How do you effectively compete with an open source project?

Question

A company with a solid open source project competing against a traditional closed-source product seems impossible to beat.

I read this article wherein the author lays out this scenario:

Suppose one could divide a software market—say network management—between two products. One did everything possible and cost $1 million, and the other only did 10% as much, but was free and open.

The price tag of the commercial solution would automatically filter out a large number of users, and those people would have to turn to open source. But some users would be satisfied with the 10% functionality and choose it outright.

For example, I have an original Macintosh computer on my desk. It runs a word processor called MacWrite. It does everything, with the exception of spell check, that I need a word processor to do. I can format paragraphs, choose fonts, make text bold or italic, and even paste in pictures and graphs. All in a "what you see is what you get" user interface.

It takes up 76K of disk space. That's "K" as in "kilobyte."

Compare that to Microsoft Word. I think the last time I installed just Word it was around 30MB, many times larger than MacWrite, but I don't use it for much more than I use MacWrite. Like me, many users are happy with basic functionality. They don’t need all the bells and whistles.

But back to my analogy. In the beginning, the commercial company would probably ignore the open source project. It represents no threat to their revenue stream, so why should they pay attention to an upstart?

If this project is healthy and sustainable, however, in a year or so perhaps it does 15%-20% of what the commercial product does. This should bleed a few more users from their business, and maybe now they start to pay attention.

Most likely, this attention would take the form of marketing against the project. They would claim it is too small or too underpowered to take seriously. And in the short run this would probably work. But the mere fact that they acknowledged the project would pique interest. Some people would determine for themselves that it was neither too small nor too underpowered and would start using it.

Another year or two goes by and now the project is up to 50% of the functionality of the commercial product. People start joining the project in droves. The commercial company now has to do something. What do they do? They add more features.

Remember, the commercial product already did 100% of what people needed. So what kind of features could they add? Unnecessary ones. They might change the look of the user interface or add features outside of network management. In any case, this development will cost money, and that will start to eat into the company's margins.

Finally, with a healthy community and this influx of new users, the open source project will eventually approach 80%-90% of what the commercial product does. Having exhausted all avenues of generating revenue, the commercial company still has one final option: put the screws to their remaining customers. Find ways to charge them more, to eek out what they can from their investment, which ultimately will drive their clients away.

Farfetched? I don't think so. There are only two main requirements:

First, find a market where open source provides a compelling alternative, such as network management.

Second, build a sustainable community around the open source project.

It seems very plausible. If you were the closed-source company, how would you compete??