February 4, 1998
Stephen E. Margolis, Stan J. Liebowitz, Robert A. Levy, Bruce H. Kobayashi

Contents

• Introductory Remarks by David Theroux
• Stephen Margolis, Head, Department of Economics, North Carolina State University; Co-author, Winners, Losers & Microsoft
• Stan J. Liebowitz, Professor, School of Management, University of Texas, Dallas; Co-author, Winners, Losers & Microsoft
• Robert A. Levy, Georgetown University Law Center; Senior Fellow, Cato Institute
• Bruce H. Kobayashi, Professor of Law, George Mason University
• Questions from the Floor

Introductory Remarks by David Theroux

My name is David Theroux and I am the President of The Independent Institute. I would like to welcome you to our luncheon program today on the subject of economic and legal issues concerning antitrust and monopoly and competitive markets as they pertain to the high technology industry. And as you know, Microsoft has been the leading firm that’s being scrutinized regarding these matters.

For those of you not familiar with The Independent Institute, we were founded over ten years ago. The Independent Institute is a non-profit, non-politicized, scholarly, public policy research institute. We annually produce numerous books and other publications, and we conduct various conference and media projects based on the results of this work. Currently, we have about 120 research fellows at different universities currently involved in Institute research projects.

Of our many books, I would like to note one of them that is particularly germane to our discussion today, Antitrust and Monopoly: The Anatomy of a Policy Failure, by the economist D. T. Armentano. In addition, you may wish to consult our quarterly journal, The Independent Review; which also addresses many of the economic and legal issues relevant to today’s program. For anybody interested in receiving a copy of these and other Independent Institute publications, please contact the Institute.

The Institute is funded by a little over 600 supporters, including foundations, businesses firms and individuals. We don’t do consulting work; we’re not a consulting firm. We don’t do contract work. We don’t take government funding, which is all contract work. Instead of focusing on issues as they are temporally debated in Congress or in other public forums, we concentrate on developing a more in-depth analysis of major economic and social issues based on the cause and effect nature of public policies.

In so doing, we seek to engage the work of top scholars and other experts. Hence, our panel today consists of several excellent scholars. Many of them, especially Professors Stanley Liebowitz and Stephen Margolis, have been involved in an ongoing scientific research process on the theory of “network externalities” that was begun about ten years ago by such economists as Brian Arthur, Carl Shapiro, and Michael Katz. But although the work of Professors Liebowitz and Margolis is today largely viewed in the economics profession as having thoroughly discredited this theory, “network externality” doctrine has since been brought into public forums through the public relations campaigns of various interest groups who seek to use it for there own regulatory purposes.

More specifically, “network externalities” pertain to the potential harm to consumers from different high technology business behavior and market phenomena, and whether antitrust in some form is appropriate to create a more fair, competitive system.

In April 1990, Professors Liebowitz and Margolis published the first of numerous technical articles on this topic in the Journal of Law and Economics. We’ve also been involved in arranging for them to author and publish articles in more popular publications, such as Upside, Reason, and Regulation magazines, as well as leading newspapers such as the Wall Street Journal, San Francisco Chronicle, the Christian Science Monitor and many others. Currently, they are also completing an important new book for us, Winners, Losers & Microsoft: Competition and Antitrust in High Technology.

Recently in November, Ralph Nader sponsored a conference on this issue. There’s also a conference being held tomorrow sponsored by a conservative policy group. And of course, this issue has been one that has dominated a lot of the reporting in Washington, nationally and internationally, not just in business but on the economy and in a more cultural vein.

So it seemed to us that from both the Left and Right, there’s been sort of a politically-driven consensus in certain circles that there indeed may be something to this “network externalities” perspective. So we believe that it would be very useful to make the work of Professors Liebowitz and Margolis and other top scholars a major part of the public debate, and that’s why we have organized our program today.

The basic format we thought we would use today is to have each of the four speakers make a presentation of about 10 minutes or so. And then at the end of all the four presentations, we’d open the discussion up to a roundtable Q&A, which hopefully will last for about an hour or so.

In your packet, there is a breakdown of the biographical background of each of our speakers. There are also copies of various articles, both popular and technical on our topic today. Please note that this is only a sampling of the available literature. In addition, please note that our panel represents only a portion of the economists and legal scholars in the academic world involved in this topic. If you are interested in speaking with more of them, we would be very happy to be of assistance in your contacting them.

So the first person I wish to introduce is Professor Steve Margolis from North Carolina State University.

Stephen Margolis

Thank you. We started this in 1987, ’88, talking about the economics of standards. That led us into literature that really was very much a part of an academic debate about how well markets work and something economists worry about all the time. And then it only became a policy issue very explicitly in about ’95, the time of the antitrust action involving Microsoft.

The title that I’ve given this brief talk is “Locked Into Inferior Technologies: A Proper New Foundation for Antitrust?” And I guess I want to emphasize the question mark at the end of that title. Just so you know kind of what ax I’m grinding here, so you don’t have to wait till the end to try to interpret, here is the short version of the abstract of my talk: These new theories that suggest that market processes would leave us locked into inferior technologies are not a proper foundation for antitrust.

I have a longer version of the abstract: Some theoretical writings of economics argue that it’s likely that free-market choices of products would result in a “lock in” of inferior technologies. This is what you’ve been hearing about in the arguments where the word “lock in” is used for network externalities, increasing returns, economies.

Our argument really consists of two major points. Stan and I have divided up what we’re going to talk about. I’ll focus on the first part, and Stan will pay more attention to the second part.

First, this problem is a theoretical argument. And this theoretical argument leaves out important features of the real world that consumers and producers use to unravel potential traps that people allude to in these theories of “lock-in.”

Second, there are some empirical claims associated with this literature of lock-in, and they are wrong. And much of our writing, in fact the first paper, is a debunking of something of an urban legend of the typewriter keyboard story.

So then my conclusion is that theories of lock-in of inferior technologies are an unsound foundation for antitrust.

I realized that most of you seem quite tuned into this particular literature. If you have or haven’t, there’s been an outbreak of this stuff in Slate recently. There’s a real good piece in the New Yorker by Cassidy. Bob Krugman responded with a piece about his involvement in the literature. And then following that was a very interesting piece on network externalities. And then after that, there was the Forum that involved a number of contributors, including Krugman, Cassidy and Ken Arrow. And that’s a good place to consult for more of this discussion. And there’s a link to our Regulation magazine piece in that statement.

Now, here are some words I am going to talk about that I think you’ve been hearing about: “increasing returns economics.” What’s that? Theories of increasing returns have been around in economics for a very long time. The basic idea of increasing returns is that bigger is better. And in the traditional setting, the bigger the firm is, the lower the costs of producing goods are, if they are subject to increasing returns. Traditional economics argues that if firms experience some range of output, there are increasing returns. But ultimately, they run into capacity restraints. For those of you who have taken some economics, that’s the upward slope of the cost curve that you saw over and over and over again.

The new claim is that in high-technology industries there are increasing returns of the usual sort: bigger is better. But there are also reasons, people argue, that we will see increasing returns to the level of activity in an industry. Improvements, the level of activity, geographic concentration of activity promotes certain economies. These lowers costs to the firm.

“Network externalities,” as it’s called in the literature, simply means that the value you might place on a good depends upon how many other people also use the good. By the way, that’s not confined just to new technologies. One of the reasons you might have bought a Chevrolet is that there are a lot of places to get your Chevrolet fixed. There are fewer places to get your Renault fixed, for example, or your Peugeot, if you drive one of those.

But in the new technology setting, you have something like a telephone. It’s a toy, if only a few people have it. It becomes much more valuable, much more important if many people have it. The first guy who bought a fax machine, what was he going to do with it? But once there were lots of folks with fax machines, they become a very valuable tool.

We have argued in our publications that using the term “network externalities” begs the question. “Externality” has a specific meaning in economics; and it is a kind of market failure. We have written in a number of places that we ought to think of these as network effects—the more people who have telephones, the more valuable they are. But then we ought to argue, consider, debate whether these things are externalities. We have argued in a few places that there are a number of important instances in which these network effects are internalized very effectively. In particular, if you have a single owner of a network, and you’re not going to appropriate participation charges for the value of the network, the externality is internalized by the income potential.

