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Winners, Losers & Microsoft
Competition and Antitrust in High Technology
By Stan J. Liebowitz, Stephen E. Margolis
Independent InstituteCopyright © 2001 The Independent Institute
All rights reserved.
"Build a better mousetrap and the world will beat a path to your door." This adage, most often attributed to Ralph Waldo Emerson, is implicit in enough economic thinking that it might well take its place alongside "Incentives matter" and "Marginal returns eventually decline" as a fundamental building block. In the past decade, however, some journalists, bureaucrats, and even some economists have begun to doubt Emerson's adage. The markets for new technologies, they say, seem to behave differently from the markets for traditional goods and services. Laissez-faire policies may have produced good results in other times, but they cannot be relied on in the Age of Technology. Emerson, they say, may have been right about mousetraps, but his adage doesn't hold up so well if the only mouse in sight is a computer mouse.
Doubts, of course, are niggling things, but once they gain a footing, it's only human nature to look for evidence that doubts may be facts. And the evidence seems to be everywhere. Consider the typewriter keyboard. Everybody knows that the QWERTY keyboard arrangement is completely arbitrary. We'd all be better off if we had a different one, but changing now would just be too much trouble. We stick to the old, inefficient arrangement only out of unhappy habit. The market failed us on that one, didn't it?
And what about VCR format? Surely you've heard that the Beta format was much, much better than the VHS format that dominates the market today. Another market failure?
Or let's look at the war between Apple and DOS operating systems. Talk to any Mac owner. He'll be quick to tell you that Macintosh was a whole lot better than DOS. We'd all be using the Mac today except for one thing: The market failed. Didn't it?
If such stories were true, the evidence would be incontrovertible: In markets for technology, the best does not always prevail. And in this unpredictable New World, quality would lose out to the oddest things: a trivial head start, an odd circumstance, a sleight of hand. When there are benefits to compatibility, or conformity, or certain other kinds of interaction that can be categorized as network effects, a single product would tend to dominate in the market. Moreover, this product would enjoy its privileged position whether or not it was the best available.
Thus, the new technology gives economics, the dismal science, a chance to forge an unhappy marriage with the bad-news media. Journalists have been quick to file the bad-news story of how the world is not only unfair, but also illogical. Private litigants in the antitrust arena file suits alleging unfair competition. Incumbents, they say, are using unfair advantages to foist inferior products on an unsuspecting public. The U.S. Justice Department has been quick to second the notion, using it to support their cases against Microsoft and other successful U.S. firms.
The good news for consumers, though the bad news for the failure-mongers and the U.S. Justice Department (and possibly for consumers if the Department of Justice should prevail), is that the economic theory of a high-tech market locked in to failure has its foundation only in shallow perceptions — not in facts. A hard look at the claims of real-world market failures shows that they are not failures at all. The winners in the high-tech world have won not by chance, but rather by the choices of consumers in an open market. A responsible examination of the historical record provides evidence that entrepreneurship and consumer sovereignty work as well in high-tech markets as they do in more traditional ones — which is to say, very well indeed.
Does Wheat Separate from Chaff?
The prospect that the mediocre prevail is certainly intuitively intriguing. Anyone who has spent any time watching the celebrity talk shows, where celebrities talk about being celebrities, has already confronted a version of the world where cream doesn't seem to rise to the top. Do television commentators really represent our best intellects? How many of these people are famous for being famous? How many of them just look and sound good, inasmuch as they merely need to read statements over a teleprompter?
One might also ask how many political leaders represent the pinnacle of the talent pool. It is easy to suspect that success might be arbitrary. Alternatively, if success is not perfectly arbitrary, perhaps it is imperfectly arbitrary: the consequence of a head start, being in the right place at one particularly right time, or having the right connections.
On the other hand, television viewers might not necessarily want to watch someone who reminds them of a teacher in school, no matter how erudite that teacher might have been. Instead, they might want to be entertained. They might prefer a politician they like over one who might better understand the issues. They might prefer Metallica to Mozart, or Sidney Sheldon to Shakespeare. If we want to, we can conclude that they have bad taste, but we can't conclude that they are not getting the products that provide them the most quality for their money. So we need to be careful when defining quality.
Quality might well be in the eye of the beholder, but for certain utilitarian products, consumers can be expected to prefer the ones that perform tasks the most economically. Who wants a car that breaks down, or doesn't accelerate, or fails to stop when the brakes are pushed? Who prefers a television with a fuzzy picture, or an awkward-to-use tuner, or garbled sound? We ought to expect some agreement about quality among these utilitarian products. But even here we need to distinguish between efficient solutions and elegant solutions. In 1984, a Macintosh operating system might have ranked highest in terms of elegance, but DOS might have gotten the job done most cost effectively.
