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Predatory Pricing - Microsoft's Modus Operandi

by

William C. Spaulding

Complete Table of Contents for this site.

NEWS ALERT: Microsoft wins antitrust trial! Why? Because, in spite of its settlement, Microsoft doesn't have to lower prices. The raison d'être for being a monopoly is to be able to set prices to maximize profits at the expense of the consumer. Indeed, this is the very definition of monopoly. Microsoft suppressed competition so that it didn't have to compete on price. A monopoly has no other purpose for stifling competition! The Department of Justice's myopic focus on competition is because this trial was brought about by the behest of Microsoft's competitors, and not by consumers, who are being gouged by the billions! Because Microsoft's monopoly is firmly established, the concessions it made in its settlement will have little effect on the company or the competition, and will do nothing to lower Microsoft's truly exorbitant prices.

Introduction

There has been much debate recently, spurred by the antitrust trial brought against Microsoft by the Department of Justice (DOJ), about whether Microsoft is a monopoly, and if it is a monopoly, is it nonetheless good for the public. It is apparent from reading the pros and cons about Microsoft that many people don't understand what a monopoly is (although they think they do), and why it isn't good for the public. While Judge Jackson has done an excellent job of showing Microsoft as a monopoly (U.S. v. Microsoft: Court's Findings of Fact), this trial focused mainly on the tying of Internet Explorer (IE), Microsoft's web browser, with Microsoft's Windows operating systems, where it has a de facto monopoly in PC operating systems. Because Microsoft is not explicitly charging for IE, this is also an example of predatory pricing—pricing products below their cost of development and distribution to drive competitors out of the market. Predatory pricing is the major tool that Microsoft uses to establish its various monopolies. Although Microsoft's free distribution of IE is a classic case of predatory pricing, Microsoft has attempted to muddy the waters in the current DOJ trial by claiming that IE is part of the operating system. Furthermore, Microsoft claims in its Proposed Conclusions of Law that even if IE were a separate product, predatory pricing as a cause of action must fail because Microsoft never recouped any of IE's costs of marketing and development, and never will, and therefore fails to establish the second requirement of predatory pricing as a cause of action, that of recoupment of costs, clarified by the Supreme Court in BROOKE GROUP LTD. v. BROWN & WILLIAMSON TOBACCO CORP. These arguments are specious, as the rest of this article will show. Predatory pricing has been a Microsoft tradition since its early days, and there is no better illustration of its modus operandi than its greatest success story and most profitable product, a product that is NOT being covered by the antitrust trial and where Microsoft has definitely recouped its costs—Microsoft Office.

Monopoly Defined

There are various definitions of monopoly. Often, a monopoly is described as a single seller of goods or services for which there is no close substitute and for which there are high barriers to entry. However, this definition does not accurately characterize a monopoly, because it is possible for a monopoly to exist, even if none of the above criteria is true. Such is the case for Microsoft.

Consider Microsoft's monopoly of the office-suite market with its product, Microsoft Office. Microsoft isn't the only seller of office suites. Corel WordPerfect Office, Lotus SmartSuite, and StarOffice are comparable products and close substitutes. Moreover, even though it would cost a lot of money for a new company to create another office suite to compete with the established players, thus creating a high barrier to entry, this is not what makes Microsoft a monopoly. What makes Microsoft a monopoly is a high barrier to competition. In economic terms, a monopoly is often described as a price setter. Certainly, Microsoft sets prices without regard to competitor's prices, which is why MS Office is the most expensive office suite. But Microsoft is also a value setter. Constrained by market expectations, Microsoft doesn't raise prices. It simply maintains historically high prices while giving the least value for the money.

Artificial and Natural Barriers to Competition in the Software Business

A monopoly cannot exist without strong barriers to competition. Obviously, the traditional factors, such as a high barrier to entry, or lack of close substitutes can help establish a monopoly, but there are strong natural barriers to competition in the software industry that are unique and exist only if one company predominates. The more it predominates, the greater the natural barriers. Thus, the key to establishing a monopoly is by gaining predominance as quickly as possible. Once a monopoly is achieved, the natural barriers to competition will maintain the monopoly. The primary and most effective method that Microsoft has used to establish predominance is predatory pricing—either giving the software away for free, as with Internet Explorer, or distributing it through OEMs, as it has done for years with Microsoft Office, and still continues to do so. (Look at the back cover of virtually any issue of PC Magazine. Dell Computer regularly advertises there, and almost every system they sell is sold with some version of Microsoft Office or Works.)

However, to establish a monopoly more quickly, Microsoft also created artificial barriers to competition.

Artificial Barriers

Microsoft gave OEMs an incentive to distribute Microsoft products with every computer sold.

