ArticleIP_1933.txt

   
   
      
         
            Soft Microeconomics

            I wrote this piece in
WordPerfect, not Word, mainly because Word's equation editor is awful (are you
listening, Mr. Myhrvold?), and I may as well use the same software for plain
English articles and professional gobbledygook. I surf with Netscape Navigator
and check e-mail in Eudora. So, I am not a fan of Microsoft's products.
Moreover, for reasons explained below, it is in the public interest to have
Bill Gates always running a bit scared of the Justice Department. Nonetheless,
the more anti-MS propaganda I read, the more pro-MS I get. There is a
case against Microsoft, but it is not the one you hear, and I would hate to see
crude misunderstandings posing as sophisticated analysis prevail.

            Probably the first thing one
ought to say is that the public has no interest in helping Bill Gates' rivals
for their own sake. It's easy to think of the people who run software companies
other than Microsoft as underdogs fighting Big Bad Bill. But those "little"
guys are no more in need of extra money than Gates is, and if allowing him to
get an extra billion at Larry Ellison's--or even Marc Andreesen's--expense is
good for the rest of us, so be it. Those of us who do not get paid in software
stock options should not allow ourselves to become pawns, either way, in
struggles among those who do.

            So what
is the public interest?

            The case for leaving Microsoft alone does not rest on some
naive faith in the perfection of free markets. Software is an industry
characterized by powerful increasing returns in both production and
consumption: The more units Netscape ships, the lower its per unit cost; the
more copies of Navigator in use, the more attractive it is to the typical user.
These increasing returns make the kind of atomistic, "perfect" competition that
prevails in the market for, say, wheat impossible in the market for browsers or
word processors. Necessarily, each type of product will in the end be produced
by only a few companies, perhaps only one.

            But how
does this concentration of production take place? One of the depressing things
about public discussion of the Microsoft case, even among supposedly
well-informed people, is that much of it has come to be dominated by a
basically primitive view about what increasing returns do to markets--namely,
that they convey monopoly power purely randomly, on whoever happens to be in
the right place at the right time--and that this "path dependence" allows
clearly inferior technologies to become "locked in." Now path dependence has
its place--but when applied to the Microsoft case it misses the point. After
all, high-technology companies are themselves quite aware of increasing
returns, and their strategies--above all the prices they charge when they are
trying to establish themselves in a market--are very much affected by that
awareness.

            
Consider, for example, one particular form of
increasing returns: The so-called "learning curve," which says the more units
of something you have already produced, the lower the cost of producing the
next one. You might think this means that whoever gets into a market first will
simply have a snowballing advantage. But as Stanford's Michael Spence pointed
out in a classic, 20-year-old paper on this subject, profit-maximizing
companies that know they face a learning curve will compete fiercely to move
down it more rapidly, selling cheaply in the early stages of a product cycle
(and therefore losing money) in the hope of making the money back later.

            The same
logic applies to increasing returns on the demand side: As a manufacturer, if I
know that a typical customer's choice of browser depends both on the price and
on the number of other people using that browser, I will initially make my own
browser cheap--maybe even free--so as to build market share. In either case I
must incur initial losses that are, in effect, part of the price of entry into
the market--an add-on to the cost of developing a product in the first place.
And because nobody will want to pay this entry fee without a reasonable hope of
earning it back, only a few companies will enter a market subject to strong
increasing returns. The point is that the eventual domination of an industry by
a few companies--and a high rate of profit on sales for these companies in the
later stages of the cycle--doesn't happen because these companies just happened
to get a head start. On the contrary, it is precisely because it isn't
purely a matter of luck--because everyone competes so fiercely on prices in an
effort to get some of those nice increasing returns--that only a few dare
enter.

            Of course, there is also an element of luck. It's
not true that whoever gets a head start always dominates the market--if a
company has a small head start but offers a clearly inferior product or has
clearly higher costs, rivals can and will overtake it. But nobody can be sure
just what an as-yet undeveloped product will cost to produce, or how it will go
over with consumers. Thus, competition in a market characterized by increasing
returns is--as it must be--a sort of demolition derby in which only some of
those who enter cross the finish line. Those who do make it across the finish
line will typically make big profits. But this profitability is necessary to
the enterprise. Who will enter a demolition derby without the ?

            So this is
the case for leaving Microsoft alone: High-tech competition is, necessarily, a
competition that ends up being won by a handful of players. Those who make vast
fortunes may not always be the most deserving--but so what? For the rest of us,
what matters is not who wins or loses, but how they play the game. And if they
know or suspect that too much success will be punished--that anyone who does
too well will become a target of envy-driven litigation--they will have that
much less incentive to play hard.

            
Now there is, of course, also a case against
Microsoft. Never mind the crude complaint that it is too big, or too
profitable, or that nerdy types tend to dislike its products. The real concern
is that because Microsoft's victory in an earlier derby happens to have given
it control over a particularly strategic part of the industry--because it
supplies operating systems--it is in a position to squeeze out rival suppliers
of other software. And that is a real concern: If Microsoft had, for example,
written Windows 95 in a way that made it hard or even impossible for me to use
WordPerfect, the Justice Department would have been absolutely justified in
calling out the arsonists.

            But the
fact is that MS has been very careful not to use its undoubted power to
practice any crude, obvious version of what is known in the trade as "vertical
foreclosure." WordPerfect and Netscape work just fine on my Windows-based
machine. This restraint may partly reflect Microsoft's market strategy--after
all, Microsoft beat Apple partly because Apple did practice vertical
foreclosure, and as a result inhibited the development of complementary
software (although the main problem was Apple's persistent belief, despite all
the evidence to the contrary, that everyone would be willing to pay a premium
price for a niftier machine). For sure, however, Microsoft has mainly been
restrained by the knowledge that any crude use of its power would indeed land
it in court.

            And yet, despite all that restraint, Microsoft is in court
anyway. Any nontechnologist ventures into the browser wars at his peril, but
here is how I understand it: After initially missing the significance of the
Internet, Microsoft has gone to the other extreme, designing Windows 95 so that
it uses an Internetlike metaphor for everything. It makes sense, then, for a
browser that can find both internal and external documents to be an integral
part of the system--unless, that is, you regard browsers and operating systems
as still basically different things, and view Microsoft as practicing vertical
foreclosure under the guise of product enhancement. Well, maybe--but it's a
pretty subtle point. Microsoft isn't preventing anyone from using Netscape or
charging Netscape for the right of access; it's providing Internet Explorer
free, but then that would be normal practice in this kind of industry even if
IE wasn't allegedly an integral part of Windows 95. You can argue that
Microsoft has stepped across the line on this one--but surely by only a few
inches.

            Here's what worries me: Given
the subtlety of the real issues here, what is the chance that this stuff will
be decided on its merits? When you hear that despite the fact that he has
economists who know better, the Justice Department's Joel Klein apparently
either believes or chooses to claim that this case is about path
dependence, you start to wonder. And when you hear that the anti-Microsoft side
has retained the services of that economic and technology expert Bob Dole, you
start to despair.