Open source inherently lowers cost of development and distribution by distributing those costs amongst outside companies and individuals. Open source is a more efficient system - by allowing outside contribution and distributing costs you create less pressure on any one component and reduce the need for expenditure.
Because the costs are reduced it becomes economical to allow software to be distributed. Failing to understand open source as a business fails to understand basic economics. Software doesn't just serve a demand, it creates it. In the same way paper becoming a commodity facilitated other markets like printing and art tools, software increases demand for developer time and expertise. Companies like Red Hat, Novell, Canonical etc. create models that work with these advantages, not against. They build models where software given away freely acts as input to demand for services, whether they be integration, customisation, storage or bundled with hardware. A cheaply reproducible good created with a cheaper, more efficient system is used to generate more value to genuinely scarce, hard to reproduce goods.
Saying open source and proprietary can coexist as part of a single model is an oxymoron. They are two fundamentally different systems that rely on different sets of assumptions about what is economically viable to give away and distribute. One takes advantage of modern technology to spread out and reduce cost and increase efficiency, the other places all burdern on a comparatively small group and assumes there is a cost in reproduction.
Not to mention the stupidity in the idea of calling one business model real due to simply an attempt to recreate old conditions whilst the other fake as it makes use of new conditions and continues to be successful for various companies that implement it.
In other words, companies look to add some value to the goods that makes their goods better than the competition in some way -- and that unique value helps them command a profit. But, the nature of the competitive market is that it's always shifting, so that everyone needs to keep on innovating, or any innovation will be matched (and usually surpassed) by competitors. That's good for everyone. It keeps a market dynamic and growing and helps out everyone.
So, let's go back to the "can't compete with free" statement. Anyone who says that is effectively saying that they can't figure out a way to add value that will make someone buy something above marginal cost -- but it's no different if the good is free or at a cost. Let's take a simple example. Say I own a factory that cost me $100 million to build (fixed cost) and it produces cars that each cost $20,000 to build (marginal cost). If the market is perfectly competitive, then eventually I'm going to be forced to sell those cars at $20,000 -- leaving no profit. Now, let's look at a different situation. Let's say that I want to make a movie. It costs me $100 million to make the movie (fixed cost) and copies of that movie each cost me $0 (marginal cost -- assuming digital distribution and that bandwidth and computing power are also fixed costs). Now, again, if the market is competitive and I'm forced to price at marginal cost, then the scenario is identical to the automobile factory. My net outlay is $100 million. My profit is zero. Every new item I make brings back in cash exactly what it costs to make the copy -- so the net result is the same. It's no different that the good is priced at $0 or $20,000 -- so long as the market is competitive.
Saying you can't compete with free is saying you can't compete periodHowever, the mistake here is to look at the market in a manner that is way too simplified. Markets aren't just dynamic things that constantly change, but they also impact other markets. Any good that is a component of another good may be a finished good for the seller, but for the buyer it's a resource that has a cost. The more costly that resource is, the more expensive it is to make that other good. The impact flows throughout the economy. If the inputs get cheaper, that makes the finished goods cheaper, which open up more opportunities for greater economic development. That means that even if you have an infinite good in one market, not all the markets it touches on are also infinite. However, the infinite good suddenly becomes a really useful and cheap resource in all those other markets.
So the trick to embracing infinite goods isn't in limiting the infinite nature of them, but in rethinking how you view them. Instead of looking at them as goods to sell, look at them as inputs into something else. In other words, rather than thinking of them as a product the market is pressuring you to price at $0, recognize they're an infinite resource that is available for you to use freely in other products and markets. When looked at that way, the infinite nature of the goods is no longer a problem, but a tremendous resource to be exploited. It almost becomes difficult to believe that people would actively try to limit an infinitely exploitable resource, but they do so because they don't understand infinity and don't look at the good as a resource.
Infinity is your friend in economics