1. The Antitrust Assault on Microsoft

The 1998 antitrust suit brought by the Department of Justice and twenty state attorneys general against the Microsoft Corporation¹ captures everything that is still wrong with antitrust policy and demonstrates why the laws must be repealed.

A brief historical review of Microsoft’s antitrust difficulties is in order. The Federal Trade Commission started investigating Microsoft’s software licensing practices in 1990 but closed its investigation in 1992 without filing charges. (This was significant since the FTC is expressly charged with policing so-called “unfair methods of competition”) But in an unusual development, the Clinton administration’s Justice Department, under Assistant Attorney General Anne K. Bingaman, picked up the aborted FTC probe of Microsoft and sharply expanded its scope.²

After an additional two-year study, the Justice Department concluded that Microsoft’s “per processor” licensing fee system discouraged PC manufacturers from installing competitive software and that Microsoft’s standard two-year lease unfairly foreclosed software rivals from the market. To avoid long litigation, Microsoft signed a consent decree with the Department in 1994 and agreed to end its per processor licenses and shorten its standard two-year lease period to one year. U.S. District Judge Stanley Sporkin refused to certify the agreement because it did not provide an “effective antitrust remedy” and was not in the public interest, but he was overruled by a Court of Appeals. The consent decree became fully effective in 1995.

With one set of alleged restrictive practices resolved, the federal antitrust authorities immediately focused on a new set associated with so-called “Internet access.” The new concerns stemmed from Microsoft’s decision to integrate (or tie) various software applications into its increasingly popular Windows operating system.

First, in an unprecedented move, the Justice Department threatened to delay the introduction of Windows 95 because Microsoft bundled its own on-line Internet service (Microsoft Network) with Windows. Then Justice and Microsoft disagreed bitterly over Microsoft’s decision to tie its Internet browser, Explorer, to its operating system. The government claimed that the bundled browser violated the 1995 consent decree; Microsoft claimed that the decree explicitly allowed “integration” of the browser as well as other applications. An appellate court ruled definitively in Microsoft’s favor in June of 1998³ but, in the interim, the Department of Justice and twenty states filed an antitrust suit against Microsoft.

The suit claimed that Microsoft had a monopoly in operating systems for personal computers, that it attempted illegally to leverage its monopoly power in operating systems to other products or services, that it engaged in restrictive agreements with PC manufacturers and Internet service providers, and that its monopolization injured competitors and consumers. A trial began in October 1998.

Microsoft’s Monopoly

Whether Microsoft had a monopoly in operating systems depends, of course, on a precise definition of monopoly. A perfect monopoly, presumably, would control all of the available supply of a product in some well-defined relevant market with strong legal barriers to entry. Since Microsoft was said to license 90 percent of the operating system software sold in new personal computers and since there were no legal barriers to entry in software, Microsoft did not have a perfect monopoly. There were other operating systems for personal computers available (Mac OS, Unix, OS/2, Linux) and consumers could turn to them if the Microsoft system were unavailable; in addition, new suppliers could always enter the market. Yet, legal scholars citing precedent would argue that any market share above 70 percent (with or without legal barriers) can constitute monopoly under antitrust law.⁴

As we will elaborate in the following pages, the market-share theory of monopoly is confusing and ultimately misleading. Much depends on how the relevant market for the product is defined. More importantly, a firm could produce a superior product at low cost and consumers could establish that firm as the dominant supplier; the law, presumably, was not meant to restrict such beneficial behavior.⁵ Indeed monopoly, however defined, isn’t illegal under the Sherman Act; “monopolization” is. What the law really requires (after a threshold market position has been established) is a showing that the defendant engaged in so-called monopolistic practices. The important questions are: How did the firm come to obtain its market share? Did the firm unfairly exclude competitors from the market? Did it unfairly restrain the competitive process?

In our view, Microsoft’s dominant market share in operating systems evolved legitimately from a free-market competitive process. The PC software industry was legally open and contained many talented players (Sun, Netscape, Novell, Oracle, Apple, IBM), some larger than Microsoft, some smaller. The market process in this industry has always been characterized by intense innovation, rapid growth, sharply falling prices, and bitter rivalry (and occasional cooperation) between rivals. The industry exemplifies Austrian economist Joseph Schumpeter’s vision of competition as a process of creative destruction.