1. Per-Processor License — For years, Microsoft stipulated that OEMs would have to pay a per-processor price for Windows—the OEM would have to pay Microsoft for each computer sold, whether that computer had Microsoft’s operating system or not. Thus, an OEM had a strong disincentive to sell any other operating system, regardless of how little the competing products cost, or how great their quality. Although Microsoft was forced to stop charging a per-processor fee by the DOJ, it was too late. Microsoft’s market share had increased tremendously, allowing the natural barriers to competition to continue stifling Microsoft's competitors.
2. Price Discrimination — Microsoft gave the best prices for Windows to those OEMs that also sold or distributed Microsoft’s other products. Thus, OEMs could lower their own costs by distributing Microsoft's other products, which, in turn, foreclosed competition in other areas.

Natural Barriers

1. Network Effect — As a company’s software becomes widely distributed, it draws more third-party support. There will be more schools, businesses, websites, and private tutors using, teaching, and supporting the software, and there will be more books and magazine articles. For instance, the computer section of just about any bookstore has far more titles on Microsoft software than that of any other company. Third-party support helps to advertise Microsoft’s products, and increasingly, people and businesses see it as a standard, and a safer investment in both time and money. Buying non-Microsoft software would be seen as increasingly risky, for as more people buy the standard and fewer people buy competing products, then one questions how long the other companies will have enough money to continue improving and supporting their product, or even if they will be around much longer. For as a company’s sales diminish, so does the network effect, causing a downward spiral of the company’s sales and prospects. WordPerfect Office is a good example. In the early 1990’s, there were numerous books on Quattro Pro, the spreadsheet in WordPerfect Office. Now, it would be hard to find a single book about it, even in a large bookstore. The best one could find is a few chapters in one of the few remaining books on WordPerfect Office.
2. Investment Effect — When people and businesses invest time and money for particular software, they will continue to upgrade to the same software in order minimize lost productive time. Learning the new features of an upgrade will be quicker, easier, and less stressful than learning entirely new software, and it helps maintain compatibility with old files. Because Microsoft has been distributing its software with new computers for years, most people and businesses already have a large investment in Microsoft software, and thus, are effectively locked to the company.
3. The software business is a natural monopoly business. Although it is generally expensive to produce software, it is very cheap to make copies. The marginal cost of software is virtually zero, so average total costs decline with each copy sold. Once a company establishes a lead, it will become more difficult for competitors to compete against the leader with lower prices, since their own costs have to be recouped with fewer sales. The fewer the sales, the greater the price competitors will have to charge to remain profitable. However, because the network and investment effect for Microsoft products is already great, Microsoft doesn't need to lower prices to maintain its monopoly, which is why it doesn't.

These natural barriers will insure that Microsoft will be the predominant software company for years to come, no matter what the courts finally do about Microsoft!

Predatory Pricing

The idea of predatory pricing is simple enough. Lower prices below cost to drive out competitors, then raise prices for maximum profits. When true competition exists, a company can only raise prices slightly above its costs, because competition prevents the company from raising prices further. But a monopoly can raise prices much higher, because it doesn't have to consider the competition. This isn't the highest price it could charge, because a monopoly has control only on the supply, not the demand for a product, and thus is subject to price elasticity just as other companies are. The higher the price, the lower the demand. Another factor that limits the price that can be charged for software is illegal copying. The higher the price of software, the greater the distribution of illegal copies. So there is a price at which profits are maximized. A higher price will reduce the number of copies sold that will lower profits more than the higher price will increase it, and a lower price will reduce profits more than the greater number of copies sold will increase it.

Let's look at a simplified, abstract example. A company sells widgets and it costs $20 to make a widget. The company has no competitors, so it's a monopoly. The company measured the price elasticity of widgets, by varying its price, and found the following demand schedule:

Without competition, the monopoly can freely set its price at $60, even though it costs the company only $20 to produce a widget. But what if competitors moved in, and starting charging $30 for a widget. Obviously the company would no longer be able to charge $60 a widget; otherwise, the company's customers will buy from its competitors at the lower price. A monopoly charges a price significantly higher than its costs, and higher than what it could if the company had true competition.

If the company responded to its new competition by lowering the price of a widget to $10 until it bankrupted or drove out its competitors, then resumed charging $60 for a widget, this would be an example of predatory pricing. Of course, for predatory pricing to work, there must be a high barrier to entry; otherwise new competition will move in as soon as the monopolist raised prices.