Okay, so we start with increasing returns, economics, bigger economies, or economics, bigger is better. Network externalities are an example of that.

And that leads us to ideas of “path dependence” and “lock-in.” Path dependence, I suppose, is somewhat broader an issue than lock-in. But the idea of path dependence is how some process gets started—even very insignificant things about the way a process gets started—can have a tremendous effect on the eventual outcome.

But the particular application of path dependence for this industry is what is sometimes called “lock-in.” And that term is connected with the current debate over software. So you get locked into some technology, and that lock-in may have to do with a head start, with early standardization. And the reason this gets raised as a problem is that if there is such a thing as lock-in, could we be locked in to a standard or a technology that’s second best or that’s inferior to something else that’s available?

Now, let me give you a quick finger exercise of lock-in, and it has been illustrative, though as a counter-factual example. We have written about this example, about the actual case. But people use this as an example to get a grip on what “lock-in” means.

And so we take the Beta and VHS case. This contest involved two standards for video tape recordings, Beta and VHS, and VHS prevailed.

Now, some people reconstruct the story in the following way: They make the claim that Beta was better, but that an early start for VHS locked us into the inferior technology. Now, some of you already are kind of stirring, “No, that’s not what happened.” Let me have the counter-factual case for just a minute.

In principle, it could happen that we all liked Beta better, but nevertheless we ended up with VHS. So a few people bought VHS machines. We all go to the store; we look at the Sony Betamax machine, and we like it. We look somebody else’s VHS machine, maybe a Hitachi or a Panasonic, and we think, “Gee, just looking at the features, I kind of like this Beta machine. But I think you’re going to buy a VHS, and I won’t be able to interchange material with you. You think I’m going to buy a VHS, and you want to be able to interchange material with me.” And so we all buy VHS. We buy VHS because we think the other guy is going to buy VHS, perhaps because the first few people to buy these things bought VHS.

Now, what’s wrong with that? In the end, we all feel smug: “Hey, we dodged the bullet, we didn’t buy the one that died, we didn’t buy Beta.” We’re feeling like we predicted the future correctly. But we could have had something better. There’s a position on the board that we would have all preferred, given this story.

So we all went to the store and discovered we liked Beta better. But figured everybody else was buying VHS. So we decided to buy VHS.

In this case we each have a very narrow focus; we’re relying on a very narrow set of information. We go to the store; we have only our own assessment and some very simple information about what other people are doing.

Now, what has all this got to do with antitrust? We say in the world of increasing returns—whether due to network effects or some other source of increasing returns—that we are likely to end up with a single supplier in the some industries. That is, monopolies.

But the story says that because of network effects, because bigger is better, because we all want to be able to trade tapes, because we want to have the standard, we will gravitate to a single-supplier solution. And that could be VCR formats; it could be computer architectures; it could be lots of kinds of things. Well, then if monopoly seems inevitable, traditional antitrust has a problem because you end up with a monopoly format: everybody adopts the VHS format. Do we say that Matsushita did something wrong if, after the fact, we’re going to get to a monopoly outcome just as a result of the interest in compatibility?

Now, antitrust enforcers have embraced lock-in as a social problem that warrants antitrust intervention. We’ve got this monopoly story but what’s the fear? The monopoly itself seems like the efficient outcome, so what’s left to worry about is whether you’re getting the right monopolies. So people have been arguing that antitrust policy needs to pursue this because—and this, I think, is the key—there’s a tendency according to this path-dependence story for markets to lock into an inferior standard.

Where has this come up? Recall the amicus brief submitted in connection with ratification of Microsoft’s consent decree. Joel Klein has been written about as recognizing this as a kind of founding theory for a new effort in antitrust.

Let’s get back to the issue of lock-in. What’s wrong with the Beta/VHS story? Well, I think you can get to it on your own if you think about this. What’s wrong with the story is that we all go to the store; we all think Beta is better; each independently think Beta is better, and we end up with VHS. What’s gone wrong there? What’s going wrong with this story about the world? Well, you’re going to make this choice. You’re going to commit. You’re going to commit for a long time. You’re going to spend a few hundred dollars. What do you do?

You talk to your friends. “What do you like?”

“Well, I kind of like this Beta machine.”

“Oh, yeah, me too. Everybody seems to like that Beta machine. I guess that’s the way the market’s going to go.”

You read consumer magazines. Again the same story, this counter-factual story that everybody thinks Beta is better. What do the consumer magazines say? They’re all saying Beta is better. Which way are you going to forecast the market going? If you want to be compatible with other people, you’re going to try to anticipate which way the market’s going to go.

So there’s a problem with this story: We each go to the store independently with limited information, with no communication; we each like Beta better, but we all get VHS. That captures the character of these very abstract theoretical models that give you the network trap.

You say, “What’s wrong with that?” Well, they’re leaving things out that really belong in any representation of real markets. One is communication. We talk to each other. Another is anticipation. Which way is the market going to go? Consumer magazines are a third relevant element that gets omitted from the discussion. Consumers in these models of network externalities or increasing return economics are often models that are very passive. Products are prices are simply put out there on the market. Consumers don’t talk to each other; they don’t anticipate. They’re passive.

Entrepreneurs in the models are also passive. But in the real world you have all kinds of entrepreneurial activities, and people try to establish the standard. Let’s say you’re the owner of a standard, the owner of computer architecture, or the owner of a VCR format—and let’s say it’s the better alternative. Well, you have a lot to gain by establishing yours as the standard. You will make extraordinary efforts to communicate that it’s better.

What do you do? You advertise; you offer discounts. “Get the products out there,” you say. “Let’s lose money—for a while.” We’re all worried about Netscape and Microsoft giving stuff away. But in fact, the way you invest in establishing a standard is to give discounts, even 100 percent discounts for a while, giving the product away.

Another strategy you may chose: lease out the product. “You don’t have to buy this. We’ll make arrangements for you to lease it. If you don’t like it, if the market doesn’t go this way, we’ve got to take it back.” This strategy is probably more applicable for higher technology, bigger computers and packaging machines.

Still another strategy: money-back guarantees and similar offers for more conventional consumer goods, and brand names. We associate the new standard with successful brand names. We see new technology products becoming associated with established technology firms or established names.

All of these strategies are features of the real world—and they raise questions about these models. Models are models; they can only prove things within the abstract world they set up. We don’t know if they capture the essential element of markets or the world they’re supposed to be addressing. That ultimately, unavoidably becomes an empirical issue.

So that leaves us with the question, was “lock-in” demonstrated to be an important phenomenon? Are there good examples of instances in which there are clear examples in which we know that the better product lost? One example, the paradigmatic example is the typewriter keyboard. We’ve written about that and also about Beta and VHS, and about DOS and Macintosh. In the first two cases, we argue that it’s not the case that the better product lost. The third case is slightly more complicated. And I’m sure I’m over my ten minutes.

David Theroux

Professor Stan Liebowitz is Associate Dean and Professor of Managerial Economics at the University of Texas at Dallas.

Stan Liebowitz

I guess I should point out that we’re referring to products being sold in markets with well-defined property rights.

Okay. The bottom line to some extent here is whether or not these theories of getting stuck are reasonable. I guess I should point out that we’re really referring to products being sold in markets where there are well-defined property rights. We’re not talking about social systems, or institutions where it is perfectly possible to get stuck with an inferior choice. Social systems are not bought and sold in markets and thus do not provide entrepreneurs with profit opportunities if they can provide consumers with a better product.

Reasonable theories have empirical support. What kind of support do these theories have?

The first, and by far the most influential example is that of the QWERTY Keyboard. The claim is that this keyboard was created to slow down typing so as to keep the keys from jamming. A supposedly superior alternative keyboard was created in the 1930s by one August Dvorak, a professor at the University of Washington. The story is that during World War II, these keyboards were compared and the QWERTY keyboard was found to be remarkably inferior to the Dvorak keyboard.