Microsoft achieved its market position by aggressively innovating and promoting an open, standardized operating system platform that integrated various applications (file sharing, fax utilities, network support) that had been available separately. Hundreds of PC manufacturers, thousands of software applications developers, and eventually millions of consumers came to appreciate the advantages of the Microsoft Windows approach. A standardized and integrated operating system was less expensive to produce and distribute, easier to use, and ultimately more beneficial for consumers. As a consequence, some early market leaders stumbled and fell by the wayside while Microsoft emerged out of the competitive process with a legitimately-earned market share.

Network Effects and Path Dependence

Some critics hold that market dominance in software is enhanced unfairly by so-called network effects.⁶ Successful firms like Microsoft are said to have unfair advantages over smaller firms because a larger number of product users—larger networks—leads to expanded consumer benefits which leads, in turn, to even larger networks and profits for dominant firms.

It can be admitted that network effects can create demand-side advantages for larger firms and increasing benefits for consumers that use their systems. Even further, economies of scale can also generate cost-side advantages for market leaders, making it even more difficult for smaller firms to be competitive. But there is nothing economically unfair or regrettable about these developments.

In the first place, increasing returns and low marginal costs are no iron-clad guarantee of long-run success; business history is filled with “first mover” firms that experienced dramatic losses in market share because of changes in consumer tastes and technology. Second, low costs and increasing advantages for a large pool of network users are the economic benefits of the free competitive process; they are never to be regretted. The competitive process is supposed to generate low costs and increasing benefits for consumers and is supposed to punish low value, high cost rivals. Competition is supposed to reward firms that innovate first, that build integrated systems, and that expand before their rivals do. Thus, to make such firms prime antitrust targets is a screaming contradiction to the alleged intent of antitrust law and reveals, instead, its true protectionist purpose.

Another consideration is the notion of path dependence whereby an increasing returns monopolist is said to be able to lock in some inferior technology while locking out rivals with superior innovations. Presumably this has occurred repeatedly in business history (the QWERTY keyboard is often cited) and it is alleged to be a serious inefficiency associated with monopoly.

Myths die hard in the antitrust area. With costs correctly taken into account, there is simply no empirical support for the notion that inferior technology can exclude superior technology—a kind of Gresham’s Law in innovation.⁷ The QWERTY keyboard myth has been effectively debunked as have other alleged examples such as the Beta/VHS video recorder format controversy.⁸ The lack of empirical support is not surprising since path-dependent theorists have the innovation story backwards. Market share, after all, is the direct result of consumers rewarding firms that have continuously rewarded consumers with superior innovations. Again, the antitrust assault on market leaders is an attack on demonstrable efficiency and on revealed consumer preferences.

Restrictive Practices

The trustbusters had a very different perspective. They held that Microsoft engaged in certain restrictive practices with original equipment manufacturers and Internet content providers that had the effect of foreclosing the market to important Microsoft rivals. Take, for example, the issue of the Internet browser. Since Microsoft bundled its own browser, Explorer, with Windows, and offered Explorer free of charge to PC manufacturers, rival browser makers—such as market leader Netscape Communications—argued that they were increasingly foreclosed from the browser market.

But the antitrust issue is whether Netscape and others were unfairly foreclosed. When Microsoft licensed its software, it did not generally restrict PC manufacturers from installing competitive software.⁹ Microsoft did not have explicit exclusive dealing agreements with PC manufacturers. Prominent computer makers such as Dell, Compaq, Gateway, and thousands of so-called resellers that package almost one half of all new PC systems, were free to install Netscape’s browser Navigator (or any other browser) if they so desired. Thus, Microsoft’s product integration in and of itself did not create any physical foreclosure of rivals.¹⁰

Microsoft’s successful product integration may well have lowered Netscape’s market share, but that is another matter entirely. If consumers preferred the integrated browser from Microsoft, they may have lowered their demand for alternative browsers; Microsoft would do more business and its rivals would do less. But, as we will argue in the following pages, this sort of consumer choice does not restrain trade or reduce competition. Indeed, the competitive process is enhanced when firms take business away from other firms and overall trade is expanded when, say, a fully integrated browser works more effectively for consumers.

The antitrust authorities also held that Microsoft was able to leverage its monopoly power in operating systems into the browser market and harm consumers. This argument is unconvincing. First, if Microsoft’s operating system was already leased at a price which maximized profit, there was no additional leverage to exploit browser users. In addition, it made no economic sense to dilute the value of a superior product (operating system) with an alleged inferior add-on product (browser). Finally, Microsoft gave away its browser for free, poor evidence, indeed, of any leverage or consumer injury. Clearly, an operating system with a free browser is better for consumers than one without a browser or one with a browser at some additional cost.

