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February 1998
Volume 16, Number 2

Pile on Microsoft
by Françoise Melese

Scrooge came in the form of government last year. The company Bill Gates built into the planet's leading money machine is still the target of a federal probe and a senate inquiry. The charge: anti-competitive behavior.

Microsoft's stunning financial success comes from two sources: a "natural monopoly" in operating systems, and an "unnatural" monopoly in software applications. The Justice Department grudgingly accepts the first, but strongly objects to the second. The senate, motivated by "serious concerns about Microsoft's efforts to exercise its monopoly power" (Orrin Hatch of Utah), is now reviewing the government's antitrust laws to see if they can handle high-tech monopolies.

A little history helps to clarify events. Every computer needs two things: a language for creating applications and an operating system. In 1981, IBM called on Bill Gates and Paul Allen, founders of a small, relatively unknown company called Microsoft, to develop a language and operating system for a desktop computer called the IBM PC. This was to counter a revolutionary new computer marketed by Steve Jobs called the Apple II.

Microsoft had the language ready (BASIC, developed by Gates and Allen while at Harvard), but not the operating system. At the suggestion of Gates and Allen, IBM went to visit a computer scientist named Gary Kildal in Pacific Grove, California. Kildal, a professor at Monterey's Naval Postgraduate School, had invented a popular operating system called CPM. Unfortunately, he was too busy to deal with IBM on their terms.

So IBM returned to Gates and Allen and promptly signed them to deliver a language and an operating system for the IBM PC. $50,000 later, Gates and Allen had obtained a "reverse engineered" copy of Gary Kildal's CPM operating system called QDOS--for "Quick and Dirty Operating System." They changed the name to Microsoft or MS-DOS, and the rest is history.

IBM was soon rocked by an explosion of PC clones. Having anticipated the demand for clones, Gates licensed MS-DOS to every clone maker. Since Gates first started licensing MS-DOS, he discovered the value of stretching the definition of an operating system. Microsoft's stunning success is based on preempting competition through an ever-expanding definition of what constitutes an operating system. As The Economist magazine recently observed, "the operating system is whatever Microsoft says it is."

With the development of Windows, Microsoft recognized its emerging "natural monopoly" in operating systems, and the competitive advantage this offered in the distribution of commercial applications such as word processing and spreadsheets. Ever since, Microsoft has made a very good living by convincing PC makers to accept its software as a condition for licensing its operating system.

"Integrate and Bundle" should be Microsoft's motto. Stand-alone software products are routinely bundled into upgrades of Windows. Over the years, this has included applications like word processors, spreadsheets, calculators, games, and, more recently, an operating system used to navigate the world wide web: Microsoft's Internet Explorer. Customers love this practice. Today Windows is the industry standard, and the most widespread software applications on the planet are those bundled into Windows.

The fixed costs of developing, improving, advertising, licensing, and protecting an operating system are high, but the marginal costs of producing additional copies of the product are negligible. The result is that unit costs fall dramatically as fixed costs are spread over large sales. One way a "natural monopoly" can occur is if a single company develops and owns a scarce resource (like a popular operating system) that prevents other companies from providing the product at a lower price. A natural monopolist enjoys economies of scale, that is, its unit costs fall as it expands its sales.

Some economists fear that while costs fall, natural monopolies have limited incentive to pass on those lower costs. This is one explanation for governments' repeated attempts to regulate prices charged by so-called natural monopolies. But as Austrian School economists have long pointed out, there is no reason to fear exploitation by single suppliers, unless they're protected by the government. To stay profitable, they invariably have to improve their product or cut prices to sustain their market position. Competition does not require a certain number of competitors or a government-defined market share; it requires equal rules for everyone in the rivalrous process of innovative development.

Case in point. The telecommunications industry, once considered a natural monopoly, has largely been deregulated. AT&T had only a fleeting advantage before competition from MCI and Sprint eroded its monopoly position. Similarly, the Baby Bells were given local monopolies which have been steadily eroded by cellular providers, and are soon to be threatened by long-distance providers and Internet telephone service.

Today, electric utilities face similar deregulation. But, whereas the generation of electricity has been deregulated to encourage competition, the infrastructure required for the distribution of electricity--power lines, transformers, substations, etc., will remain regulated (local) "natural" monopolies.

The presumption is that it is wasteful for more than one firm to distribute electricity in a region, and, in any case, it is claimed that a single large firm can distribute electric power at a lower cost than could a collection of smaller firms. So far, the Justice Department has not proposed to regulate Microsoft's "natural" monopoly in operating systems, but it lends a sympathetic ear to software companies upset with Microsoft's grabbing an "unnatural" monopoly in commercial applications.

The Justice Department reached a settlement with Microsoft in 1995. It banned the company from insisting PC makers install its software applications as a condition for licensing the Windows operating system. The Justice Department contends Microsoft broke that agreement when it required firms to bundle its Internet Explorer web browser as a condition for licensing Windows 95 (thereby troubling its main competitor, Netscape).

The dispute centers around the definition of an operating system. Microsoft claims that the definition of an operating system has grown to include an integrated web browser. Netscape, Sun, Oracle, and IBM are trying to convince the Justice Department (and anyone else who will listen) that the only way to combat Microsoft's "unnatural" monopoly in commercial software applications is to break its "natural monopoly" in operating systems.

They point to Java, a software language which can run on any platform, developed by Sun Microsystems, and also to Netscape, still the most popular web browser, as the best hope of breaking Microsoft's monopoly in operating systems. The importance of the web browser is that, combined with Java, it may become a rival to the Windows operating system. Unfortunately, this battle for the marketplace looks set to end up in the courts.

The Justice Department called for an unprecedented $1 million-a-day fine against Microsoft. The threat to consumers is also real. Many of us think Microsoft is the best company to work out the bugs in Java. If it succeeds, it will have preserved its "natural" monopoly in operating systems from MS-DOS through Windows 95, to the Internet Explorer. Microsoft must be doing something right. The government is not acting on behalf of consumers; it is merely raising the costs of doing business.

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Françoise Melese teaches economics at the Naval Postgraduate School.

FURTHER READING: "A Bundle of Trouble," The Economist, October 25, 1997; Dominick T. Armentano, Antitrust and Monopoly (New York: John Wiley & Sons, 1982); Microsoft's website: microsoft.com

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