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Path Dependence and Antitrust

November 9, 1999

Winners, Losers, and Microsoft: Competition and Antitrust in High Technology
by Stan J. Liebowitz and Stephen E. Margolis
Oakland, California: The Independent Institute, 1999

Reviewed by TIMOTHY D. TERRELL
School of Business and Government
Liberty University, 1971 University Blvd., Lynchburg, VA 24502

Having suffered the destruction of key antitrust defenses in recent years, government planners in the
Department of Justice have resorted to legend and hearsay to support their case against Microsoft. It is
vital that DOJ’s new attacks be repulsed, as the success or failure of their arguments bears important
consequences for the future of technological development and entrepreneurial freedom.

The legend is as follows: A mere historical accident or individual whim in an expanding market produces
a large number of users of a particular technology standard. The standard becomes valuable simply
because many people use it, not because of an inherent superiority. Latecomers offering better
technologies cannot overcome the powerful network effects generated by millions of users accustomed to
the inferior technology. Makers of the old technology are protected from competition by "lock-in." A
market failure called path dependence has resulted, perhaps requiring remedial antitrust efforts.

Rumors of path dependence abound, and some have gained extensive play in the mainstream economic
literature. Best-known is the persistence of the QWERTY keyboard over allegedly superior alternatives.
Developed in an effort to prevent the hammers on early mechanical typewriters from jamming, the
keyboard has carried over into the present day even though the initial reason for its arrangement no longer
applies. Other keyboards, particularly the 1936 Dvorak Simplified Keyboard, are said to be faster, yet they
cannot succeed against the older QWERTY layout. No individual who uses keyboards belonging to
QWERTY users wants to learn the Dvorak keyboard and thereafter suffer the costs of going against the
established standard.

Some commentators also gripe vociferously about the established VHS standard in videotape. The rejected
Beta format, they claim, has better video quality. However, no one buys Beta because they would be unable
to share tapes with users of the dominant VHS technology. Similarly, DOS won chunks of market share
from the supposedly better-quality Macintosh operating system, the metric system seems unable to
displace English measurements without government coercion, and Microsoft Word overpowered
competitors such as WordStar and WordPerfect. In general, path dependence is alleged to be a problem
whenever there are benefits to using the same technology standard that other people are using.

Professors Stan Liebowitz and Stephen Margolis, in a recent publication from the Independent Institute,
efficiently demolish path dependence as an excuse for government intervention. Though they
acknowledge that network effects can theoretically produce inefficiencies in a market economy, their book

Winners, Losers, and Microsoft: Competition and Antitrust in High Technology

shows that it is difficult to find a clear example of a locked-in technology protecting market participants
from competition. Calling the perceived prevalence of harmful lock-in "empty conjecture," (p. 117)
Liebowitz and Margolis argue that "if anyone ever does find a real-world example, it will be an
extraordinary exception to an important rule: Consumers do not get locked in to inferior products." (p.
227)

It is indisputable that the past influences the future. Yet path dependence says much more: Even when all
users of an established technology prefer a world dominated by a competitor, the incumbent prevails if
users are unable to coordinate their choices. To help us distinguish this strong form of path dependence
(the form employed by the DOJ) from weaker forms, Liebowitz and Margolis divide path dependence as
follows:

  • First degree path dependence: There is simply "an element of persistence or
    durability in a decision."
  • Second degree path dependence: A decision was made without good information,
    and there is some regret over the chosen path at a later date.
  • Third degree path dependence: Good information about an inefficient choice is
    available, but the inefficient technology is chosen because there is no way to coordinate
    with others to collectively choose a more efficient alternative.

Only third degree path dependence implies a real market failure, though first and second degree
path dependence have been used by socialist planners to defend their capital reallocation schemes.
[Socialist planning on the basis of first and second degree path dependence is rebutted by Ludwig von
Mises (1981) in his essay "Inconvertible Capital," chapter 8 of his neglected Epistemological
Problems of Economics
. A discussion along the same lines is presented in Human Action (1998, pp. 502-510).

Path dependence only presents an efficiency problem when a superior technology is suppressed
and when switchover costs are lower than the benefit of the technological improvement. If we ignore
switchover costs when alleging that the market has failed to replace an old technology with a more
efficient new contender, we are unfairly comparing market results to an unattainable ideal.