Predatory Pricing of Microsoft Office Through OEM Distribution

Microsoft Office is, by far, the dominant office suite today. Microsoft Office was and is a good office suite, but so is WordPerfect Office and SmartSuite. There are plenty of reviews listing the various office suites as editor's choices through the years, which underscores their comparability. In fact, even listing an office suite as an editor's choice isn't really too informative. Since each suite has its strengths and weaknesses, it would be better just to list those strengths and weaknesses so that people could choose based on what they do. For instance, WordPerfect has a vastly superior mail merge than Microsoft Word, even today. Where Microsoft did lead is that it came out with an office suite for Windows earlier than the others, and had better integration. Of course, this is because Microsoft developed Windows and OLE, a Windows technology that allows programs to communicate better. The other predominate advantage was that Microsoft had a better and more consistent macro language, based on BASIC, the computer programming language. Nonetheless, it can't be denied that Microsoft Office's rapid and widespread popularity resulted primarily from distribution by OEMs, such as Compaq and Dell Computer. And this same distribution curtailed sales of WordPerfect Office and SmartSuite. (For a current review of the Office suites, read http://www.zdnet.co.uk/pcdir/content/2000/05/software/gr_office_suites/. Here's an interesting quote: "...a huge quantity of new PCs are shipped with a version of Microsoft Office already installed on the hard disk."  More about this later.)

Microsoft has been distributing its software for years through OEMs, as evinced by the many ads, both old and new, for computer systems, which almost always included some version of Microsoft Office as part of the system. This is a form of predatory pricing. To establish a monopoly in the office suite, predatory pricing was the perfect method for Microsoft to use. Because Microsoft has had a de facto monopoly in PC operating systems for many years, and computer manufacturers, such as Dell and Gateway, needed the operating system to sell computers, Microsoft parlayed this relationship by having the PC manufacturers distribute Microsoft Office on each of their systems sold.

Indeed, the pressures that Microsoft exerted to promote Microsoft Office are illustrated by how it dealt with IBM. In 1995, IBM acquired Lotus Development Corporation, which had the Lotus SmartSuite that competed with Microsoft Office. Joachim Kempin was in charge of Microsoft's sales to the computer manufacturers. According to Judge Jackson's findings, Microsoft was going to delay the issuance of the license for Windows 95 to IBM to "resolve an ongoing audit of IBM's past royalty payments to Microsoft for several different operating systems." Paragraph 124 of Judge Jackson's findings of fact are particularly instructive:

Note Kempin's concern about competition! Does this sound like a competitor or a monopolist? To tell a company—not only one of the largest companies in the world, but the very company that helped establish Microsoft's operating system monopoly in the first place—not to sell its own products! Only a monopoly could consider such an outrageous act; otherwise, how can Microsoft expect a company not to sell its own products that competed with Microsoft? Why would Microsoft think it had that kind of power except that the company was already well aware that it was a monopoly? And why did Microsoft want to prevent IBM from bundling SmartSuite for six months to a year? The only reason that would make sense is because by then, Microsoft Office would have a large enough share of the market to make it a standard, and then the other office suites wouldn't matter anymore. This characterizes the office-suite market today.

I purchased a Gateway 2000 computer on January 12, 1995. This is the invoice for that purchase (divided in 2 to keep the image size smaller, and to delete confidential information). The blue arrow head points to the entry for Office. I received Microsoft Office Professional 4.3, which included Access, Microsoft's database, and Money, Microsoft's financial package, for free. Today, Microsoft Office Professional 2000 retails for $599! The upgrade retails for $349!

Price discrimination was one method of coercion that Microsoft used with the OEMs to have them distribute MS Office, part of the reason why these contracts were secret. Microsoft gave the lowest prices for its software, especially its operating systems, which every OEM needed, to those companies that were most compliant to Microsoft's wishes. Did the OEMs pay Microsoft for Office, or did Microsoft give it away, as it is currently doing with Internet Explorer? My Gateway invoice listed it as free, but the recent Dell ads seem to indicate that Microsoft is getting some money for Office. Of course, whether Microsoft got paid for Office by the OEMs may have changed over time, and depending on the OEM. What is clear is that Microsoft had the OEMs distribute MS Office to their customers as if the customer were getting it for free, or at no additional charge. In most of the computer ads and catalogs, there is no itemization of the price for MS Office, unlike some other peripherals, such as monitors. When a customer sees a certain price for a monitor that's itemized, the customer assumes that he can order the computer without the monitor, and save the cost of the monitor. But MS Office was almost never itemized like this in the ads; so most customers would think that they would not be saving anything by not getting MS Office; they would think that they're getting it for free, or at no extra charge. So even if Microsoft did receive payment by the OEMs for Office, the way the OEMs distributed Office gave the impression to most people that they were getting it for free. The effect of all of this is the same as predatory pricing, even if Microsoft were receiving payment for Office. The effect will certainly be the same for IBM and Corel—they won't be selling very many copies of their software. (According to this story covering a consumer lawsuit filed against Microsoft about high prices, it was reported that Microsoft charged little or nothing for Word and Excel in the beginning to establish widespread distribution of its software, then, afterward, started charging the OEMs.)

