- The Washington Times - Friday, June 9, 2000

In "Man of La Mancha," Sancho Panza observes that "Whether the stone hits the pitcher or the pitcher hits the stone, it's going to be baaad for the pitcher." When the law and economics collide, it is usually economics that gets shattered. That's literally true in the Microsoft case; the Justice Department and Judge Thomas Penfield Jackson want to break up the company.

Microsoft is accused of injuring Netscape by offering Microsoft's Explorer Web browser for free with the Microsoft Windows operating system. This forced Netscape to offer its browser for free to compete. Did Microsoft hurt Netscape? Yes, but somebody had to. Microsoft hurt Netscape only in the sense that Pepsi hurts Coke and vice versa. Competition is a boon to consumers and is no grounds for complaint.

How much is that browser in the window? It's a basic law of microeconomics (undergraduate Econ 102) that, in a competitive market, a product sells for the cost of making one additional unit (the marginal cost). Why? Because if farmers in Kansas can produce additional bushels of wheat for $2 each, then farmers in Nebraska can't charge $3 a bushel, or Kansas will steal the business. Marginal-cost pricing is a sign of a competitive market.

The marginal cost of making one more copy of a browser available to one more computer owner is virtually zero. The browser can be installed on the computer at the factory or downloaded by the user from the Internet for a penny's worth of electricity. Therefore, it was inevitable that a competitor would emerge to drive the price to zero sooner or later.

Covering development costs. In creating its browser, however, Netscape incurred significant development costs (fixed costs) in addition to the low marginal costs of producing added units, which is true of many technology products.

In most industries, marginal costs rise with output and are high enough to exceed average costs, both fixed and marginal. Jurists sometimes assert that a business charging less than average cost is engaging in "predatory pricing" to drive a rival out of business. That's what Microsoft was accused of. However, Microsoft didn't engage in predatory pricing by charging zero for the browser because the marginal cost and competitive price really are zero.

But if competition drives the price down to the marginal cost, how are development costs to be recovered?

Get a patent. Some products are eligible for patent protection. For example, patents enable drug companies to charge a price above marginal cost for several years to recover their enormous development costs and to justify continued research. Once drugs go "off patent," generic producers copy them and the price tumbles.

Hurry up. Particular software can be copyrighted, but basic concepts such as a browser or a word processing system cannot be. Firms make money on new software by beating the competition to the market with a fancier product, charging what the market will bear until competitors write equivalent software and drive the price down. Previous basic browsers, such as Mosaic, had been free. Netscape offered a better product and charged for it until the competition caught up and drove the price back down.

Advertise. For a broadcast television or radio station, the marginal cost of having an additional viewer or listener tune in is zero. Station owners are happy for additional people to intercept their broadcast signals at no charge because their ratings rise and their advertising income goes up.

Even at no charge, Netscape makes money on its browser, thanks indirectly to advertising. The Netscape browser steers its users to Netscape's portal, Netcenter, and, since America Online bought Netscape, to AOL's portal, too. Portals make money by displaying ads and by providing prominent links to Web businesses that pay to be featured first when users search for "travel" or "stockbroker" services, etc. As long as Netscape is in wide use, it provides a vehicle for the company to earn advertising revenue. Did Netscape's browser still have value after the price went to zero? AOL thought so when it paid billions for buy it.

Bundle up it's a cold, cruel world outside. In short, Netscape gave away the browser, which it could no longer charge for anyway, and thereby attracted customers for its bundled portal, which earns money. "Bundled"? Isn't Microsoft being criticized for "bundling" Internet Explorer with its operating system? Yes, and Netscape bundles products, too. AOL always has bundled a browser with its Internet service, and that browser soon may be the newest Netscape. Bundling services you can charge for with a service you can't charge for but that enhances the value of the other services is one way to make money on the zero-priced service. There's nothing wrong with it.

Law and economics. The Microsoft case and the recommended breakup of the company are overreactions to a fast-moving type of competitive situation that federal officials aren't used to. All that's needed for a competitive, consumer-friendly market is for Microsoft to reveal enough information about its operating system to enable competing software makers to design applications to work with it.

When courts base rulings on legal theories that are at odds with the laws of economics, as in the Microsoft case, the results are "baaad" for producers, consumers and investors. We may be seeing that reflected in the collapse of the Nasdaq tech stocks. When the law makes a mistake, it is the public that gets hurt.

Stephen J. Entin is president and executive director of the Institute for Research on the Economics of Taxation.

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