The claim was that in just 10 days you would be typing so much faster on the new keyboard that you would have fully recovered all your costs from typing very slowly the first few days. After that, the faster typing speed would all be gravy.

In the late 1980s we examined this story. Our paper was published in the 1990 issue of the Journal of Law and Economics and there has not been any refutation attempted in the journals since then. As far as we can tell, our version of the story is now accepted as correct. What is our version?

There were many problems with the World War II tests on alternative keyboards. First, it was almost impossible to find the study. We tried every library we could think of and no librarians could find it. Finally, after our paper had actually been accepted for publication, we came across a copy of the study.

It was found in the attic of a woman who was a member of a group called Dvorak International. She asked us if we would be the repository of the information since she was not interested anymore, but since we were about to discredit her beloved Dvorak keyboard, we didn’t think it right to hold the papers, although there would have been a delicious irony to that.

The study did not list the authors. The tone of the study was very unscientific. When we read the footnotes, it was clear that the experiments were not conducted properly, and that some of the results appeared to be fudged. The Dvorak typists were, for example, given new keyboards. We don’t know anything about the QWERTY keyboards. Also, the starting point for the very slowest QWERTY typists was measured differently than for the slowest Dvorak typists, a result that biased the results in favor of Dvorak.

We had already come across a study conducted by the GSA conducted by a professor of ergonomics at Penn State. In the preface to that study, it was mentioned that the prior study performed for the Navy was conducted by none other than Lt. Commander August Dvorak, the creator and patent holder of the Dvorak keyboard.

This GSA study was very influential, since at that time the government was seriously thinking about changing keyboards. The GSA study, which appears to have had far better controls, concluded that retraining typists on QWERTY would make more sense than training them on Dvorak.

It turns out, you see, that any retraining increases typing speed, at least temporarily.

We also looked at the ergonomics literature, where they had simulations of typing activity. These simulations generally concluded that there was very little difference between the two keyboards.

We also examined the history of typing competitions in the late 1800s which made clear that other keyboards existed and that QWERTY was superior to most of them, even a few that resembled the Dvorak keyboard in some respects.

So we conclude that QWERTY is not an example of lock-in to an inferior system.

The second frequently mentioned examples is that of Beta videorecorders. The claim is that Beta is better than the dominant VHS system.

Note that this simple story is not really consistent with the lock-in story since Beta came first.

When we investigated, we discovered that Beta had a head start of one and a half to two years. That is why the famous case on home video taping is the Betamax case, and not the VHS case.

We also discovered that Matsushita, the owner of VHS, and Sony, the owner of Beta, had jointly produced a prior-generation machine called the U-matic, and had a patent-sharing agreement.

In fact, Sony asked Matsushita to once again come in with them and jointly produce the Betamax. Matsushita engineers examined the Betamax and noted all of its improvements. Some time later, they invited Sony to compare the Betamax with a machine that JVC, a subsidiary of Matsushita, was working on.

At this meeting, Sony engineers were outraged because they considered VHS a clone of Betamax. All of the important electronic improvements available in the Betamax were also incorporated into the VHS machine.

The only real difference was size of cassette and threading of tape. Sony, having become famous for miniaturization, believed that a cassette that could fit in a shirt pocket was important. Matsushita believe that a cassette that would allow a movie or baseball game to be recorded was more important.

In fact, it is often forgotten that the original Betamax could only tape for one hour.

The difference in tape threading allowed for better special effects on the Betamax. For this reason, professional studios and television stations preferred the Betamax since it allowed much better editing of tapes. The rest of the market preferred the longer playing time that VHS afforded.

Analog tapes always allow higher quality performance at faster tape speeds. Because of the larger VHS tape, VHS could always play longer at a given quality, or produce a higher quality for a playing time.

Magazines such as Consumers Reports found no advantage for Beta picture quality, and actually found a small advantage for VHS.

So this example is hardly one of lock-in. In fact, it is just the opposite. The superior system started late but was able to overcome the advantage of the incumbent.

The pattern building up here is one of very weak empirical examinations by those enamored of path dependence and lock-in theories. That pattern continues to this day, as I will discuss shortly. First, let me discuss one more popular case of lock-in: Macintosh versus IBM - DOS.

Let me first point out that there is something very different about this standard. It is not fixed. Unlike the keyboard and videotape formats, this standard is capable of changing over time, and did change. It is much harder, and perhaps impossible, to have lock-in when standards are capable of changing.

The story here is that at a certain level it is obvious that graphical operating systems are superior to text-based systems. They are easier to learn and use, and allow the user to produce much better-looking documents more easily.

But forgotten in this are some facts about computing in the mid 1980s. Memory was expensive, processors were slow and hard drives small or nonexistent. Under these circumstances graphical operating systems might not be better, and may in fact have been worse, than text-based systems. For example, graphical operating systems were much slower since they required moving much more information around.

I believe that 2K of memory was needed for the DOS screen but almost 30K was needed for the Mac screen. This is a ratio of 15 to 1.

On top of that, one couldn’t print fancy documents without a postscript printer, and those printers usually had a premium of about $1000 over ordinary printers. As well, the computers themselves were more expensive.

Let us not forget that multitasking did not yet exist in these markets, so that computers were used for one task at a time, and often for but a single task. So, if a secretary used a computer for word processing, there was little advantage in having an operating system that was easier to learn and use, since only one program was going to be used anyway, and it could be open upon booting up.

So for ordinary computing, DOS was faster and cheaper.

As computing power increased and became less expensive, the advantages of a graphical operating system became increasingly obvious. And indeed, if we were still using DOS, it would be a case of using the wrong standard. But we don’t use DOS anymore.

Someone waking up from a ten-year sleep, if they looked at modern computers, would think that the Mac won, since all computers have icons and windows and mice. Indeed, the graphical operating system did win. It is just not owned by Apple.

These standards are not static, and DOS migrated toward the Macintosh. This is certainly not a case of getting stuck with an inferior standard.

These examples, are, I think, illustrations of theorists not giving much thought to whether the world matches their theories. So they throw off some examples that seem to match the theory without any serious examination. Not a good way to do science.

Here are two quotes that I think illustrate the continuation of this type of thinking.

Business Week (Nov. 1997): “[In a traditional industry] If a rival introduces a worthy product, the monopolist’s edge will begin to erode. But in the high-tech market, the network features that helped a company gain dominance ‘may make it more difficult for new entrants to dislodge the market leader,’ says Carl B. Shapiro, an economics professor at the University of California at Berkeley.”

Is this true?

I spent a few minutes thinking about changes in market leadership in the computer industry. Here is a list I came up with:

VisiCalc loses to Lotus which loses to Excel.

WordStar loses to WordPerfect which loses to Word.

Dbase loses its dominance.

Ashton-Tate disappears.

IBM loses its dominance.

Hayes loses to US Robotics.

CompuServe and Prodigy lose to America Online.

Borland virtually disappears.

Is this an industry where it is difficult to dislodge market leaders? Admittedly, this is not a serious study of the issue. But if you look at automobiles, or home appliances, or fast-food chains, do we have this level of market turbulence? I think not. Has the other side performed studies to determine whether their claims are true? Not that I have seen.

It is possible that the relative youth of the computer industry is responsible for the dramatic shifts in market leadership. But a serious study is needed before we can answer any of these questions fully. We certainly shouldn’t be basing policy on these offhand comments.

Here is another one:

Business Week (Nov. 1997): “Antitrust enforcers’ biggest concern is that the computer giant can leverage its ‘locked-in’ customer base to dominate the next generation of technology—for example, the market for Internet browser software. ‘If I have a steel monopoly, my ability to leverage to autos is not tremendous,’ says Garth Saloner, a professor at the Stanford University Graduate School of Business. ‘But if I have an operating system, I can own all kinds of things downstream.’”

Is this true?

Microsoft had a much larger share of application software (wordprocessor, spreadsheet) in the Macintosh market than it did in the Windows market. Isn’t that inconsistent with this quote?

Microsoft hasn’t been able to dislodge Intuit even though Microsoft gave away its software for a lengthy time. Why couldn’t it turn its ownership of the customer base to its advantage in that instance?