Of course, another reason for the secrecy of the contracts between Microsoft and the OEMs was the nature of the licensing deals. If the public could read these contracts, they might be outraged by the unfairness of it (see parts of the agreement of Apple Computer and Microsoft below, and Microsoft's attempts to destroy DR-DOS in table above), and see clearly that Microsoft wasn't competing on quality, efficiency, or innovation; that, in fact, it wasn't competing at all. It was dictating what the public should have—their software. One of the constraints imposed by the 1995 consent decree indicates that Microsoft was using its operating system monopoly to get its other software distributed, and competitors' software not distributed. The decree obtained by the Department of Justice from Microsoft contained the following provision, under Section IV, Prohibited Conduct:

Microsoft is enjoined and restrained as follows: ... E. Microsoft shall not enter into any License Agreement in which the terms of that agreement are expressly or impliedly conditioned upon: (1) the licensing of any other Covered Product, Operating System Software product or other product ... or (2) the OEM not licensing, purchasing, using or distributing any non-Microsoft product.

This would indicate that Microsoft did use exclusive dealing and tying contracts to distribute its products; otherwise, why prohibit such conduct if Microsoft were not doing it. Judge Jackson's findings of fact also amply show price discrimination.

Since Microsoft is always saying that it competes on quality and innovation, then why have exclusive dealing and tying contracts, and price discrimination? Why use the tactics that Microsoft employed to destroy DR-DOS? Why pressure IBM to distribute Office rather than its own product? Why threaten Apple to include and make default Internet Explorer? Let the market decide, based on quality and features!

Microsoft Office was distributed by almost every major computer manufacturer, and thus, as more computers were sold each year, more and more people got Microsoft Office. And unlike most other software companies that gave beta software or older software away for free in the hope of getting upgrades, Microsoft distributed its current version.

Microsoft had an ideal situation. First-time computer buyers would already have Microsoft Office, so why spend hundreds of dollars to buy WordPerfect Office or SmartSuite? And if they already owned a computer and had an older version of WordPerfect or SmartSuite, why pay hundreds of dollars for an upgrade, since Microsoft distributed their latest edition of Office. But couldn't people just refrain from buying Microsoft Office, and just wait until they upgraded their computers to get the latest version of Office? Most systems are being shipped with less than full versions of MS Office, such as MS Word, or with Microsoft Works, a lesser version of Office (although some OEMs, since the consent decree, have been distributing non-Microsoft products, such as Corel WordPerfect). If Microsoft Works users want to upgrade, they are far more likely to buy MS Office, since they have already invested time and effort into learning Works. Microsoft's dominance of the market is so complete that it now even charges for beta software (http://www.microsoft.com/PressPass/features/1998/11-12office.asp)!

Would it not behoove the computer manufacturers to let the customer choose what software they wanted on their machines, especially when many people already have lots of software, and don't want their machines preloaded with unwanted or unneeded software, especially if they are paying for this software without realizing it? And by offering customers a choice of software, would this not help the OEMs sell their systems, especially in the days when WordPerfect, Lotus, and dBase were more popular than Microsoft's products? Had it been this way, then the people would have chosen what software they were receiving, not Microsoft.

Thus, predatory pricing worked wonders for Microsoft. At one time, WordPerfect and Lotus (part of SmartSuite) were far more popular than Microsoft's products. In fact, you might even remember dBase, that de facto standard of databases in years past! Or maybe not! So completely has Access supplanted it. Microsoft prevailed, not because its product was better, or because it was a more efficient company; it achieved its market share by leveraging its relationship with the computer manufacturers to distribute its software to every personal computer buyer, the only people who would need personal computer software. As more Microsoft software is distributed, the natural barriers to competition increase, particularly the network effect, thereby making it increasingly difficult for anyone to compete against Microsoft.

Predatory Pricing of Internet Explorer

Much of the current debate about Internet Explorer and Netscape focused about whether Microsoft's practice of giving away software was good for the consumer. Free software would seem to be good for the consumer. This is a great marketing gimmick for Microsoft, for many people like Microsoft for this reason. Indeed, this is one reason why the Justice Department did little or nothing about Microsoft for years. And while Judge Jackson's findings of fact do depend on much testimony and the credibility of witnesses, no such detailed examination and cross-examination is necessary to see what Microsoft has done with Office. The evidence is plainly visible to anyone who wishes to look, and it isn't disputable.

Microsoft's distribution of IE is predatory pricing. Not only is Microsoft not receiving any direct revenue from its distribution of IE, it's actually spending a lot of money developing and promoting it, more than $600 million so far. Thus, IE's cost is actually negative. From the start, Microsoft offered its browser for free in an effort to establish a monopoly in browser software. Furthermore, Internet Explorer was mainly distributed by the computer manufacturers, just as Microsoft Office was. And just as before, Microsoft's main competition, in this case, Netscape, will be minimized. After all, what other result was possible when Netscape's major revenue source was being diminished because Microsoft was giving its browser away for free. Microsoft understood exactly what it was doing. Bill Gates said it clearly in an interview published in the Financial Times on July 3, 1996: "Our business model works even if all Internet software is free," says Mr. Gates. "We are still selling operating systems. What does Netscape's business model look like if that happens? Not very good."

