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Making sense of Microsoft and the Net

MIT Dean Richard Schmalensee puts the antitrust controversy about Microsoft into historical context. Also: Why no e-businesses will exist 10 years hence.

Unlike most economists, who scribble away in careers of relative anonymity, Richard Schmalensee very much plays the role of a public intellectual.

In part, that's due to his influential role as the Dean of MIT's prestigious Sloan School of Management, where he is a professor of management and economics. It's also connected to his starring role as the

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  Guiding students through a tough economy
Richard Schmalensee, dean, MIT Sloan School of Management
economist who testified on Microsoft's behalf during the company's antitrust trial, where he went head-to-head against the government's lead attorney, David Boies.

Microsoft is still in the news--and Schmalensee has thoughts about that, as well as about the developing story of the Internet and its larger effects upon business. But the professor is also preparing the groundwork for a project in conjunction with the Sloan School's 50th anniversary in October 2002.

"We're doing a number of things. But the core of it is to research a set of issues relating to future management, and how technology will change marketing and organizations," he told CNET during a West Coast swing. "We're going to examine what new technologies will drive industries and globalization's development."

Sounds like an interesting read once the data are in.

"Come to the 50th anniversary and we'll tell you all about it," he quipped.

Q: At the trial, you argued that Microsoft did not hold a monopoly. Still hold to that?
A: The argument I tried to make was that at any moment in time, could they raise prices? Sure they could. But I was trying to raise this question: For antitrust, you've got to ask not only whether their power over price is substantial, but is it durable? Is this the kind of power that requires the sort of thoroughgoing structural relief that you think about in a Section 2 case?

The European Union apparently thinks there's something there. They're hopping mad about a change in Microsoft's licensing program for XP.
Boies' brilliance was that he got the judge much more engaged in the first part of the trial, and the judge was saying, 'These guys are bad; they're just bad, dammit, and I'm going to get them.' Microsoft's XP site license pricing is kind of clunky. You had to have 100 (copies) to make it worthwhile. And if you had 20, they were making you buy 20 copies instead of giving a discount, which just seemed dumb, frankly. It just seemed like bad pricing design because you want to give small businesses a multiple discount. I don't think that's an issue too much. There just has to be a better way to price it.

During the trial, Microsoft pointed to the emergence of Linux as evidence that it couldn't be defined as a monopoly. But the truth is, Linux hasn't even remotely challenged on the desktop.
It's interesting. Linux has done better on servers than people thought it might but still hasn't managed to get the desktop.

And it's not likely to challenge there for a long time.
And it's clearly not going to. I don't understand the technology, so I can't figure out why it's that hard. Linux may be harder, but I keep saying to myself there are certain basic things you want. Couldn't you take Linux and put an interface on it that made it, in effect, into a Windows emulator? Why couldn't you do that? You're doing certain functions, there are certain Linux commands. Why can't you write something that takes what you do graphically to do it in Windows, translates it into Linux commands, and executes it? I don't have a clue. I don't know this technology, but obviously no one's done it, so it can't be quite that straightforward...Because it's such an obvious thing to do and haven't done it. IBM's spent jillions on this. Maybe IBM just says, Why do we need this fight?

During the Microsoft antitrust trial, you testified on behalf of the company as relating to economic issues and you went mano a mano with David Boies. He gave you a pretty tough time. What was that like?
I was unprepared for him the first time. I'm just not used to having my credibility hammered for three weeks in front of the national press. (Laughing.) It was not a pleasant experience, and I was just wrong-footed.

It seemed as if there were two trials: One was in the courtroom, where the pyrotechnics played out, and the other was in the documentary evidence supplied by the two sides. What do you think accounted for Boies' success in convincing Judge Thomas Penfield Jackson to rule in the government's favor?
Boies' brilliance was that he got the judge much more engaged in the first part of the trial, and the judge was saying, "These guys are bad; they're just bad, dammit, and I'm going to get them." I think he won it by winning the first part of trial. And none of us appreciated how difficult that was going to be.

Let's turn to the hypothetical. What might have been the implications for Microsoft had the original breakup order been upheld?
Well, I frankly never understood the government's logic. If the issue was about adding features to the operating system to thwart system competition, a breakup has no impact on incentives in that regard or ability. If that was the core issue of the case--and it would have been a very interesting hearing on that remedy--the argument that the (Microsoft) apps people would have written Office for other systems is inconsistent with the government's argument that you don't write for tiny, little operating systems.