Not withstanding the screams of the Justice Department, the Microsoft Network has failed to get many subscribers. It certainly hasn’t imperiled America Online, contrary to claims made by lock-in advocates when the Microsoft Network was started.

There is no evidence that ownership of the operating system causes success in other markets.

The bottom line is that we have a theory with no support, and claims with no support. Yet they are taken very seriously by you reporters. Why aren’t you questioning these claims?

David Theroux

Thank you. Our next speaker is Robert Levy, a distinguished fellow at the Cato Institute. He’s also an adjunct fellow at Georgetown Law Center, has his Ph.D. from American University and J.D. from George Mason.

Robert Levy

Our topic today is Microsoft’s purported monopoly in PC operating systems. I’d like to focus on three key issues: (1) Does Microsoft in fact have a monopoly? (2) If so, have consumers been harmed? (3) If so, will government intervention improve matters? If the answer to any of those questions is “No,” then government has no role to play.

The Department of Justice (DOJ) persists in its crusade to force Microsoft to offer two versions of its Windows operating system—one with its Internet browser, one without—even if both are identically priced. If the goal is to force Microsoft to offer an inferior product, then the government’s position is simply unfathomable. In the end, consumers and taxpayers will foot the bill for this legal fiasco.

DOJ’s apparent rule is that products initially distributed in separate boxes must be permanently distributed in separate boxes. But almost every new feature added to Windows was sold in a separate box first: Hayes’ modem, $155; memory management, $79; CD-ROM drivers, $99; fax utilities; disk defragmenters. All of those now-standard features once came in separate packages. Most of them originally cost more than the whole of Windows costs today.

Any system without those functions would be incomplete. That is why IBM and Sun Microsystems, like Microsoft, have packaged browsers with their operating systems. That is also why Netscape has itself tied a wide range of other software products—e.g., e-mail, security systems, and graphics—to its browser. Such decisions, argues Microsoft, are better left to computer companies than to government lawyers.

In real markets, sellers continuously seek to carve out mini-monopolies; the profits from market power are the incentive that drives the economy. What might have happened in a utopian, perfectly competitive environment is irrelevant. The proper comparison is what would occur if anti-monopoly laws eliminate the incentives for new and improved products.

Regrettably, policymakers ferreting out market power too frequently mischaracterize legitimate business dealings as anti-competitive. Just look at tying arrangements.

Supposedly, they force consumers to purchase a tied product that they would prefer to buy from someone else or perhaps don’t want at all. But practically speaking, the product in which market power is presumed to exist is rarely if ever an essential good. So the customer who is opposed to buying the tied product can simply decline to transact.

In the Microsoft context: First, no one is required to own a personal computer; millions of Americans don’t. Even if PCs were essential, producers would try to sell multiple computers to each home or business. Competition for those discretionary purchases would restrain any attempt to “coerce” first-time buyers.

Second, the corollary of Microsoft’s 85 to 90 percent share of the operating system market is that one customer in eight doesn’t use Windows. Alternatives are available—MacOS, Unix, and OS/2, to name a few—with more on the horizon.

Third, network computing technology, with its reliance on the Internet for software applications, will radically diminish the importance of the operating system.

Fourth, many tying arrangements are just an implicit price hike for the tying product. A $200 price for Windows tied with a useless Explorer is no different than a $200 price for Windows alone. Clearly, if there were no tie-in, Microsoft could raise the price of Windows from $150 to $200 without incurring the government’s wrath. Why should DOJ react differently if Microsoft sweetens the deal by including a browser that at least some customers want?

If a company doesn’t have power in the tying market, e.g., operating systems, then competition in that market automatically disciplines the tied market, e.g., browsers. That is, if a customer doesn’t like the browser, he can buy a competitor’s operating system. It’s only when there are barriers to competition in the tying market that a tying arrangement can expand the scope of market power. True barriers to competition arise not from private power but from government misbehavior—special-interest legislation or a misconceived regulatory regimen that protects existing producers from potential competition. The obvious answer—which has little to do with the antitrust laws and nothing to do with tying arrangements—is for politicians to stop creating those barriers.

For its part, when Microsoft advertises, lowers its price, improves quality, adds features, or offers better service, it may indeed discourage competitors, but it cannot bar them. A tying arrangement is just another tactic—no more objectionable and no more sheltered from a competitive response.

That brings me to the latest rationale for an activist antitrust agenda: the theory of “network effects.” The theory holds that competitors can be excluded from high-tech markets when customers, concerned about compatibility are seduced into purchasing an inferior good. More generally, the term “network effect” (or “network externality”) refers to the change in perceived value of a product that is caused by a change in the number of people who use it: as more people use the product, the theory says, the more its value rises.

When that happens, consumers’ actions can become “path dependent”—meaning that a consumer can be locked into an “objectively” second-rate product, despite known alternatives that are better. At the same time, producers benefit from “increasing returns to scale”—not due to declining production costs, but from higher revenues as the product becomes more valuable to each new consumer.

But looking back, it’s crystal clear that consumers are not inveigled “network effects.” Consumers refused to anoint WordPerfect as ruler-in-perpetuity of word processing, or Novell as permanent king of network operating systems, or Lotus as spreadsheet leader forever, merely because usage of those products was ubiquitous.

In fact, consumers benefit when software developers capitalize on “network effects.” Globally, millions of programmers have created thousands of compatible products—thanks in part to the standardized platform that Windows affords.

Furthermore, before too eagerly substituting DOJ’s political power for Microsoft’s market power, we should carefully consider the consequences. The very thought that the government might be entrusted with determining whether a buyer, supposedly swayed by “network effects,” acquired an inferior product, should be unsettling to anyone who values liberty.

Remember that Nixon, when he wanted to browbeat the three major TV networks, used the threat of an antitrust suit to extort more favorable media coverage. On a recently released tape, Nixon told Chuck Colson, “Our gain is more important than the economic gain. We don’t give a goddamn about the economic gain. Our game here is solely political. As far as screwing the networks, I’m very glad to do it.”

Still, proponents of antitrust enforcement assert that the possibility of government corruption is overweighed by the iniquity of private monopoly power. Even if that proposition were true in some isolated context, it’s simply not applicable to the software industry. Unlike oil, utilities, railroads, and other capital-intensive ventures, software is not based on physical equipment but on ideas—on human intellect, which economist Julian Simon has called the “ultimate resource.” No company monopolizes ideas. The history of software is that better ideas mean better products, and better products prevail in the market.

Of course, advocates of “network effects” argue that consumer purchases are not a reliable indicator of a “superior” product. Instead, the advocates would have us believe that objective measures can tell us which products are technically “superior,” no matter what consumers actually buy.

The problem with that argument, of course, is that it leads directly to government paternalism, to the idea than an elite group of government officials knows our interests better than we—and can regulate affairs to satisfy those interests better than the market does.

When we permit government to make such assessments, and we allow those assessments to trump the subjective choices of consumers, we are well on the road to tyranny. In the process, we will have reduced consumer choice to a formalistic appraisal centering on technical features alone—notwithstanding that products are also desired for their quality, price, service, convenience, and a host of other subjective variables.

Today, Microsoft’s commanding lead is threatened on two main fronts. First, Sun’s Java technology, when fully operational, promises an environment in which applications can be run both on stand-alone PCs and across the Internet without compatibility problems. Second, Netscape’s browser may soon offer Internet users a means by which they can overlay and eventually replace major parts of Windows.

Together with low-cost network computers, Java and Netscape jeopardize Microsoft’s control over PC desktops. If competition were barred, Microsoft would enjoy clear sailing. But it doesn’t. “Network effects” may slow competition over the short run, but they are not an effective barrier to longer-term competition; nor, therefore, are they a valid excuse for government intervention in high-tech markets.

If DOJ prevails in its attack against Microsoft, we will have politicized competition by enlisting the public sector in pursuit of private, parochial interests. We must remember that the alternative to big companies is not small companies, but big government—the most formidable and coercive monopoly of all.