Obviously!

Microsoft argues that even if IE and the operating system are separate products, distributing IE for free isn't predatory pricing, because it is not recouping its costs. Microsoft is actually recouping its costs (see below), but, even if it weren't, recoupment of costs need not be a fait accompli. There only needs to be a dangerous probability of succeeding at recoupment, and, let's face it, if Netscape is eliminated, what's to stop Microsoft from subsequently charging for IE. But, as argued later, Microsoft is recouping its $600 million dollar investment in IE, by allowing Microsoft to maintain its high upgrade prices for Windows.

Windows and Internet Explorer Are Separate Products

In its conclusion of law, Microsoft argues that the browser is actually part of the operating system. Microsoft relies heavily on the Court of Appeals decision (147 F.3d at 951) it obtained earlier. That decision stated that there is nothing wrong integrating two products if it is beneficial to the consumer. Wouldn't it be beneficial to integrate Microsoft Office with the operating system? Or any other software product for that matter? Clearly this ludicrous decision doesn't distinguish between separate products. With a decision like this, Microsoft can tie any product it wishes into the operating system.

The appeals court specifically argued that computer manufacturers couldn't combine the operating system and Netscape in the same way that Microsoft combined Internet Explorer with the operating system. It even cited this specific example: "Windows 95 without IE's code will not boot, and adding a rival browser will not fix this." (Id. at 948 n.11) First, it's obvious that since Microsoft develops both operating system and browser, it can easily arrange this. Second, there is nothing inherent in the boot sequence that requires browser code. Operating systems have been booting up long before there were any browsers. In fact, when I bought my retail copy of Windows 95 shortly after it came out, it didn't even have Internet Explorer! So how could it be required for the boot sequence, and indeed, what aspect of the boot sequence would require browser code?

The appeals court made another dubious argument, which Microsoft argued in its conclusions of law:

But isn't Internet Explorer a stand-alone browser? There's an Internet Explorer for both the Macintosh and Unix operating systems! Clearly, IE isn't a part of those operating systems, so, perforce, it must be a separate software product!

A more probative approach to determine whether the browser is separate from the operating system is to look at the fact that there was a company, Netscape, that was selling a browser, but not an operating system. Opera is another browser that isn't distributed with its own operating system. Even Microsoft sold Internet Explorer separately, in its own shrink-wrapped box. Indeed, Microsoft's own book publishing company, Microsoft Press, publishes books that have CD-ROMs with the complete Internet Explorer software. One of the goals of antitrust law is to foster competition. If there are separate companies selling a similar product, then isn't that prima facie evidence that they're separate products? And certainly, in view of the goals of antitrust law, particularly that of promoting competition among companies, shouldn't this be the accepted definition—the bright line—that would best promote public policy?

Why IE is Sold as Part of the Operating System, but Microsoft Plus! 98 is Sold as a Separate Product
	Microsoft® Plus! 98 is the ideal companion to the Windows® 98 operating system. Plus! 98 extends the advanced functionality in Windows by adding utilities, themes, and games to let you further manage, customize, and enjoy your PC.
This is how Microsoft describes its product, Microsoft Plus! 98. Why isn't this a part of the operating system? With features such as McAfee VirusScan®, desktop themes, file cleaner, Start menu cleaner, and Compressed folders, this product would seem to be more a part of the operating system than IE, yet Microsoft sells this package separately for $44.95, almost half of what Windows 98 itself costs! Microsoft argues that it is including IE in the operating system because it benefits consumers. Wouldn't incorporating Plus! 98 into Windows 98 instead of making it a "companion" benefit consumers? In fact, according to Microsoft's own research with focus groups for Windows 98, one of the most requested features for the new OS was an anti-virus program that could be updated over the Internet. Why didn't Microsoft include an anti-virus product with any edition of Windows, especially considering that almost all of the viruses today take advantage of Microsoft security holes? Since this was one of the most requested features, Microsoft saw this as another opportunity to increase its revenue at the expense of the public. True competition would have compelled Microsoft to include an anti-virus program and make the OS less vulnerable to viruses. So if Microsoft is giving us such great software updates with IE for free, then why is it charging us for small improvements in other areas of the operating system? And why sell a "companion" such as Plus! 98 for even more money when it could obviously just be included with the operating system? Again, the only rational explanation is that Microsoft wants to monopolize the browser market, not to benefit consumers. This is the only explanation that would explain Microsoft's behavior in any sensible way! This is a clear violation of the Sherman Antitrust Act and the Robinson-Patman Act.

