Leave Microsoft Alone

Corporations, Securities & Antitrust Practice Group Newsletter - Volume 2, Issue 1, Spring 1998

May 1, 1998

Donald J. Boudreaux

On October 20, 1997, the Department of Justice announced an unprecedented $1 million per day fine against Microsoft for allegedly violating a 1995 consent decree. In that decree, the software firm agreed not to condition the sale of its popular Windows 95 operating software on purchasing certain other Microsoft products. The Department of Justice ("DOJ") is now investigating Microsoft's insistence that computer producers who install Windows 95 include Microsoft's Internet Explorer ("Explorer") with this installation as a potential violation of the consent decree.

Microsoft counters that Explorer is an integral part of Windows 95 and not a separate product. While the outcome of this current dispute will turn on whether the courts accept the DOJ's contention that Explorer is separate from Windows 95 -- or Microsoft's contention that adding Explorer to Windows is nothing more than a permitted upgrade of Windows 95 -- the underlying issues go far beyond the narrow question of how faithfully Microsoft obeyed the consent decree.

At least two larger issues are raised by the DOJ's action against Bill Gates's firm. The first is the legitimacy of the antitrust rule against tying arrangements. The appropriate role of antitrust policy represents the second, even broader, issue. Black-letter law dictates that it is per se illegal for a firm with monopoly power in good A to tie sales of good B to sales of good A if this tie-in affects a substantial amount of commerce in good B and its rival products. If Microsoft has a monopoly in operating-system software, and if Explorer is indeed a separate product from Microsoft's operating-system software (Windows 95), then it is per se illegal for Microsoft to refuse to sell Windows 95 separately from Explorer. Antitrust enforcement policy maintains that this rule stops firms from "leveraging" whatever monopoly power they enjoy in one market into other markets.

The law's distaste for tying, however, has long been questioned by economists. First, identifying tying is unavoidably subjective because it is too often unclear what constitutes separate products. Is the editorial page of the Wall Street Journal separable from the pages reporting stock prices? Are tires on an automobile separate from the rest of the car? Is the beer in the bottle separable from the bottle? Every product is a bundle of different features that could, at some cost, be unbundled.

Second, and more importantly, economics makes clear that even pure monopolists cannot enhance their monopoly profits through tying. Therefore, tying is practiced only when it creates efficiencies that would not otherwise arise.

Consider why tying cannot enhance monopoly profits. If Microsoft enjoys a monopoly on operating-system software (and assuming that it seeks to maximize its profits), then it will charge a profit-maximizing price for Windows. This price, of course, will be a monopoly price. But once Microsoft charges this monopoly price, any further increase in the price of Windows will reduce Microsoft's profits. If Microsoft can increase its profits by increasing the price it charges for Windows, then it must be true that Microsoft did not previously charge the profit-maximizing price for Windows.

So, assuming, that Microsoft charges the profit-maximizing price for Windows, Microsoft cannot further increase its monopoly profits by tying Explorer to Windows. If Microsoft ties Explorer to Windows and charges a price for Explorer exceeding the profit-maximizing price that consumers would pay for Explorer standing alone, then Microsoft effectively raises the price of Windows above its profit-maximizing level. The result will be unambiguous: Microsoft's earnings will fall.

Any attempt by Microsoft to leverage its monopoly power in operating-system software into competitive markets lowers, dollar for dollar, the price that Microsoft can fetch for Windows 95. The general lesson is that Microsoft can completely capitalize on its monopoly in operating-system software by charging the full monopoly price directly for Windows 95.

"But suppose," argues the MSphobe, "that by today insisting that Explorer be bundled with Windows 95 Microsoft tomorrow monopolizes the market for web-browsers. Microsoft bundles these two products together not to increase its current profits but, rather, to destroy Netscape (whose Navigator software is the still-dominant web-browsing software)."

Although superficially appealing, this later argument is flawed. Windows 95's profitability rises as the prices of all products complementary to Windows 95 fall. The lower the price of applications software, the greater will be the quantity demanded of this software. Added purchases of applications software will cause the demand for the operating-system software to run these applications to rise -- just as the demand for automobiles will expand if the price of gasoline falls. Because web-browsing software is complementary to Windows, the lower the price of web-browsing software, the higher is the demand for Windows. Microsoft has every reason to keep applications software priced competitively.

Microsoft sells computing ability. To garner maximum monopoly profits in this market, all it needs is monopoly power in one essential input to computing ability. If Microsoft does indeed have monopoly power in operating-system software (which it must possess for the tying allegation to have legal legs), it will do all that it can to ensure that web-browsing software is priced as low as possible.

Additional economic arguments justify calling off the antitrust dogs from their attacks on Microsoft. Foremost among these is the fact that antitrust has largely been used to foster monopoly rather than competition. Accumulating evidence shows that even the sainted Sherman Act was intended to protect less-efficient (but politically powerful) producers. (See Fred S. McChesney & William F. Shughart, The Causes and Consequences of Antitrust, 1995.)

Economic competition is always unpleasant for firms that offer lesser value to consumers than their more successful rivals. Such competition directs less-successful firms either to become better at what they do or to dissolve, thus freeing their scarce resources for better use elsewhere. Thus, the net effect on business (particularly entrepreneurs), and for consumers, is a positive one.

But if these less-successful firms can point accusingly at rightfully flourishing rivals and scream to the government "Omigod! That success portends monopoly! Save us!!," firms will divert their competitive energies into courting government and judicial favors and away from figuring out how to compete in the only legitimate arena: the market. The law then ends up as a tool for creating economic inefficiency and less desirable products and prices for consumers.

Microsoft's track record of aggressive competition no doubt causes angst in the boardrooms of its rivals. Consumers by their actions have demonstrated a different view of the tremendous advances that Microsoft has made and of its steadily declining prices for computing products. Antitrust law should not be allowed to serve as a cudgel to deaden competition. The appropriate presumption is that Microsoft owes its success to its capacity for pleasing consumers. Government regulators should not punish Microsoft for its prosperity.

Donald J. Boudreaux is President of The Foundation for Economic Education, Irvington-on-Hudson, New York. His J.D. is from the University of Virginia; his Ph.D. in economics is from Auburn University.