additional advantage that Mac OS X has an open-source core; it only needs to invest in developing value-added software, whereas Microsoft has to maintain the whole enchilada.

As the hardware price continues to drop below the operating system price, Microsoft will face increasing pressure to sell a “Microsoft PC,” with all that entails for its relationships with hardware vendors and its operating margins. It’s been learning how to do this for some time. The X-Box is “software in a box,” and Zune is a clone of the iPod model. (Imitation is the sincerest form of flattery.)

(Thanks to Brad G. for the fascinating conversation that inspired and informed this post.)

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