Piracy as a Form of Predatory Pricing

Ironically, piracy can be an effective way of establishing a monopoly, working in the same way as predatory pricing. Although Microsoft probably doesn't intend to establish its monopoly in China this way, its inability to stem piracy now may benefit Microsoft in the future. The wide dissemination of pirated Microsoft software will help to standardize the software in China, and augment the other natural barriers to competition. If technical and political advances allow Microsoft to enforce the law more vigorously in the future, this may yield a windfall for Microsoft. If Microsoft succeeded in enforcing the law today, it would thwart software distribution significantly, since most Chinese can't afford to pay Microsoft's exorbitant prices. More importantly, since China is a communist country and controls business to a much greater extent than the government does in the United States, China may decide to force the country to standardize on open source and free software, such as Linux and StarOffice rather than shell out billions to an American company, much as France intends to do! On the other hand, as the natural barriers to competition become stronger with greater distribution of pirated software, then Microsoft software will become so entrenched in homes and businesses—and even the government—that not even the Chinese government will be able to change it.

Predatory Pricing is the Perfect Method to Establish a Software Monopoly

There are some who believe that predatory pricing is a myth and that antitrust laws are no longer relevant or useful in today's high-tech economy. Predatory pricing is a myth, they argue, because:

• It would cost too much for the predator, since the predator would be selling at below-cost, and the larger the company, the greater the loss it would incur, because of its higher sales volume.

• The predator couldn't know how long the price war would last. It would be foolish to sell at a loss in the hope of making monopoly profits in the uncertain future.

• There is nothing to stop the competition from shutting down until prices rose again after the would-be monopolist attempted to recoup its losses. Even if the monopolist bankrupted its competitors, new competitors would enter the market when the monopolist started charging much higher rates.

• The theory of predatory pricing assumes the prior existence of a "war chest of monopoly profits" that the predator can use to subsidize its practice of pricing below average cost. But how does that war chest come into being if the firm has not yet become a monopoly?

• The opportunity cost of the money used for predation needs to be taken into account. Later monopolistic profits would have to yield a greater rate of return than any other investment for the company; otherwise it wouldn't be rational for a company to attempt predatory pricing.

It is easy to see why these arguments fail with Microsoft. Not only do these arguments NOT show that predatory pricing is a myth, but that, in fact, predatory pricing is the perfect method to establish a software monopoly!

When Microsoft has the OEMs distribute its software, Microsoft's cost is zero. The OEMs pay for distribution and supplemental materials such as books. And because Microsoft makes plenty of money from its operating systems and from retail sales, it doesn't have to wait until its competitors are eliminated. Indeed, once customers and businesses start using Microsoft software, Microsoft can sell upgrades at a high price because of the network and investment effect, regardless of the presence of competitors. If Microsoft includes software as part of its operating system or other software as it has done with IE, then that cost is already covered by the extremely high price of Microsoft's software. Microsoft doesn't have to worry about any new competitors entering into the market, because of the natural barriers to competition that only become stronger with greater distribution of Microsoft software. And, of course, Microsoft's "war chest" could have come from its operating system monopoly that IBM gave it, if it needed it, but Microsoft doesn't need it, because the marginal cost of its software as distributed by OEMs is zero. And since Microsoft's software prices are many times what its costs (more than 33 times in the case of Office!), Microsoft would never be able to find any other investment that would yield the rate of return that Microsoft is achieving with its monopoly, and the proof is in its profits.

Economists are finally seeing clearly that predatory pricing works, and in the software industry, it works beautifully. The question is, will the courts see the truly harmful effect of predatory pricing?

Clearly, antitrust laws are needed today more than ever.

Because the Marginal Utility of Software Upgrades is Declining, Microsoft has been and will be Forced to Include More and More Software in Each of its Packages

Declining marginal utility of software upgrades—not generosity!—is what's forcing Microsoft to include more software for the consumer dollar, and since Microsoft wants to monopolize the browser market and control the Internet, IE was a natural choice to include in Windows. People aren’t going to pay Microsoft’s high upgrade prices just for a more stable Windows, or for fixes and modest improvements. That’s also why Microsoft added PhotoDraw and FrontPage (and now, Visio 2000) to Microsoft Office Premium Edition, so that it can maintain its high upgrade price and still have decent sales. Years ago, people upgraded constantly because computer systems and software had serious limitations, but now that both hardware and software satisfy the needs of most people, the demand curve is shifting, and the price for maximum profits is declining. And, of course, piracy, which is rampant in poorer countries, will be more pervasive at higher prices. Nonetheless, prices haven't dropped nearly as much nor as fast as they would have if Microsoft had true competition.

So by including IE in Windows, Microsoft is recouping its costs for IE; it’s just not itemizing the revenue. Without the inclusion of additional software, Microsoft would have had to charge a lower price for Windows. (Although it is true that people can download IE for free, many people don't. They would rather buy it as a complete package, and not worry about download times or installation problems.) And since IE is part of the operating system, and Microsoft has raised prices on its OS yet again (Windows 2000 is the most expensive operating system ever, and, eventually, Microsoft wants to move everyone up to it.), do you think Microsoft is making a profit? Absolutely! And a hefty one at that. Microsoft said it spent $1 billion developing Windows 2000. Since Microsoft already said that it spent $600 million developing IE and IE is part of Windows 2000, then more than half of the development costs went to IE. Ergo, Microsoft is recouping its costs through the revenue it obtains from the operating system. (Although Microsoft is also getting advertising revenue from IE, this is only a small fraction of the revenue obtained from the sales of Windows itself. Netscape was getting advertising revenue, also, but this revenue wasn't sufficient to cover development, marketing, and distribution costs, as Microsoft noted in its own research! Thus, without retail sales, Microsoft knew that Netscape would either be bankrupted or seriously weakened.)