David Theroux

Mr. Bruce Kobayashi is at the School of Law at George Mason.

Bruce Kobayashi

I worked at the Justice and at the FTC during the Reagan-Bush years, 1986-’89. So, you know, I will burn in hell for that. I remember when a competitor came in and complained bitterly about a merger. Both the attorneys and the economists then felt that this was like a free pass. And it goes to the interests and the objectives of antitrust laws, which is not the protection of competitors but the protection of competition. And I think that since the Bingaman and Klein years, we have seen a large and I think misguided foray into vertical restrains and paying attention to competitor complaints, which, in my view, means just looking at the interests of who’s complaining, and is more likely to subvert rather than promote competition.

I’m not going to spend too much time on traditional theory. I just want to say that one of the hallmarks of antitrust enforcement, and throughout its history, is that when antitrust enforcers do something, I’m less concerned about it, because usually at the end of the day they really didn’t do much. And we can look at what they’ve achieved through today. They brought a contempt proceeding, as you all know, and they suggested that Microsoft was in contempt of Section 4E of the final judgment entered August 21, 1995, which involved the process or license. But Section 4E provides that “Microsoft should not enter into any license agreement in which the terms of the agreement are expressly or impliedly conditioned upon the licensing of other covered product, operating system software product, or other product.” And then, of course, there’s a left parenthesis: ”(provided, however, that this provision, in and of itself, shall not be construed to prohibit Microsoft from developing integrated products).” Once again, a poorly drafted consent decree leads to further problems. That’s not new.

The fix is new. And, of course, all the recent controversy is over whether Internet Explorer is integrated, whether or not Microsoft plotted the decree by removing it. And now the current fix is, of course, that Microsoft will in effect lose the icon.

What was done here, and what the Antitrust Division had in mind, was to prevent what economists call “pure bundling.” That is, offering a bundle of products without offering separate components. Microsoft is still allowed to bundle, but it must “mix bundle,” meaning it must offer separate products as stand-alone units. When we look at the fix here, offering a mixed bundle is only effective if in fact the mix—the stand-alone product—costs less than the superior products, the bundle. And here, of course, there’s no additional marginal cost of providing customers with the full Windows 95, plus Internet Explorer 4.0 compared to providing them with the same program absent the icon files. And so what Microsoft will probably predict is that they will offer computer manufacturers the version of the browser, either with all the files removes and disabled, according to the DOJ, or the complying version, which has the icon to Internet Explorer rates. And who is going to agree to have the inferior version at the same price?

The decree does nothing. If you look at FTC and the DOJ, their decree really does nothing. Even if a large percentage of purchasers are going to prefer Netscape Navigator, why would you then not offer a choice to your computer manufacturer. Why would you not say “It’s the same price. Why don’t I give at least some of my consumers who want it the chance to use Internet Explorer.”

You have to remember that there’s two parts to Section 4E. The other one is that you can’t condition the license of Windows 95 Internet Explorer on the fact that you don’t license, say, Netscape. But there’s no allegations they’ve done that.

If they had, the Justice Department certainly would have, and probably more seriously, brought a case against violating Section 4E2, which says you shall not condition on the OEM [Original Equipment Manufacturer] not licensing, purchasing or using or distributing any non-Microsoft products.

But Microsoft has not—they have not been charged with violating that part of the decree. They’re charged with bundling. There’s no restriction on the use of Netscape.

Questions and Answers

Reporter

I’ve read the papers, whatever that they wrote to—when they got full contracts license. I don’t know if you’ve looked at that.

Bruce Kobayashi

Well, they threatened to pull the licenses based on the fact that they wanted not to license the Internet Explorer part of it. But there is no any allegations by the Justice Department nor—I mean if Microsoft did that, they would be in violation of the consent decree.

If they went to Compaq and said “We will not license you if you—if you put Netscape, if you license, get a license for Netscape.” So Netscape can be on; Internet Explorer cannot be on if Compaq says they don’t want it.

Reporter

But, no, I’m confused now about what you’re saying, because what happened was that they wanted them to restore the Internet Explorer...

Bruce Kobayashi

That’s right. But there’s no allegation that they said “You cannot put Netscape on it.”

They said “You take all of it. You take the bundle or nothing.” That’s pure bundling and that is what the Justice Department is arguing is a violation of Section 4E1. So I’m sorry there’s confusion. But there’s no allegation that they’ve violated Section 4E2, which says you can’t have Netscape on it. This appeared in a lot of papers. But it’s not true.

[Comment by panelist inaudible.]

Bruce Kobayashi

This is the display preference. There was a very similar regulatory antitrust case with respect to the computer reservation services on the display preference. As an example of a display preference, consider a Coke machine. It may have Coke and Pepsi, but the Coke button is four times bigger than the Pepsi button. There’s certainly no notion that you have to have exactly the same treatment, exactly the same expenditures on advertising. The whole notion is that your screen comes up, and you see Internet Explorer. And the icon’s here, and the Netscape icon could be anywhere to the right, maybe at the top. And it’s not clear that there is a display preference. If there is a display preference, then, so what? You can move the icons all over the place.

Unidentified Panelist

It’s not a matter of “so what.” If you take Coke and Pepsi, it would be different if one of them was a monopoly. If Coke was a monopoly and it forced all soda pop machines around the country to only take Coke, I can imagine the government would probably be concerned about it. It is not a good analogy, because Coke is not a monopoly compared to Pepsi.

Bruce Kobayashi

The whole notion is that there’s a grid, and if somebody wants to license and put on as a matter of, you know, an OEM, a manufacturer wants to license Netscape, they can put on Netscape. It’s going to be at the end, as a default setting when they put it on. It’s going to be at the bottom. Now that bottom could be way down at the bottom in the center, or it could be at the top. So it’s unclear depending upon how you’ve arranged your desktop and how many applications there are. But the first thing you see on the left at the top is not Microsoft Internet Explorer. It’s somewhere down at the left. So it’s not clear that the display preference is actually there.

I have Netscape on my Windows 95 machine at home and at work. I use Netscape and I use Internet Explorer. I think they’re pretty seamless. And it’s not clear like the CRS [Computer Reservation System] cases, which involved the airlines. Apollo put their flight on first and all the United flights even though you really wanted to fly Northwest and that was a better time and a lower fare. But here it’s not clear that there really, truly is a preference. I’m Japanese, so maybe I have a preference for looking to the right rather than the left first. But Internet Explorer is not at the top left in a prominent place.

In any case, there are three points. One is that the paper tiger aspect of the Justice Department is seen here too. They really haven’t done anything, because nobody is going to actually buy the unbundled good. At the same price, you’re just adding a small feature. Even in the unbundled product, you’re not actually having the files removed. It’s just hidden. And so if you’re Compaq and you want to license Netscape Navigator, some consumers are going to prefer, as Stan has noted, Internet Explorer.

Reporter

Wait. Wait again. The Justice Department disputes that last statement. I mean their position is that they’re doing more than hiding the button, that even though it’s simple, they claim. I mean Microsoft has a very different perspective. Their perspective is that you actually have removed some software that doesn’t let you.....

Bruce Kobayashi

That purely technical point doesn’t matter, because the OEM would say, “Well, some people probably value Internet Explorer. I get a choice of two licenses from Microsoft. Both cost the same amount. Don’t I want to avail my customers, even if I choose to let them have Netscape Navigator? Why should I pay the same price and give my customers less?”

What they really wanted them to do is to remove files that would disable the functionality of Internet Explorer in favor of Microsoft. The program was stripped down and nobody bought it. What they said is “Okay, let’s just get rid of the display preference.” I think that is a valid characterization of what they have done. They’ve just removed the icon. We could add it back, if we wanted to.

Unidentified Panelist

The market may have changed and so it may now be irrelevant. It may be a paper tiger. I’m not necessarily disagreeing with that aspect. But what it does do is it specifically permits behavior that Microsoft had prohibited between Compaq and Netscape, which was that Netscape was going to get a featured place and Internet Explorer would not get a good place on the desktop.