What about prices and the pace of product evolution? Would there have been any effect there?
One thing that would have happened is that pricing incentives would have changed, and so prices of both products (Windows and Office) would have gone up immediately. It's hard for me to see how product evolution would change dramatically. The only other interesting question is whether it would have made sense for the Office company to make Office into middleware in any kind of useful way, which was a government argument. But the technical people at Microsoft say that doesn't make any sense.

How do you think that might have played out?
Well, again, this was the government's theory. But once Office runs on lots of different operating systems, then just as Netscape threatened to do, you add a rich set of APIs (application programming interfaces) and then you program to Office. But what the Microsoft technical people say is that it's not a simple thing to do. To make it rich enough to support an application, you'd have to add so much to Office that's not there now, that it would not be a very easy undertaking.

Is there a role for antitrust regulators in high-tech? That is, can conduct remedies be imposed that would not impede the efficiency of a company, such as Microsoft, by putting restraints on its behavior, which would harm what it considers to be its ability to innovate?
There won't be e-business in five or 10 years. We don't teach courses in television. I think there's absolutely a role. And there are a lot of things that are noncontroversial. Suppose Microsoft had actually been able to deny Netscape distribution; you can talk about dynamic competition all you want, but if you can't get the product to market and if an established firm can prevent an entrant from getting the product to consumers, that is--and ought to be--a violation.

So there are a lot of things where standard antirust principles carefully applied make sense for society. The trap the Clinton people fell into--and what the states appear to be falling into now--is trying to use antitrust, which is a fairly blunt instrument, as a tool to micromanage an industry. I just think that's not on.

Will or should antitrust get involved in the question of setting boundaries on what Microsoft can include in the operating system? Microsoft has asserted its right to improve the product, but competitors complain that they're slowly being put out of business because everything but the kitchen sink gets thrown in. For example, there's been a lot of heat about Media Player and Windows XP.
I was just at the L.A. Times and got into a debate about how Media Player is just going to destroy RealPlayer. I said, "Well, what is the rule for what features? What's the principal rule that says when something goes out? If the rule is, 'Gee, it's going to take out something that inconveniences a cuddly little company,' then we're in trouble. We need another rule."

What should be the appropriate standard, then, for deciding about something like Media Player, for example?
The argument made in the government case (against Microsoft) is that if adding a feature has the effect of suppressing competition with the OS or the platform, then that's at least a proper concern of the antitrust law. And you can worry about what the standards are, but there's no such argument about Media Player. There's a whole lot of people who say, "This is a problem, and we ought to do something to fix it." That's a danger, trying to engineer the industry and engineer the product. If you've read the District Court discussion about commingling of code, are you going to say, "Oh, I want these guys to do the engineering"? I don't think so.

We heard a lot about Old Economy-New Economy, and how one was destined to supplant much of the other. Put some context around that. Was it all a chimera, or was Lou Gerstner right in that all companies will eventually become e-companies and the law of averages just caught up with the e-commerce upstarts?
There are two distinct things going on. First, there's a set of industries where competition just looks different, and here I particularly look to the software industry. You can vanish overnight, you could dominate the market overnight. Competition doesn't look like classic competition, and it's sort of Schumpeterian. You're dBASE one day and gone the next. Industries that look like that, where standards and intellectual property are critical, tend to have transitory and sometimes permanent dominance because of network effects and so on. So in that sense, economies change.

But I think Gerstner's right. We've placed lot of emphasis on e-business at Sloan--not because we thought dot-coms would rule the world, but because supply changed, management's been changed fundamentally by the new technology, and marketing is undergoing various kinds of revolutions. So yes, there won't be e-business in five or 10 years. We don't teach courses in television.

What about first-mover advantage? An was able to carve out a niche and establish brand presence because it got there earlier than most.
I have the disadvantage of having actually studied first-mover advantage years ago, and they're not important in all businesses...When the Internet boom happened, and everyone said the key thing is to be first mover, I had a skeptic's reaction. There are plenty of industries where the first mover got killed.

Remember VisiCalc? Or how about Wilkinson Sword, the first stainless blade company. Gone! Boom!