Still, it is natural to suspect that things — products, technologies, standards, networks — might be successful independent of their quality. It might be even more predictable that intellectuals, who prefer Mozart and Shakespeare, or at least Norman Mailer and Woody Allen, might disdain markets as reliable arbiters of product quality.
One part of the answer seems clear. Success sometimes does breed more success. It's human nature to get on a bandwagon — as any parent who has tried to track down a Cabbage Patch doll, a Beanie Baby, or a Furby can tell you. And bandwagons can be more than mob mentality. Some things are more useful when lots of people have them. The owner of the first telephone or fax machine found his purchase a lot more useful when a lot more people jumped on that particular consumer bandwagon.
A different and more interesting question, however, is whether it is possible for a product like a telephone or fax machine to continue to be successful only because it has been successful. If this can happen, it could be that in some important aspects of our economic lives, we have the things we have for no particularly good reason, and, what is more important, we might be doing without better things, also for no particularly good reason.
Let's look at the VCR example again. People benefit from using videotape recorders that are compatible with other people's videotape recorders. That way they can rent tapes more readily at the video store and send tapes of the grandkids to mom. If some early good luck in the marketplace for VHS leads people to buy mostly VHS machines, VHS might come to prevail completely over Beta, the alternative, in the home-use market. Further, Beta might never recover because no one would want to go it alone: No one buys Beta because no one buys Beta. Some people allege that not only can this happen but also that it did happen, in spite of the fact that Beta (it is alleged) offered advantages over VHS.
Although this story is at odds with the actual history of VCRs in a number of important ways (which we will examine in detail in chapter 6), it does illustrate the kinds of allegations that are often made about market performance regarding new technologies. First, if there are benefits to doing or using what other people are doing or using, it is more likely that we will all do and use the same things. This condition might lead to a kind of monopoly. Second, it is possible that for some kinds of goods, it is only by chance that the resulting market outcomes are good ones.
If in fact these allegations about market performance could be borne out, we would indeed have a problem. But these scenarios are not true stories; they are mere allegations of problems that could occur. The thrust of our research for the last decade, and that of a several other scholars, shows that in the real world, the marketplace is remarkably free of such disasters. Nevertheless, the fearmongers' allegation of possible problems has begun to exert a powerful influence on public policy — particularly antitrust policy.
Where's the Beef?
Almost everyone will acknowledge that the market is a pretty efficient arbiter of winners and losers for most goods. If two brands of fast-food hamburgers are offered in the market, we expect people who like McDonald's better to buy McDonald's, and people who like Burger King better to buy Burger King. No one is much concerned about how many other people are buying the same brand of hamburger that they are buying, so each person buys what he wants. If one product is, in everyone's estimation, better than the other and also no more costly to produce, then the better one will survive in the market and the other one will not. If it is possible for new companies to enter the industry, they probably will choose to produce products that have characteristics more like the one that is succeeding.
But many other outcomes are possible. If some people like McDonald's and some like Burger King, then both brands may endure in the market. If Wendy's comes along, and everyone likes Wendy's better, Wendy's will displace them both. If some people like Wendy's better and others are happy with what they've had, then all three may survive. None of this is terribly complicated: May the best product win. It might be that VCRs can be successful merely because they are successful, but hamburgers are different. They have to taste good.
The VCR and hamburger stories appear to be different in three important ways. First, the tendency toward monopoly is alleged only in the VCR story, not in the hamburger story. Second, the possibility of the best product failing is alleged only in the VCR story, not in the hamburger story. Third, the impossibility of a new champion replacing the old one is alleged only in the VCR story, not in the hamburger story.
Size Matters: The Economics of Increasing Returns
If, for some activity, bigger is better, we say that the activity exhibits increasing returns to scale. Economists have long observed that increasing returns can pose special problems in a market economy. In the best-understood cases of increasing returns, the average or unit cost of producing a good — the average cost of a good — decreases as the level of output increases. Such effects can be witnessed within firms — for example, there are often economies to mass production. They can also be observed at the industry level — a whole industry may experience lower costs per unit of output as industry scale increases.
Most production exhibits this increasing-returns property to some degree. As we go from extremely small quantities of output to somewhat larger outputs, the cost per unit of output decreases. A great deal of direct evidence supports this claim. It explains why a homemaker might make two pie crusts at once: one to fill right away; one to put in the freezer. It explains why two might live almost as cheaply as one. It explains why we don't see a television manufacturer or a tire plant in every town. Instead, larger plants serve broad geographical markets. Regions specialize.