As a Monopolist, Microsoft Adds as Little Value as Possible To Each Upgrade It Sells, and Not to Upgrade Too Quickly.

While Microsoft will be forced to include more software for the consumer's dollar, it will do so as slowly and as little as possible. If Microsoft tried to raise prices for its software, people would balk. People would ask why software prices are going up while hardware prices are plummeting, creating bad public relations for Microsoft. It doesn’t want any more scrutiny into its practices than is already occurring. The solution, of course, is to keep prices the same, but only add enough value to each upgrade to make the price look at least a little reasonable. And it can also create separate products, such as Microsoft Plus! 98, to generate more revenue. It could have easily added Plus! 98 features to Windows 98, but that would be adding too much value. Microsoft wants people to get the least amount for their money. Eventually, of course, Microsoft will add the Plus pack features into the operating system, because, as I have said, it has no choice. But the mere existence of the Plus pack just shows that Microsoft really does want to stretch out the upgrade cycle, by adding the least value at the greatest cost to the customer! Thus, Microsoft earns a higher rate of return on its development costs even without raising prices. Microsoft is helped in this by the buzz created by computer magazines. Magazines are always looking for new material, and obviously, new editions of software provide that material. The magazines write about the new software, give tips on how to use it, and, in effect, help Microsoft sell its wares.

Why wouldn’t Microsoft upgrade faster? If upgrades came out too fast, people would probably scrutinize the cost-effectiveness of the upgrades more. Moreover, upgrades take time to sell. If Microsoft upgraded too quickly, people who were slow to purchase would just skip the intervening upgrade and buy the new upgrade that just came out. Consumers may also delay their purchase because of anticipation of a new upgrade. More people would start skipping upgrades, and just wait until they actually needed the features of the new upgrade, if they would ever need it, and at some point, they won’t. Thus, Microsoft can maximize its profits not only by setting the right price, but also by adding minimal value to each upgrade, thereby allowing the upgrade cycle to be extended.

Now what if Microsoft had competition? Then Microsoft would add as much value as possible to each upgrade and release it as soon as possible, so that it can sell more copies and lower its development costs per copy and therefore enjoy higher profits. Thus, Microsoft the competitor is the complete opposite of Microsoft the monopolist! Microsoft the competitor adds the most value to its customers; Microsoft the monopolist adds the least value. Which one is better for the public?

Software Bundling

Software bundling is problematic. While it is certainly desirable for the consumer to have more software bundled together, because supplementing Windows with other software is expensive, it also makes it difficult for competitors to compete, even if their product is vastly superior. Furthermore, bundling does have a legitimate business purpose, because bundling is one way that a software company can add more value to its product, and, as argued above, this will be necessary as software matures. However, lack of effective competition has allowed Microsoft to be discrete in its bundling, adding products where it wants to dominate, such as browsing software, or products that Microsoft thinks will help to sell more upgrades, such as Windows Movie Maker bundled with Windows ME. Otherwise, Microsoft provides the minimum value that it perceives will be effective in selling upgrades. That's why Internet Explorer is a great product, and thus, nobody buys a browser, but there is still a big market for Norton Utilities and other operating system utilities, much of it shareware.

The ideal competitive situation would have prevented this "innovation trickling." Lack of competition allows Microsoft to dollop improvements and features to extend the upgrade cycle. Only where Microsoft has real competition in areas where it clearly wants to be a leader does it deliver. One thing that could have, and still might, prevent this slow dolloping of improvements is Microsoft's diminishing sales unless it starts adding real value to its upgrades. I said could have because Microsoft wants to try to force people to pay it constantly through the use of subscriptions, thereby obviating any need to add significant value to its upgrades-or no value at all, if it so chooses. I said still might because I don't think Microsoft will be successful with subscriptions, unless they add real value for the money. But how can one know the value of a software subscription beforehand? According to this article, subscriptions will be more expensive than buying upgrades. Without competition, the only factor that can impel Microsoft to add more value for the money is by people refraining from buying upgrades that have little value, or worse yet, that require subscriptions.