Bruce Kobayashi

The consumer could swap them. In any case, because it’s the same price, I mean Netscape is on, and both icons are on now, on all computers as far as I can tell. Nobody’s going to avail themselves of the mixed bundle option. They haven’t done anything because they haven’t addressed the pricing. I don’t think you want to address the pricing. But nobody is going to buy an inferior product. And the computer manufacturers can redo on their master copy the display preference. But that’s all it is. It really isn’t much, given that it’s not a linear ordering or a line that you’re looking at, and there’s not a clear preference for down here or up here.

Unidentified Panelist

That difference can’t give Microsoft a monopoly in the browser market....

Reporter

We’re talking past each other here. I’m not disagreeing with you at all. I’m just saying that the Justice Department saw itself as addressing actual behavior of Microsoft. They addressed that behavior, and the agreement changes their behavior. In fact, the market’s changed since all that occurred.

Bruce Kobayashi

It affected it. My point is that it really hasn’t done much substantively, because nobody is actually buying the version that Judge Jackson has ordered them to do.

Unidentified Panelist

Nobody wants to buy the disabled version.

Bruce Kobayashi

No, no. But nobody wants to buy the “without icon” version either. They’re the same price, and they give you more. I mean if you’re an OEM, you’re going to pass these things through to consumers, some of which like Internet Explorer, because it’s a good program.

Unidentified Panelist

He’s right. Netscape could come along, and so could Internet Explorer. Which is what happened in 1996 with Compaq. I don’t know, but that is my speculation.

Bruce Kobayashi

Right. But then that, of course, should be condemned just as well by the Justice Department, because Netscape, of course, is both leader in new browsers...

Unidentified Panelist

Yes. But nobody is arguing that case as a monopoly.

Bruce Kobayashi

Well, okay. The traditional antitrust argument is that you’re leveraging monopoly. Now if economists are in agreement about a few things, one of them in the fixed-proportions case—as this is. Watch Carl Shapiro give his talk tomorrow—and I’ve seen his paper—he’s saying this bundling stuff is no big deal. As a matter of economics, there’s no problem. It’s a fixed-proportions case. There’s no such thing as getting another monopoly. You can’t squeeze two monopolies out of one. And the fixed proportions case is not a big deal. You have one browser.....

Stan Liebowitz

....left shoes, and everybody has to buy a pair. But having a monopoly on right shoes as well, it does you no good.

Bruce Kobayashi

So even the proponents don’t think bundling per se is a big deal. Bundling, as a matter of economics, is not a big deal. In the fixed-proportions case, it can’t have any effect. In the variable-proportions case, it might have an effect in allowing somebody to price discriminate, not in a violation of the Robinson-Patman Act, but basically charging or metering use, maybe charging somebody more who values it more. It’s not clear that it reduces economic welfare. When I was at the Justice Department, the antitrust agencies weren’t worried about Robinson-Patman. The law may be very much screwed up, but here in the fixed-proportions case, I think even those economists who support antitrust action against Microsoft aren’t going to say that the issue of bundling is a big deal.

Reporter

I think you’re right.

Bruce Kobayashi

So the second issue is a broader issue, which is that these are information industries. So they can’t bring a predation case because the marginal costs of distributing this actual code, whether it’s the alt 1E4 file or just the icon file, is zero. So they’re going to have a hard time meeting the Areeda-Turner criteria for predation, which has been, of course, another debunked antitrust doctrine.

The final issue is that what the Justice Department has done. Throughout their history antitrust laws have attacked intellectual property contracts. And there’s also a parallel conflict in copyright and patent law called “patent misuse,” which is also based largely on a time theory. But the whole notion is that you have your intellectual property, or we’ve decided that you don’t deserve intellectual property protection from a statute, the patent or copyright law. You can go no further. But that really is not the case. You guys are all newspaper reporters. So you should be well aware of problems with the particular problems you face in gathering and disseminating information. That’s your job. In fact, the Supreme Court in the antitrust laws has addressed you profession in two seminal cases, both involving AP. The first one was in 1918 with INS v. AP. I don’t know if any of you are familiar with it. But the Hearsts had really ticked off the allies in World War I by siding with the Germans. And so they barred all of their reporters from the front lines. And so what they did was they would go to the East Coast. The AP would post—they used to have bulletin boards back in those days. The reporters would then write down what was on the bulletin board posted in New York and then call—this was a West Coast paper—call the West Coast. So they would have the same information. So they were basically free-riding on all of the AP’s work. And I mean how would you like to be scooped like that by your rival newspaper? It’s unconscionable. But there was no copyright protection to news.

So they sued them, and not under copyright, because you can’t copyright the news. But the Supreme Court created a quasi-property right to hot news. It’s the theory of misappropriation, which still exists in a small set of cases today, but it’s generally limited by the fact that most of these cases are pre-empted by copyright law.

There’s a similar problem in the software. And also there was an antitrust case against the AP’s bylaws in 1945—they had a restriction that you could not sell AP news to non-members. It led Justice Murphy to say it’s ridiculous have to give up all your work to your competitors. And it would take the antitrust laws to absurd lengths. But if we go on into something where the antitrust laws are doing something that actually have teeth—not this toothless stuff that they are doing, like talking about making Microsoft a common carrier similar to what you saw in the Berkey Photo v. Kodak case—then we’re talking about predisclosure of their APIs, or letting competitors in on an equal basis. Then you really are taking antitrust law to a place where it’s going to start interfering with the intellectual property rights of Microsoft. And there is a danger. The Antitrust Division is saying we’re worried about the future. Maybe it’s because of tipping. But what they are doing is, I think, destroying the future by eviscerating Microsoft’s attempt to contractually protect whatever intellectual property they have.

Now you could protect software with copyright. You could protect software with patents. But that area is so much in flux. And in Computer Associates v. Altai, the judge said this is like trying to fit the square peg in a round hole; it doesn’t work that well. And so what computer companies have done what all people have done when they don’t really have a good sense that the statutory intellectual property regimes will protect them well: They have gone to contracts, because you have to show a separate wrong, a breach of trust of contract, in order to enforce something. There’s an Easterbrook case in the 7th Circuit, Zidenberg v. ProCD, which is all about contractual protection of intellectual property. We see this often. Every time you open up your software, there’s a license. That is a contractual mechanism to get around the first doctrine in copyright law. And so contract is all-important in protecting intellectual property in this particular industry.

Now what is the Justice Department doing and what have antitrust laws done in general? They’ve gone out and they’ve attack the contracts that seem to exclude, seem to impede competition—without thinking about the future. These contracts may be necessary in order to get people to invest in information. You wouldn’t go out and bust your butt to get a story if you had to then come back before publication and share that story with all your competitors. You wouldn’t be the one out there getting shot at in World War I, right? You’d be the one sitting around in New York waiting for somebody to post the bulletin board. And that is the heart of the intellectual property laws. The heart of contracts is to protect intellectual property. It’s been the history. Maybe the height of it was nine “No-Nos,” when the Justice Department said that anything—any license agreement that we can think that is ancillary to a patent agreement—would be considered an antitrust violation. We backed off of that in the 1980s. But what is scary about this, and not just with Microsoft, is that there’s been a long-standing hostility toward intellectual property in antitrust. There are books on the patent-antitrust paradox and the intellectual property and antitrust paradox.

And I see that coming back in spades, because, you know, Janet Reno, Joe Klein or Anne Bingaman, although they seem to suggest that they’ve read Schumpeter, it’s obvious that they haven’t. They haven’t thought about the dynamics. Joseph Schumpeter’s great book is not about how static market structures affect competition. It basically says you can’t look at contracts in a static sense and then judge them, because you have to think about the fact that the market is a gale of creative destruction, and these innovations help create that gale of creative destruction.

So my objections to antitrust are that, by the Antitrust Division’s own admission, they don’t know what they’re doing. And, furthermore, they have been locked into this unrealistic focus on static things, like “this contract excludes,” or “this market share is too big,” or “Microsoft has a monopoly,” when the real issue is that we want Microsoft, and companies like that, to have rents. We want them to be able to exclude because it’s intellectual property. And I see no evidence that the Antitrust Division is going to take these things into account on a systematic basis, and I think that’s the real danger.