So what makes the Internet different?
It's hard to see. It's not obvious to me that Amazon has the kind of permanent loyalty that you would make from a first-mover advantage. Now, it has the advantage of scale and experience and name recognition--but does it have stickiness? I don't think the rules have changed. First-mover advantage will work in some markets, not in others.

After the heyday of irrational exuberance, has the prevailing sentiment about the significance of the Internet as a tool swung too far in the opposite direction?
It has swung. I think the notion that because I understand the Internet, I can beat you selling soapsuds, no, everybody pretty much understands the Internet nowadays. Being quick and being a pure play and that's all you bring to the table in terms of your Internet technology isn't enough. It's a distribution system, it's a communications system, it has certain richness--but selling pet food over the Internet? OK. (Laughing.)

Microsoft is an example of a company that woke up late to the potential and challenge of the Internet.
They would have been gone.

Yes, and now the company is moving even further in its embrace. What's your assessment of their chances for .Net?
The trap the Clinton people fell into--and what the states appear to be falling into now--is trying to use antitrust, which is a fairly blunt instrument, as a tool to micromanage an industry. .Net is sort of a bet-the-company play. Everybody assumes that it will succeed--which is, of course, what Microsoft wants everybody to assume. But it's not obvious from a distance that it's preordained.

During the Internet gold rush, did Sloan lose many potential students--or students who were already in the program, for that matter?
I think we lost people who just didn't apply. We're pretty heavily involved in the technology area, and we have a strong entrepreneurial tradition. We have an unusually high percentage of scientists and engineers in the student body but didn't have a lot of dropouts. I think the folks who would have come to us just didn't bother to apply rather than come here and then find out about that world.

As an economist, you've tracked speculative bubbles. Is there anything particular about the bust-up in tech--besides the technology--that stands out in your mind from other historical crashes?
The answer is certainly yes, since history never repeats itself exactly. The 1929 crash, people argued, was largely about new technology. If you read the business press in the '20s, it was all about how automobiles and radio and all this stuff was changing the world. And you saw these big multiples before the crash. But those were still extraordinarily good technologies; radio wasn't too bad! They were over-hyped and they crashed, but the companies kept going, technology kept going, and the economy was transformed.

In his study of speculative bubbles, John Kenneth Galbraith goes back several hundred years. Is there something genetic to the human condition that makes us prey to periodically losing our minds?
I don't know. There are a lot of studies. There's a mixture of rational and irrational because the "greater fool" theory does have some merit. If everybody in the world is saying that this stock is a great buy and they're screaming for it, then you figure it'll run awhile, even if it makes no sense at these multiples. But there is this fascinating question in finance, which is the role of emotions. There may be something but we're just starting to explore what that is.

Is there some good that comes out of all this? Do we walk away with at least one lesson learned or structural reform that's very valuable? If that's true about the dot-com bust-up, what would that lesson be?
It's like getting sick after having too much to drink. You say the hangover's good because it reminds you of life's realities. On the other hand, it was a lot of fun drinking all that alcohol. It's good for you in some sense, but it would be nice if it didn't have to happen.

Are we in a recession?

Will it be harder to emerge because of the after-effects of the suicide attacks in New York and Washington?
It's easy to overstate the effect of Sept. 11. Is it fundamentally going to change the way consumers behave? After six months, I think not, assuming no further catastrophes. But we still haven't worked off the over-investment that got us down this road to start with. I see no reason why we're not going to bottom late this year--or early next--and begin a recovery.

What about IT spending? How long will it take before it's again on the uptick, and what does a comeback depend upon?
Not until next year.

How difficult a predicament is high-tech in?
It's a recession, and the notion that in five years' time high-tech will not be high-tech as we define it, and will not be an important industry, is just wrong. Certainly, there are risk factors based on synchronization with other major economies, which have affected high-tech, obviously. But there are lots of new ideas, lots of potential to further transform the way business gets done, and a lot of excitement intellectually. These things have cycles.

As a percentage of the overall economy, IT is still a relatively minor player. But when tech took a tumble, the other dominos followed. Why such a strong multiplier effect? Was it just market psychology, or was there something else more complex at play?
Well, you're here in S.F. If you're in Chicago, it doesn't have the same effect. It makes good press and gets more press coverage. Remember, Silicon Valley was the master of the universe for a time. And people love to write, "Oh, how the mighty have fallen" stories. It's really easy to overstate the impact of psychology.