The Courts Need to Recognize that there are Different Methods of Predatory Pricing and Different Methods of Recoupment in the Software Industry

Because the essential elements of predatory pricing have been developed in case law long before the existence of a software industry, OEM distribution and bundling cannot be easily characterized as predatory pricing in the legal sense, because Microsoft is probably now getting paid for Office by the OEMs, and Microsoft does make a profit on bundled software, thus making prosecution of Microsoft uncertain under a predatory pricing cause of action. Moreover, because bundling has a legitimate business objective, it requires a rule-of-reason analysis. However, it is predatory pricing because (1) the customer is getting the software for no apparent charge; (2) it reduces competition, and (3) it allows Microsoft to keep prices far above competitive levels. The effectiveness of this strategy can easily be seen in the office-suite market, where the markets for WordPerfect Office and Lotus SmartSuite are mere vestiges of what they once were.

The reason why the Sherman Antitrust Acts were written in broad language was because it was difficult—indeed, impossible—to know beforehand what methods a business would use to gain and maintain a monopoly. Congress left the details to the courts and, eventually, to the Department of Justice and the Federal Trade Commission. What the courts, the DOJ, and the FTC need to recognize is that the software industry allows new variations on both predatory pricing and recoupment.

Software bundling is obviously a form of predatory pricing, because the consumer doesn't have to pay anything additional for the software. Note that this is not the same thing as not paying for it. As discussed above, the consumer is paying for it—just not separately. OEM distribution is another form of predatory pricing, even if Microsoft is getting paid for the software by the OEMs. The consumer is not paying additionally for it, or he doesn't realize that he is, and, therefore, this just as effectively locks out competition unfairly. This has the same effect as the traditional form of predatory pricing—that of giving the software away for free. In fact, OEM distribution is even better because the software is already installed and set up!

The software monopolist also has a new variation on recoupment of costs. As can be seen with Windows and IE, software bundling allows the recoupment of costs because the monopolist gets to maintain high upgrade prices by bundling more software. This isn't explicit recoupment, but it's recoupment, nonetheless. Adding IE to Windows allowed Microsoft to maintain its high upgrade price on Windows. Without additional software for Windows, Microsoft would have had to lower upgrade prices or accept fewer sales. This trend is continuing with the addition of Windows Movie Maker and Windows Media Player to Windows ME, the next upgrade of Windows for consumers. Thus, Microsoft not only gets to eliminate competitors, but it gets to recoup its costs in a subtle way that courts have yet to recognize!

While OEM distribution and software bundling are not strictly predatory pricing as developed in case law, they are anticompetitive, and thus, violate the Sherman Acts. Case law needs to encompass these anticompetitive acts peculiar to the software industry.

Not only can Microsoft recoup its costs, it can even raise prices without raising prices! Consider this hypothetical scenario: Microsoft spends $100 million for development to upgrade Windows 95 to Windows 98. Retail price of Windows 95 and Windows 98 is the same $209 for a full install. Now Microsoft spends $50 million dollars to upgrade Windows 98 to Windows ME, and charges the same price for Windows ME, $209. Thus, Microsoft receives more money for less cost of development, thereby raising its profits. The same effect could be achieved by spending the same for development and raising the price of its software, but Microsoft doesn’t want to raise prices which might raise the ire of customers who have come to expect technology prices to drop. Furthermore, while price increases are easy to see, it is very difficult to quantify improvements in the upgrades. Thus, it can clearly be seen in this situation how Microsoft can raise prices without raising prices—simply by spending less for improvements, then charging the same price for those improvements.

Microsoft is a Natural Monopoly

Microsoft has a great reason to establish and maintain a monopoly, if it could do so without true competition forcing it to reduce prices. Software is unlike any other business. Because the marginal cost of software is virtually zero (and in the case of OEM distribution and volume licensing, it actually is zero, since the licensee pays for any packaging and distribution), its average total cost continually declines with volume, and because expanding the number of software units only involves making copies, there are no diseconomies of scale and no necessity to increase fixed costs. Because marginal cost is so low, average total cost continually declines as it asymptotically approaches marginal cost, and unlike many other industries, average total cost never rises. Thus, Microsoft is a natural monopoly.

Sales figures and cost of development for software are hard to come by, especially with multiple versions and constant upgrades becoming available, but consider this. According to Microsoft (Microsoft Office Now Fastest-Selling Business Application Ever), Microsoft sold more than 20 million licenses of Microsoft Office 97 in less than a year, at the average of rate of 60,000 per day! Furthermore, Microsoft already had an installed base of 55 million for its desktop applications prior to the release of Office 97 (Microsoft Office 97 Released to Manufacturing). With the number of computer users still growing rapidly during the late 90's, it certainly is not unreasonable to assume that Microsoft sold at least 50 million copies of Office 97 in the 2 1/2 years between its initial release on November 19, 1996 and the release of Office 2000 on June 10, 1999. (An average rate of 60,000 copies per day for 933 days yields 55,980,000 copies, so 50,000,000 is a conservative number.) Let's further assume that Microsoft received an average of $200 per copy, not an unreasonable figure considering that MS Office prices ranged fro