For most activities, however, we expect that these increasing returns will run out, or will be exhausted as output gets very large: Bigger is better — but only up to a point. This is why we do not satisfy the nation's demand for steel from a single plant or satisfy the world's demand for wheat from a single farm. Some constraint — land, labor, transportation cost, management ability — ultimately imposes limits on the size of a single enterprise.
On the other hand, it is possible for a special case to arise where a single company enjoys decreasing production costs all the way up to outputs large enough to satisfy an entire market. This circumstance is what economists call a natural monopoly. A natural monopoly arises as the inevitable outcome of a competitive process. Bigger is better, or bigger is at least cheaper, so a large firm can drive out any smaller competitors. Many of the so-called public utilities were once thought to exhibit this property, and some are still monopolies. Generation and distribution of electricity, for example, was once understood to enjoy increasing returns all the way up to the point of serving entire regions of the country. This was, at least according to textbook explanations, the reason that these public utilities were established as price-regulated monopolies.
Even for public utilities, we now think that the benefits of increasing returns are more limited than we once believed. The result has been a public-policy decision to restructure and deregulate many of the utility industries, separating the increasing-returns parts of those industries from the rest. But even as deregulation in these industries proceeds, a number of analysts have begun to argue that we ought to get involved in regulating modern high-technology industries, basing their argument on the claim that high-tech industries are particularly prone to increasing returns.
The software industry, they argue, is subject to increasing returns that are almost inexhaustible: Once the code for a software product is written, a software firm has very low costs of producing additional copies of that product. But while the relationship between the fixed costs of designing a software product and the direct costs of making additional copies may explain increasing returns over some range, the idea that software production is subject to inexhaustible economies of scale merits careful scrutiny. After all, the cost of serving an additional customer is not confined to the cost of reproducing the software. It also includes the costs of service and technical support, the costs of marketing, and the design costs of serving a larger, and therefore more diverse, user population. In this way, the software industry is a lot like many older, traditional industries that have large fixed and low variable costs, including book, newspaper, and magazine publishing; radio and television broadcasting; and university lecturing.
Two's Company, Three's a Network
Many of our newest industries involve information technologies. In one way or another, they allow us to access, process, and distribute large amounts of information at high speeds and low costs. Many of these industries exhibit one variety or another of increasing returns.
One important form of these increasing returns results from what is called a network effect. If consumers of a particular good care about the number of other consumers that consume the same good, that good is subject to network effects. The telephone, though hardly a new technology, is an obvious example. Your telephone is more valuable to you if many other people have telephones. Telephones are, in fact, extremely important because almost everyone has one, and everyone expects everyone else to have one. The VCR problem that we discussed also relies on a network effect. Similarly, fax machines are much more valuable as more people get them — another network effect.
A particular kind of network effect occurs as technology develops. As more firms or households use a technology, there is a greater pool of knowledge for users to draw upon. As we gain experience and confidence in a technology, the expected payoff to someone who adopts it may become greater. Once a few people have tried a technology, others know what can be expected. Working knowledge of a technology, availability of appropriate equipment and supplies, and more widespread availability of expertise all make a well-worked technology more useful to businesses and consumers.
A special kind of network effect is the establishment of standards. Standard systems of building products allow projects to go together more quickly and more cheaply, make building materials more immediately and more assuredly available, and make design easier. Standard dimensions for nuts and bolts make it easier to find hardware and easier to fill a toolbox. In very much the same way, software standards make it much easier to build computers, design peripherals, and write applications.
Excerpted from Winners, Losers & Microsoft by Stan J. Liebowitz, Stephen E. Margolis. Copyright © 2001 The Independent Institute. Excerpted by permission of Independent Institute.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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Table of Contents
ContentsForeword by Jack Hirshleifer,
Preface to the Revised Edition,
I The Paradigm,
1. Networked World,
2. The Fable of the Keys,
II The Theory,
3. Theories of Path Dependence,
4. Network Markets: Pitfalls and Fixes,
5. Networks and Standards,
III The Real World,
6. Beta, Macintosh, and Other Fabulous Tales,
7. Using Software Markets to Test These Theories,
8. Major Markets-Spreadsheets and Word Processors,
9. Other Software Markets,
10. The Moral,
A. Networks, Antitrust Economics, and the Case Against Microsoft,
B. The Trial,
About the Authors,