Unidentified Panelist

They haven’t said Microsoft can’t. They said a monopoly properly obtained...

Bruce Kobayashi

Well, yes. I mean that certainly is sort of the case law. Tying is really an odd antitrust doctrine. It’s misguided in a lot of ways. But of course, you have cases like Kodak v. Berkey Photo, and you have Grinnell, which says you could have a monopoly if it was not obtained improperly through hard work or through luck; you just can’t use it. So using it usually means leveraging it to something else. As a matter of economics, it’s not a problem. As a matter of law, it certainly is a problem. And what they’ve done is that they’ve gone after contracts. And contracts may be the only way in which a lot of software companies deal with the appropriation problems and the other intellectual property problems that they cannot deal with through statutory enforcement.

[Question from panelist inaudible.]

Stan Liebowitz

I’ll give you my theory on that. We have competitors of Microsoft who would like to hobble them if possible by bringing monopolization charges. Well, normally monopolization produces higher prices and lower quantities. To an economist, it’s really the quantity reduction that causes the inefficiency.

I don’t think they think they can make that case stick, because prices don’t seem to be high, and Microsoft doesn’t seem to be restricting quantity in any sense. I read what reporters say Justice is doing as much as anything else. They want to come up with something that Microsoft is doing that is going to cause damage to the economy. And these theories allow you to make the claim that maybe networking is the threat. The way it sort of works is network effects lead to natural monopolies. Natural monopolies are required to get to the path of dependence, because you’re only going to have one winner. And if you get the wrong winner, you have the path to dependence. And then if it’s the wrong winner, you have this problem. And so maybe we need to have the government intervene to make sure that we don’t get the wrong winner. That’s the tie between these elements. Now why this allegedly works for Microsoft but not for any of the other high-technology companies out there, why the Justice Department wouldn’t worry about Sun setting the wrong standard in the work-station market, or why they wouldn’t worry about any of a half-dozen other companies setting the wrong standard, I don’t know. I don’t think there is a good linkage between this theory and antitrust in this case.

[Comment by panelist inaudible.]

Bruce Kobayashi

Yes. And it’s not new. And there was the Ethyl case which the FTC brought, which was a theory of increasing returns to scale and efficiency at DuPont. DuPont built a new plant that was much more efficient and larger-scale than its rivals. Efficiency was considered an antitrust violation. Now a lot of economists make fun of Ethyl, because it’s absurd to say efficiency is an antitrust violation. But that’s really the “nuts and bolts” of the case. But here economies of scale are considered a bad thing, and you have to go back to Stan and Steve’s analysis. Why? Because by accident, somebody who moves down that cost curve faster may be the wrong person. So we have to back up and think about whether or not this is the right person. I mean there are so many other dominant standards.

[Comment by several panelists are inaudible and not transcribable.]

Bruce Kobayashi

Without the economies of scale, all they’re left with is an illegal bundle. And that has absolutely no economic basis; that emperor has no clothes. And so what they’re doing is either something completely misguided; i.e., they’re preventing bundling without any welfare consequences, which I don’t think is their position. Their position is that there are longer-term issues; they’re worried about maintaining some kind of countervailing force towards Microsoft. They see it as leveling the playing field, because we’re worried about the future.

Well, the problem is that they’re not actually leveling the playing field. They see a guy running out there, Carl Lewis, and then order the sharpshooter to shoot him in the foot to slow him down. Is that a good thing? And this has been the history of antitrust, hobbling the front runner—IBM, Kodak, General Motors. It is an imperfect proxy for anti-competitive effects. But they are not stupid. They are just not in a position to judge these things, by their own admission.

So you have to say, “Okay, given that in theory we could make antitrust work, but do you really want to start doing that?” When Doug Ginsburg and Rick Rule ran the Justice Department, they decided that this probably wasn’t. In statistics, you have type one and type two errors, and you could either let the bad thing through or punish the innocent. And then there’s the good outcome. Well, it was decided that when you go after political restraints and contractual restraints, it’s more likely than not that you’re going to create an error, especially when you don’t know what’s going on.

And the expansion of political restraints in looking at contracts, I mean the biggest winner in all of this probably isn’t the consumer. It’s the antitrust bar. When Bill Baxter came into Antitrust in 1980 and cut out all that stuff, the antitrust bar suffered greatly.

Katz and Shapiro will make this point exactly: that it’s not the traditional bundling theory that matters. It is this tipping toward the inefficient standard. If you go the conference tomorrow, you will see that that is their main argument for laser-like antitrust policy in these cases. Shapiro joined the economics group at the DOJ, and he brought his colleague, Dan Rubenfeld. The Berkeley economics department is sort of the policy arm of the Justice Department these days. And so you do pay attention to what these guys say. Otherwise they really are left with an old, refuted theory.

I guess I’m saying be cautious when making policy from unproven theory. I think that’s Stan and Steve’s basic point. And if they brought this as a tying case, I think they’d have a really hard case, which is going to be made harder when they come out with Windows 98.

Reporter

Well, but you know the Justice Department admitted that. I mean they say this is a consent decree case, and Joel Klein stood up there and said if they successfully integrated the browser in Windows 98, whatever that means, then this case is moot.

Bruce Kobayashi

And you have to ask why they’ve spent so much time and money to get this—not just whether the icon is here or there. Do you remember when this started? When I was at the FTC, and the FTC had it and was deadlocked for two years. And it’s unprecedented that the Justice Department decided to take something from the FTC. I mean they collude. They have this process called “clearance”—meaning who gets what case. So this is not double jeopardy between the federal level and the states. This is federal agency one, federal agency two, and now the states. And at some point you have to think, okay, so you spent a lot of money. What did you get? And if we’re going to get them on a technical violation, if we’re going to get a paper tiger fix, then it really doesn’t pass the cost-benefit test. I don’t think any of us are saying that in theory these things can’t exist, or that in theory antitrust is bad. But I’ve worked at these agencies, and you have to be very cautious. I think caution is the right word before you go out and spend a lot of money.

Reporter

Let me ask sort of a speculative, theoretical question of my own. The Justice Department has implied and Judge Jackson expounded on at great length in his ruling that the real motive behind this theory that Microsoft is sort of trying to take over, win a new monopoly in the access point through the Internet. Couldn’t you argue that the government has a special interest in who controls the access to the Internet, because the Internet is a public domain? This occupies a unique space, because it’s not just a business proposition; it’s actually something owned by the public.

David Theroux

It’s all economics of commerce which you can bring into this, and everybody here is acquainted with it. I’m not sure if you know about this or not. There’s a term called “the tragedy of the commons,” which is used in environmental policy and other areas. And the point is that when you have a commons, you don’t have a clear situation as far as who can make decisions and who has the incentive to invest and who gets the return. It’s a free-for-all, essentially.

Stan Liebowitz

Let’s say, the worst case scenario: somebody gets a monopoly in the browser market. That’s hardly the same as a monopoly on the Internet. There are a lot of things that are going on, all sorts of transactions and whatnot. And the owner of the browser doesn’t necessarily get that control.

Bruce Kobayashi

And certainly Net Oracle is making a big splash with its $200 network computer. There are now a lot of platforms other than PCs to get on the Internet. Phone companies, AT&T, the Baby Bells can do it. The plan to introduce syndication rules, or networks are a monopoly. And they said, well, you’re going to have things like direct broadcast satellite. People laughed and said “You’re dreaming.” And now we have it, and we have cable competition. You have to look ahead. This is traditional: Antitrust Division of the Justice Department—they’re lawyers. And they go out and get to subpoena Microsoft. They get thousands of documents. And what’s the damning evidence? It’s Bill Gates and a lot of people at Microsoft worrying about competition and meeting competition. Look at their memoranda in the recent cases. All the damning evidence is that Microsoft is worried about people writing for API based on Java, or some browser technology. You look at that, and you say “Well, so what?” I would be worried as holder of mutual funds, who then holds Microsoft stock. I’d be very worried if Microsoft was not worried about these things and responding to them.

