Does Predatory Pricing Make Microsoft A Predator?

Justice's case is forcing many to ponder how harmful--or benign--the practice really is

It is perhaps Microsoft's most powerful weapon. When the software giant targets a market for domination, it frequently wins over customers with an irresistible offer: free products. Back in 1996, for example, Microsoft Corp. started giving away Internet Explorer, its Web browser--and in some cases arguably even "paid" people to use it by offering free software and marketing assistance. The strategy was crucial to the company's success in snatching market dominance away from archrival Netscape Communications Corp. "Even though Netscape constantly revised its pricing structure, it was impossible to stay competitive with `better than free,"' testified Netscape CEO James L. Barksdale in the Justice Dept.'s antitrust suit against Microsoft.

Netscape isn't the only victim. In its march toward software supremacy, Microsoft has repeatedly given away things other companies were selling--siphoning revenues away from Stac, Symantec, Novell, Oracle, and many others (table, page 132). Embittered rivals such as Mitchell E. Kertzman, CEO of Network Computer Inc., complain that many of the giveaways "are effectively predatory pricing." These rivals warn that once Microsoft captures the markets it wants, it will start charging "monopoly rents"--and they point to evidence that Microsoft is already jacking up prices in some markets.

Despite competitors' outcry over Microsoft's giveaways, the Justice Dept. has downplayed the issue at the trial. Why? Because the conventional wisdom among antitrust experts has long been that predatory pricing--a monopolist selling goods below cost--is not a particularly serious problem. In fact, the courts regard predatory pricing as a so-called legal fiction: It's theoretically against the law but nearly impossible to prove. So Justice has had little choice but to focus on Microsoft's other allegedly anticompetitive tactics, such as its tough contractual demands from business partners, that are often less devastating to competitors.

But hope for Microsoft's frustrated rivals may be on the way. A new generation of economists is questioning the current orthodoxy about predatory pricing--and argues that it's wrong, especially where software is concerned. Although their theories haven't been adopted by the courts, and therefore won't have much impact at the Microsoft trial, they are starting to cause mainstream economists to revise their thinking on the issue. And that means that antitrust law--which usually trails economic thinking by a decade or more--will probably eventually catch up.

The first to discredit the concept of predatory pricing were members of the free-market "Chicago School" of economists. About two decades ago, they conducted studies indicating that when companies tried to drive away competitors with predatory pricing, they generally lost a fortune by doing so and then surrendered any market-share gains as soon as they raised prices. Meanwhile, consumers benefited from lower prices.

In his 1978 classic The Antitrust Paradox, Chicago School mainstay Robert H. Bork belittled the laws against predatory pricing as "foolish" and argued that "attempts to outlaw it are likely to harm consumers more than would abandoning the effort." It took a while, but Bork's arguments were heeded by the Supreme Court in its landmark 1993 decision Brooke Group Ltd. vs. Brown & Williamson Tobacco Corp. Declaring that "discouraging a price cut...does not constitute sound antitrust policy," the court made the legal test for proving predatory pricing so high that few companies have been convicted of it since.

RALLY ROUND. Although the Brooke Group decision still towers over the issue of predatory pricing, frightening all but the bravest lawyers from pressing claims, more and more economists think it's outdated. They point, first of all, to economist Brian Arthur's theory of network externalities. Arthur and others hold that once a company gains a decisive lead in an industry such as computing, where there is a strong tendency for consumers to band around one standard, it is almost impossible for rivals to unseat it. Thus, there's more likely to be a payoff from predatory pricing than in, say, the cigarette business--the industry in question in Brooke Group. "In some ways, software is the perfect market for predatory pricing," says Garth Saloner, a professor at Stanford business school. "There's a tremendous incentive to give software away to build an installed base."

The revisionists also argue that Bork and his ilk made simplistic assumptions about human nature. Under Chicago doctrine, for example, it is assumed that consumers wouldn't accept a free product if there were a danger it would lock them into unacceptably high long-term costs. But noting that many buyers frequently face short-term financial pressures, University of Washington economist Richard O. Zerbe Jr. figures "that's not the way people behave."

Additionally, the Chicago School underestimated how profitable a reputation for predatory pricing can be, says Georgetown University antitrust scholar Steven C. Salop. By scaring off potential rivals, such notoriety makes it cheaper for a competitor to conquer new markets. In high-tech markets, it's even more effective, says Salop, "because there's a continuous set of new products."

Exhibit A for the revisionists is Microsoft. In recent years, Microsoft has used free software as a competitive tool. Generally, the giveaways come in the form of "bundles," in which the software is linked to an existing product and repackaged as an upgrade that's "free"--or at least dirt cheap. Microsoft's Internet Explorer, for example, has been wrapped into its Windows 98 operating system at no extra cost.

Right now, most of Microsoft's giveaways are offered as part of its effort to gain share in the lucrative corporate computing market. For example, the company is offering free Web-server software to customers who purchase the Windows NT network operating system. Netscape sells a higher-powered version of the same software for $4,100.

Microsoft vigorously defends these giveaways, arguing that cutting prices is good for consumers. Moreover, it argues that when it bundles together several types of software into one affordable package, it's "driven by what consumers want," according to spokesman Greg Shaw. As for the theory of network effects, Shaw says that it doesn't give consumers enough credit for making intelligent and independent decisions.

These arguments win over many antitrust scholars--including some who have attacked the company's other business practices. "If Microsoft enters a new market and competes aggressively by giving away its software, God bless them," says Carl B. Shapiro, an economics professor at the University of California at Berkeley.

SQUAWKING. But others aren't so sanguine about Microsoft's pricing. The primary problem isn't at the "front end," when the predator cuts prices, say rivals, but at the back end, when prices are raised to above-market levels. In recent months, Microsoft has been criticized for doing just that. The wholesale price it charges PC makers for its Windows PC operating system, for example, has doubled during the past seven years, to as much as $60, critics charge. Microsoft is also tightening the terms of its user licenses to squeeze more money out of corporate clients. Mary Welch, a consultant for Gartner Group, predicts that as the software market matures, Microsoft's revenues from new sales will inevitably decline and it will have "to look for ways to get more money out of its existing user base."

For the time being, Microsoft appears to be refraining from charging the highest prices it can get away with. But if prices start to rise, complaints are likely to get a lot louder. And that, predicts George Washington University law school antitrust professor William E. Kovacic, "could be the type of historical circumstance that would motivate a change in doctrine." Until that day comes, though, expect more cut-rate pricing.

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