Much of Winners, Losers, and Microsoft is devoted to countering an assortment of path
dependence fables. In a fascinating history of the typewriter keyboard, Liebowitz and Margolis show that
the Dvorak arrangement has no clear advantage over the much-maligned QWERTY layout. Evidence is
mixed. The legendary 1944 Navy test often alluded to in support of the Dvorak keyboard was in fact a
dubious experiment conducted by none other than Lieutenant Commander August Dvorak, the keyboard’s
patent-holder. In related lore, our authors contend that the rivalry over videotape formats of the late 1970s
and early 1980s ended not with adoption of an inferior technology standard, but with the standard that
had the qualities consumers deemed most valuable.

The technical differences between VHS and Beta were
small, but to home users, VHS’s significantly longer playing times were more important than Beta’s
advantages in editing and special effects. Liebowitz and Margolis reveal that other path dependence tales
simply do not fit the facts.

Next, Liebowitz and Margolis take on the argument that Microsoft has taken advantage of
network effects to monopolize its industry. Rather than trying to show that Microsoft does not have a
monopoly, they show that traditional antitrust arguments cannot handle high-technology markets. Our
authors are not willing to take on all antitrust theory, but they do make the case that we should view the
"serial monopoly" observed in certain industries as acceptable and even desirable. As Jack Hirschleifer
points out in the foreword, one implication of their analysis is that, in high-technology markets,
"predominant market share may be the consequence and hallmark of effective competition."

Competition
brings about market tests that determine which monopoly prevails until another firm temporarily
monopolizes the market. Monopolies that attempt to raise price or produce inferior products will find
themselves rapidly displaced by another firm.

As Liebowitz and Margolis observe, "These high stakes,
and the rivalry that they create, is apparently sufficient discipline to hold monopoly prices in check and to
keep the rate of innovation very rapid." (p. 15)

To achieve this result, the market depends heavily on a key, but neglected, actor in the market
economy—the entrepreneur. Liebowitz and Margolis are combating a view of markets in which:

"...an exogenous set of goods is offered for sale at a price, take it or leave it. There is little or no
role for entrepreneurs. There are generally no guarantees, no rental markets, no mergers, no loss-
leader pricing, no advertising, no marketing research. When such complicating institutions are
acknowledged, they are incorporated into the model piecemeal. And they are most often
introduced to show their potential to create inefficiencies, not to show how an excess of benefit
over cost may constitute an opportunity for private gain.

"In the world created by such a sterile model of competition, it is not surprising that
accidents have considerable permanence. (p. 38)"

In place of the traditional construct of perfect competition, Liebowitz and Margolis offer
something closer to the Austrian approach. Instead of passive, unimaginative units of management, there
are active, creative entrepreneurs, watchful for a profit opportunity. When large inefficiencies do appear,
such as the persistence of an inferior video format in the presence of a better alternative, entrepreneurs are
quick to muster an effective response.

It follows from the authors’ perspective on technology markets that in this world of serial
monopoly, antitrust authorities can diminish the efficiency in the market by destroying those monopolies.

The DOJ’s antitrust campaign against Microsoft threatens to deeply injure the market and reduce
technological innovation. Yet even if Microsoft does have a monopoly in certain industries, it is acting
peculiarly unlike the usual conception of a monopoly. Liebowitz and Margolis found that when Microsoft
was present in software markets, prices declined faster and farther than where they were not present.
Where Microsoft was dominant, prices fell after Microsoft became dominant.

Further, Microsoft
charged lower prices in markets where it was dominant than in markets where another firm prevailed.
Related issues such as leverage, tie-ins, bundling, and predatory pricing are considered in a valuable
appendix.

In general, the authors find a close relationship between an increase in the quality of a firm’s
product and an increase in the firm’s market share. The incumbent product, no matter whose it is, does
not seem to get locked in through network effects. Time and again, the superior product wins. Path
dependence, if it exists somewhere, is certainly not important enough to serve as a basis for antitrust
intervention. "The policy implication of all this," the authors conclude, "is that governments can help
ensure that consumers get the best products by keeping government impediments out of the way of
entrepreneurs competing to establish their mousetraps in the marketplace." (p. 243)

Winners, Losers, and Microsoft cannot be regarded as Austrian in its overall approach. Liebowitz
and Margolis are apparently taken with a neoclassical view of equilibrium—that it is a normal state which
is subject to occasional shocks—and they do not acknowledge Austrian work on the entrepreneur. Some
Austrians might take issue with their reliance upon empirical analysis instead of deductive reasoning.

Yet
their awareness of the vital role of the entrepreneur, their willingness to challenge traditional neoclassical
paradigms on antitrust, and, most of all, their effective refutation of a common attack on the market
economy deserve notice and appreciation.


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