And so, given that it seems like browsers and operating systems are getting integrated, it would be a horrible strategic mistake for Microsoft not to do that. So unless you’re really saying that Microsoft and Windows are the wrong standards and you want to kill them. But I don’t think that even Joel Klein will admit that that’s what he’s doing, implicitly or explicitly.

Reporter

Do you folks believe that Microsoft is a monopoly?

Robert Levy

First, we’ve got to define the term.

Stan Liebowitz

The definition is there a single producer.

Robert Levy

They’re not a single producer.

Stan Liebowitz

But it has a very high market share. If you only look at market share, people say, “Oh, yeah, it could be a monopoly.” But the real thing that characterizes a firm as a monopoly is whether or not it is the sole producer. The question is, does it charge the monopoly price and reduce the monopoly quantity? That’s the bottom line. And that’s a hard thing to know for sure. But I don’t think there are very many people making the claim that Microsoft is acting like a monopoly. They may have potential monopoly problems.

Robert Levy

Are there barriers to entry in that market?

Stan Liebowitz

And the potential competition is capable of keeping even a single producer from acting like a monopolist and charging a monopoly price.

Robert Levy

Potential competition is every bit as effective as actual competition.

Stan Liebowitz

It’s also the case that having the power to raise prices by itself does not cause monopoly inefficiency, only actually using that power to raise price and lower quantity causes monopoly inefficiency.

David Theroux

And the cost of information is so low within this market as far as monetary and all the rest of it. It’s far different from the steel industry years ago, or whatever, as far as the kind of changes and in communications as far as evaluations and all the rest of it. So I mean it’s a process that is accelerating not just as far as the changes, but information about the changes.

[Comment by Mr. Margolis is off-mike, inaudible and not transcribable.]

Bruce Kobayashi

Literally, I removed that icon from my desktop.

Stan Liebowitz

...you normally buy some sort of browser. So it doesn’t make any difference. If you just get a computer and it’s got an icon, that doesn’t get you to the Internet. You’ve got to have some way of actually getting there physically. And it’s an Internet Service Provider that provides that to you when you sign up. And almost certainly you’re going to have some disk that contains someone’s browser on it.

Bruce Kobayashi

And it’s usually Netscape.

Stan Liebowitz

It’s not going to make any difference.

Reporter

Do you think then that the browser, the whole browser war is really over-hyped; it really doesn’t matter? It wouldn’t really matter if someone gained a monopoly, be it Netscape, Microsoft or some other company over the so-called access point to the Internet?

Robert Levy

Somebody had a monopoly. Netscape had 100 percent of the market, then 90, then 80, now 60.

Reporter

But you have to agree: that was before there were lots of people actually using that way of accessing the Internet.

Robert Levy

It’s always before something. Microsoft is increasing its share of the browser market, but there’s new technology out there just waiting to change all of that. Network computers are going to change the very nature of the browser. The browser is going to become more like an operating system, more of a platform on which software applications are going to be developed. So to suggest that Microsoft’s increasing share all the way up to, say, 35 or 40 percent of the market is nothing to be terribly concerned about.

Reporter

Well, again, I have to interrupt. That’s not what the government’s case is alleging. They’re not saying that.

Robert Levy

The government is alleging specifically that Microsoft violated the terms of the consent decree.

Reporter

Yeah. But more broadly, they’re alleging—they’re not contesting or expressing overt concern, any way, about the fact that Microsoft is at 40 percent share of the web browser market. They’re talking about the way Microsoft is using its existing monopoly, if you want to call it that.

Robert Levy

But how is it that they’re using their existing monopoly, if you call it that, by leveraging, according to the Justice Department, that monopoly to exploit the browser market, in which they now have 35 or 40 percent of the market and in which technology is such that they’re under great competitive pressure, not just from Netscape, but from who knows how many other technologies? You just wait.

Look at what happened with IBM. Over 13 years, there was a big wealth transfer from IBM shareholders and taxpayers to lawyers and expert witnesses. Basically that’s what it was. And the problem was resolved not by DOJ attorneys, but by some guys working in garages, people that DOJ attorneys never even imagined were out. And that’s likely to be the case now.

David Theroux

As long as there are not artificial barriers of entry, even if dominant, even a 100 percent monopoly historically finds that if they try to use that power, they end up losing market share over time. And that’s one of the great insights of economic historians who have found that in too many cases. And even Marxists like Gabriel Kolko, who studied the 19th Century, found that a firm that tried to dominate a particular market by lowering prices and then raising prices, and so forth, would constantly be bombarded by new entrants. What they found was more efficient to them, it was too costly to police this market privately, and they studied the history of cartels. But it was easier to use government agencies to police them by setting price controls and many other things. And so it may indeed be that in a lot of these cases the antitrust policies are actually used in anti-competitive goals, essentially, and outcomes by competitors against each other, as opposed to actually for the consumer or the public.

And I think with the politics of it, too often you find that that’s what’s generated policy. So that’s why it’s important to look at the evidence of Stan and Steve. If you have a theory, that’s one thing. But is what’s happening holding up to the theory or not? Otherwise you end up with this political contest which may not have much content and may actually be quite destructive.

Bruce Kobayashi

You have to remember that the Sherman Act is notable for one thing, and that is that it doesn’t say much. It says very little. And for a long time, nobody ever went to court. So it was almost an administrative procedure, even more at the FTC than the DOJ. But it is an odd statute, and some people in the offices surrounding this building would say a very well-done statute, because it creates so much litigation and so much change from decade to decade.

I don’t think that over the history it has increased wealth. But that’s an unsupported assertion. I certainly think that going after these types of vertical restraints has the large danger of decreasing wealth rather than increasing it. And in the end, maybe not that much decrease in wealth, because antitrust just transfers wealth to the K Street lawyers. And in the end Microsoft just does something which doesn’t hurt that much just to get around it. Ken Elzinga wrote a famous article in 1976 called “Pyrrhic Victory.” He was talking about mergers. They’d merge, and then ten years later they’d say, “okay, you have to spin off the firm.” And they’d spin off the empty shell, and that would be it. And what was the good of that? Ten years of litigation and a lot of build-up of associate billing hours, but nothing more. And really is the history of antitrust. If it became something else, I think we’d have problems. But I think they’re constrained by the courts. They’re not going to let people under the antitrust laws require pre-disclosure of all of their intellectual property. I think we have a sensible judiciary and we’ll stop it before that. That’s my hope. And Joel Klein and everybody else knows that. So there is some precedent which will stop antitrust before they do something really destructive, hopefully.

But with this nibbling around the edges, I think you’re probably better off just letting it go; in efficient and dynamic industries just letting the market deal with alleged monopoly problems rather than having this litigation till it becomes moot.

Robert Levy

I think there is one aspect of this that the press has not picked up on, something Bruce raised earlier, and it’s the relationship between these tie-ins and intellectual property. These tie-ins are very useful for producers of intangible products to prevent piracy. And Microsoft actually advanced that rationale back in 1994 when they were negotiating the first consent decree...

Reporter

What tie-in?

Robert Levy

Well, let’s take the tie-in between the operating system and the browser. It’s clearly a two-tier tie-in. Suppose Microsoft wants to prevent piracy of the Windows operating system. Well, of course, if anybody’s out there conspicuously copying Windows and making it available in massive quantities to consumers, Microsoft could very well take care of that. But if I were to copy Windows and make it available to my friends, there’s not a hell of a lot that Microsoft could do about it, no matter what they claim in the way of copyright law. And the same thing is true with the browser software. Well, how do you resolve that kind of piracy? One way to do it is to tie into the product, in this case an intangible product, to a tangible product, a PC. So you arrange with PC makers to bundle, to tie the PC with the intangible product, the operating system. Now you’ve got control of this piracy. How do you extend that to the browser? By tying your browser to the operating system.

Bruce Kobayashi

And the process and license that would enact that exact mechanism was, of course, the focus of the first decree in 1994. And so it’s just the off-shoot of the old IBM card case. It’s a metering device, and you do want to allow Microsoft to meter who is using their product because of the piracy.

Thanks for your question.