As usual, the government has the economic logic backward. Tying or product integration is not necessarily an element of monopolization; indeed, it can be an important component of vigorous rivalry. Microsoft’s decision to integrate the browser into the operating system was intended to be a more effective way of competing with other firms that already had included Web browsing technology in their operating systems (Apple Computer) and with newer rivals, like Netscape, that established a dominant position with an improved independent browser. Thus, when the antitrust authorities and Microsoft’s rivals complained about integration or predatory pricing, they were actually complaining about the rigors of the competitive process, not about any monopolization.

The same sort of argument applies to Microsoft’s agreements with Internet service providers which were said to be restrictive of competitors. The fact remains that all business contracts are restrictive. All contractual agreements foreclose options and exclude some alternatives. And contracts that last a year are more exclusionary than those that last a week. But this approach to restrictive practices cannot be the focus of antitrust analysis—unless we want public policy to micro-manage all business contracts. The focus of antitrust analysis, assuming we have the laws, ought to be: do private agreements effectively restrict market output and raise market prices? Clearly, the evidence in the PC industry is that free-market contractual agreements have led to massive increases in output and sharp reductions in prices to consumers. That, frankly, should be the end of the matter.

Ironically, if Microsoft had restricted its licensing of Windows to a few select firms only, it would have been accused of monopolizing in restraint of trade. If Microsoft had charged exorbitant prices for its intellectual property, it would have been accused of exploiting its monopoly power. Or if it had refused to integrate applications software packages, it would have been accused of repressing innovation and shelving developments in order to enjoy the quiet life of a monopolist.

Instead, Microsoft engaged in precisely the opposite business behavior. It licensed its software to any and all legitimate PC manufacturers (throughout the world) while licensing fees for its operating systems had averaged less than 3 percent of the cost of the personal computers in 1996.¹¹ It progressively integrated various applications software at minimal cost to the consumer. And all of this was accomplished without any government subsidy, legal barriers to entry, or regulation. Yet the critics, misled by market-share statistics and the anguished sobs of competitors, still spied some evil monopolization. And in their regulatory frenzy, they threatened to smash one of America’s most successful business organizations.

The Lorain Journal Case

Robert H. Bork, a supporter of the government antitrust suit against Microsoft, has argued that Lorain Journal,¹² an obscure 1951 antitrust case, can serve as an exact parallel with the case against Microsoft.¹³ In Lorain, the town’s only newspaper engaged in strict exclusive-dealing advertising agreements with local merchants in order to prevent them from supporting a rival radio station. The government sued successfully to end the exclusive dealing contracts.

The facts and argument in Lorain have nothing to do with the Microsoft situation.¹⁴ Microsoft’s general licensing agreements with PC manufacturers did not require that they boycott the products of Microsoft’s rivals. Manufacturers were generally free to load competitive software and were free to promote their own content on the Windows opening screen. In addition, consumers were free to add or eliminate any product from Windows and free to replace the entire opening screen (if they wished) with a few mouse clicks. Moreover, Microsoft was not the only operating system (newspaper) in town, nor did it face one lonely government-licensed competitor (radio station). Finally, Microsoft could make strong efficiency arguments for integrating its browser and operating system,¹⁵ arguments that could not be made conclusively for the strict exclusive-dealing contracts in the newspaper case. In short, Lorain Journal and the case against Microsoft have nothing of substance in common.

Through the Looking Glass

The Microsoft case highlights the intellectual bankruptcy of antitrust policy. The industry was legally open; there were numerous competitors of various sizes; technological change was rapid and continuous; outputs expanded and prices had fallen dramatically; the leading software firm licensed its operating system widely and at reasonable prices; and competitors constantly complained about the rigors of the competitive process. Ironically, the government’s trial case against Microsoft was heavily predicated on explicit evidence of vigorous competition: internal memos and e-mail correspondence that speak clearly to Microsoft’s intent to bury its rivals and emerge victorious in the software and browser wars.¹⁶ In professional sports, such locker room bravado would clearly be seen as evidence of competitive rivalry. Only in the Alice in Wonderland world of antitrust regulation could competitive free speech and rivalrous performance in the marketplace be transformed magically into some sinister monopolization scenario.

