Stanford GSB: Stanford Business November 2000

Stanford Business

November 2000, Volume 69, Number 1

Debate: The Antitrust Case Against Microsoft

Should the giant software company be split? Yes, says Paul Romer, one of the Stanford economists who has looked at the impact on innovation and the nation's economic health.

By Barbara Buell

Illustration by Brian Cairns

ONCE UPON A TIME, in its quest for a fair economy, the U.S. Justice Department's antitrust regulation was pretty much about keeping prices low. This year, the Justice Department seems to have taken a different tack in the Microsoft antitrust case. "The Microsoft case is certainly about innovation," observes Robert Hall, an economist in the Stanford University Department of Economics. Indeed, the remedies proposed in response to a court finding that Microsoft had violated antitrust law may be forging a fresh code for the new economy, one that aims to preserve, even enhance, innovation.

Not surprisingly, Business School economist Paul Romer has been near the center of this development. Romer is the founder of New Growth Theory, which argues that innovation is the most important factor driving the economy. Innovation can be depressed or enhanced by the legal system and other social institutions, because they create incentives and disincentives to innovate. "Over time, small changes in the rate [of technological change] cumulate into large differences in standards of living," Romer wrote in a court declaration filed by the Justice Department to support its proposal to break up Microsoft. "Decisions about the law, and especially about antitrust law as it applies to high-technology industries, can be among the most important economic policy decisions that a society makes," Romer wrote.

Romer, who is the Stanco 25 Professor of Economics, favors splitting Microsoft into two companies—an applications company and an operating systems company—to place the "operating system monopolist in a competitive situation comparable to that which prevailed in the mid-1990s. At that time, Netscape had access to a large fraction of [computer] desktops and had an incentive to develop its browser into a critical piece of middleware on the PC," Romer wrote. "The reorganization recreates this situation with the applications company in the role played by Netscape."

Even though the two successor companies will be in separate markets for a time, they will perceive each other as a competitive threat. Importantly, Romer argues, their rivalry will raise the expected payoff for independent software developers. Instead of facing a single monopolist who controls the key distribution channels reaching final consumers, an innovator with a hot new technology will play one company off against the other. More innovation will take place, and consumers will have more opportunities to influence the path of software development. "Competitive markets are, on balance, the best mechanism for guiding technology down a path that benefits consumers," Romer wrote.

Other economists also have given thought to the issue. Stanford's Roger Noll, along with colleagues from Yale and Harvard, filed court papers endorsing the government's breakup scenario. They favored breaking the company into four entities—three operating systems firms and one applications company—fearing that a split in half could simply end up as a dual monopoly.

In June, Federal District Judge Thomas Penfield Jackson ruled that Microsoft be split into one applications and one operating systems company, a decision now on appeal. The judge's order seems to have rested heavily on Romer's argument that a reduced rate of innovation was the most serious harm coming from Microsoft's illegal actions to quash competitive technologies, and that a reorganization would return the software industry at least part-way to the competitive environment that prevailed before those acts. The ruling suggests a new regulatory emphasis. While in the past the government may have focused on preventing monopolies from extracting high prices, now it is examining how corporate practices create barriers to the entry of competitors that hinder innovation.

Some academic voices have criticized the court's prescription or its analysis. Stanford's Hall, for example, who previously consulted for the Justice Department on another Microsoft case, contends there was insufficient analysis of the cost of the break-up. MIT economist Paul Krugman, who taught at Stanford in the mid-1990s, insists the two "Baby Bills" will turn into complementary monopolies. "Textbook economics says that a breakup... will actually exacerbate the problem of monopoly power, raising prices and increasing market distortions," Krugman wrote in a June New York Times column. "Conventional economic analysis of costs and benefits has been brushed aside in favor of guesses about the effects of policy on technology innovation," Krugman wrote.

In his court brief, Romer argued that conventional analyses look only at price changes, which are a minor concern in this case. His analysis takes into account the effects of changes in the rate of innovation. "There is genuine uncertainty about the exact magnitudes" of these benefits and costs, Romer conceded, "but any reasonable calculation shows that the expected benefits [of the breakup] overwhelm the costs."

Over time, small changes in the rate [of technological change] cumulate into large differences in standards of living.

Stanford economics professor Timothy Bresnahan, who served as the chief economist of the Justice Department's antitrust division during the Microsoft trial and who continues to consult with the division, explains the benefits this way: "It is universally recognized in the computer industry that a vertically disintegrated market structure with specialized companies, such as an independent browser company separate from operating systems, is more competitive and more innovative than the single-vendor structure for all platform software that Microsoft prefers. The remedy entered by Judge Jackson creates a market structure much like the one Microsoft illegally prevented from emerging."
It will be a while before the country receives a final verdict. Microsoft appealed Judge Jackson's April decision, prompting the Justice Department to request that the Supreme Court hear the appeal directly. In September, the Supreme Court rejected that request, sending the case to the District of Columbia Court of Appeals, where it likely will resurface next spring, followed, possibly, by a later appeal to the Supreme Court or a reopening of settlement negotiations. Romer's thoughts will no doubt be considered and debated all along the way.