Economics aside, the government prosecution of Microsoft was also a travesty of common-sense justice. Microsoft had a property right to the software that it owned and innovated profitably; it had a property right to write any new code that improved computer applications; it had a property right to insist that licensees not write out any part of its operating system program; it had a property right to determine the length of its software lease and what price to charge for its property; and it had a property right to freely compete or cooperate with any rival. Yet, antitrust sought to emasculate these basic rights and impose selective restrictions on Microsoft’s freedom while leaving its envious rivals conspicuously unrestricted.¹⁷

Finally, the government’s attempt at industrial planning in the computer industry was hopelessly naive; the technological framework and consumer preferences change far too rapidly. Regulation here will create additional incentives to litigate outcomes rather than have them market-determined. It will also create strong disincentives for dominant firms to innovate and compete aggressively for market share. In short, antitrust will have achieved the opposite of the results intended: it will have punished success, restrained efficient competition and hampered economic growth.

Microsoft is simply the latest in a long line of firms that has been punished for its virtues, for the simple fact that its overall efficiency resulted in a substantial market share. Antitrust’s dirty little secret is that the laws have been employed consistently to hamper successful business organizations and protect their less efficient rivals.¹⁸ One would be hard-pressed to discover a more immoral or irrational public policy toward business, or one more worthy of repeal.

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¹United States v. Microsoft Corp. Civ. Action No. 98–1232 (1998).

²Under pressure from Microsoft’s competitors, Senator Howard Metzenbaum (Democrat, Ohio) and Senator Orrin Hatch (Republican, Utah), both urged Ms. Bingaman to reexamine the Microsoft case. See Wall Street Journal, August 2, 1993, p. B8.

³United States v. Microsoft Corp., 147 F. 3d 935 D.C. Cir. (1998).

⁴United States v. E.I. duPont de Nemours & Co., 351 U.S. 377 (1956).

⁵United States v. Grinnell Corp., 384 U.S. 563 (1966).

⁶For an extensive discussion of the issues, see John E. Lopatka and William H. Page, “Microsoft, Monopolization, and Network Externalities: Some Uses and Abuses of Economic Theory in Antitrust Decision Making,” Antitrust Bulletin 40 (Summer 1995): 317–70.

⁷S.J. Liebowitz and S.E. Margolis, “Path Dependence, Lock-in, and History,” Journal of Law, Economics, and Organization 11 (1995): 205–26.

⁸S.J. Liebowitz and S.E Margolis, “Fable of the Keys,” Journal of Law and Economics 33 (1990): 1–25.

⁹Microsoft did not restrict PC manufacturers from adding on “competitive” software beyond the start-up screen. Microsoft did restrict licensees from writing out Microsoft code, a not uncommon feature in the software market; many of Microsoft’s rivals also integrate functions and impose similar restrictions on deleting code.

¹⁰PC users can download browsers, including Navigator, directly from the web. Netscape reportedly distributed over 100 million copies of its own browser in 1998. Wall Street Journal, November 6, 1998, p. A3.

¹¹Wall Street Journal, December 2, 1998, p. B6.

¹²342 U.S. 143 (1951). The lower court decision is 92 F. Supp. 794 (Ohio 1950).

¹³Robert H. Bork, Letter to the Editor, Wall Street journal, May 15, 1998.

¹⁴Dominick T. Armentano, “Why Robert Bork is Wrong: Microsoft and the Lorain journal Case,” On Point, Competitive Enterprise Institute, August 19, 1998.

¹⁵Robert A. Levy, “Microsoft and the Browser Wars: Fit to be Tied,” Cato Institute Policy Analysis, no. 296, February 19, 1998.

¹⁶The government commandeered over 3 million pages of internal Microsoft correspondence. Much of the actual trial was taken up with debate over the meaning and intent of executive e-mail. See, for example. Wall Street Journal, November 17, 1998, p. B6.

¹⁷The Department of Justice had sought a preliminary injunction to require that Microsoft offer Netscape’s browser with Windows or, alternately, sell its own browser separately. Wall Street Journal, May 19, 1998, p. A3.

¹⁸As an example, United Shoe Machinery Corporation had held its dominant market position for decades with superior innovation and competitive pricing. Nonetheless, a lower court determined that United’s overall efficiency had illegally “excluded” rivals and eventually the Supreme Court divested the company. See United States v. United Shoe Machinery Corporation, 110 F. Supp. 295 (1953) and United States v. United Shoe Machinery Corporation, 391 U.S. 244 (1968).