International Think-Tank on Innovation and Competition
The Industrial Organization of the Software Market
December 1st, 2006
The software market, one of the markets of the so-called New Economy, developed in the very last decades through progress in the Information & Communication Technology. In the 1960s, the computer industry was dominated by IBM, which manufactured expensive mainframe computers that were used by large enterprise customers; at the time, very few consumers had access to computers. Apart from IBM, mainframes were offered by firms such as Bull, Burroughs, Data General, Fujitsu, ICL, Nixdorf and Sperry-Rand. There was little or no interoperability among mainframes from different vendors. For the most part, an enterprise customer was required to choose an all IBM solution or an all Nixdorf solution. In the 1970s, Digital Equipment achieved considerable success with a line of less expensive minicomputers that were well-suited to engineering and scientific tasks. Again, however, there was little or no interoperability between these minicomputers and mainframes offered by IBM and others. The structure of the industry at that time was still largely vertical. By 1980, a number of companies had started offering less expensive microcomputers which were not interoperable with one another: early PCs by Tandy, Apple, Commodore and Atari ran their own operating systems, meaning that applications written for one brand of PC would not run on any other brand: the industry was fragmented. In mid-1980, IBM announced plans to introduce an IBM personal computer. The first one was offered with a choice of three operating systems: CP/M-86 from Digital Research, UCSD-P System and MS-DOS from Microsoft, a company founded by Bill Gates, a young software architect who dropped his studies at Harvard to develop what was going to become a symbol of market leadership.
To understand the peculiarities of the software market in general it is convenient to focus briefly on the main functions of PC operating systems (OSs). The main one is to serve as a platform on which applications (such as spreadsheets or word processors) can be created by software developers. OSs supply different types of functionality, referred to as system services, that software developers can call upon in creating their applications. These systems services are made available through Application Programming Interfaces (APIs). When an application calls a particular API, the OS supplies the system service associated with that API by causing the microprocessor to execute a specified set of instructions. Software developers need well-defined platforms that remain stable over time. They need to know whether the system services on which their applications rely will be present on any given PC. If they did not, then software developers would have to write the software code to provide equivalent functionality in their own applications, generating redundancy, inefficiency and a lack of interoperability.
Moreover, modern OSs provide a user interface, the means by which a user interacts with his computer. User interfaces for computers have evolved dramatically over the last decades, from punch card readers, to teletype terminals, to character-based user interfaces, to Graphical User Interfaces, first introduced by Apple with Macintosh. Finally, operating systems enable users to find and use information contained in various storage devices: local ones, such as a floppy diskette, a CD-ROM drive or the hard drive built into a PC, or remote, such as local area networks that connect computers in a particular office, wide area networks that connect computers in geographically separated offices, and the Internet.
Over time, the OSs of Microsoft became the most popular because Microsoft continually added new functionality to the operating system and licensed it to a wide range of computer manufacturers with extremely aggressive pricing strategies. Microsoft recognised early on that an OS that served as a common platform for developing applications and could run on a wide range of PCs would provide substantial benefits to consumers. Among other advantages, development costs would fall and a broader array of products would become available because products could be developed for the common platform rather than for a large number of different platforms. By providing a single operating system that ran on multiple brands of PCs, Microsoft enabled software developers to create applications, confident that users could run those applications on PCs from many different computer manufacturers. In addition, applications developed for a single platform were more easily interoperable because they were relying on the same functionality supplied by the underlying OS. In other words, network effects were created.
In 1981, Microsoft released its first operating system, MS-DOS, which had a character-based user interface that required users to type specific instructions to perform tasks. In 1985, Microsoft introduced a new product called Windows that included a GUI, enabling users to perform tasks by clicking on icons on the screen using a pointing device called a mouse. Windows 3.0, shipped in 1990, was the first commercially successful version of Windows. In 1995, Microsoft released Windows 95, which integrated the functionality of Windows 3.1 and MS-DOS in a single operating system. In 2000, Microsoft shipped Windows 2000 Professional, a new generation of PC operating system built on a more stable and reliable software code base than earlier versions of Windows. Windows XP and the forthcoming Vista represent furthers evolution of the operating system, with a range of added functionality for both business and home users. Even if official and unanimous data are unavailable, consistent evidence suggests that the market share of Windows on sales of OSs for PCs rapidly increased toward 80% in the first half of the 90s to gradually arrive at 92% in 1996, 94% in 1997, 95% in 1998 and remained basically at this level since then: meanwhile the average consumer price of Windows (calculated as average revenue per licence in OEM channel based on Microsoft sales) was constant (in nominal terms) around 44-45$.
Beyond OSs, Microsoft produces very successful applications. Some essential applications have been freely bundled with the operating system: for instance a basic word processing software, WordPad, a browser to access Internet and media player functionalities have been gradually added for free to subsequent versions of Windows when they became standard components of a modern OS. Other more sophisticated applications are supplied separately. Most notably this is the case of the Office Suite consisting of the advanced word processor Word, the spreasheet Excel, the software for presentations PowerPoint and more. The main two applications, Word and Excel, have been successfully competing against alternative products like WordPerfect, WordStar, AmiPro and others on one side and Lotus, Quattro and others on the other side. Liebowitz and Margolis (1999) have shown convincing evidence for which a better quality/price ratio together with network effects were at the basis of this success (it is important to notice that Microsoft achieved leadership in the Macintosh market, hence without exploiting the presence of its own OS, considerably earlier than in the PC market). In the market for word processing applications, Microsoft's market share was hardly above 10% at the end of the 80s, to gradually increase at 28% in 1990, 40% in 1991, 45% in 1992, 50% in 1993, 65% in 1994, 79% in 1995, 89 in 1996, 94% in 1997 and to arrive at 95% in 1998, meanwhile the average consumer price of Word (calculated as average revenue per license) decreased from 235$ in 1988 to 39$ in 2001. In the market for spreadsheet applications, Microsoft followed a similar progress, with a market share of 18% in 1990, 34% in 1991, 43% in 1992, 46% in 1993, 68% in 1994, 76% in 1995, 84% in 1996, 91% in 1997 and 94% in 1998, with minor progress in the following years, while the average consumer price of Excel was decreasing from 249$ in 1988 to 42$ in 2001.
The leading position of Microsoft induced large opposition in the industry and the emergence of multiple antitrust cases with importance at a global level. In the main Microsoft vs US case, the software company was accused of monopolizing the PC operating systems market for Intel-compatible computers, tying its Windows operating system with the Internet Explorer browser with predatory purposes and to engage in anti-competitive contractual agreeements with computer manufacturers and Internet service providers. After an initial decision which imposed heavy behavioural and structural remedies on Microsoft, including the break up in a operating system and an application company (the socalled "Baby Bills"), the November 2002 ruling of the District of Court decided only to impose behavioural remedies aimed at preventing Microsoft from adopting exclusionary strategies against firms challenging its market power in the market for operating systems.
The Microsoft vs EU case was developed on very similar issues, in particular on the bundling of Windows with mediaplayer functionality and on the level of interoperability with softwares by other companies; at the time of writing, the case is still unresolved. In the March 2004 decision, the European Commission imposed the largest fine in the history of antitrust, required Microsoft to issue a version of its Windows operating system without Media Player, and mandated the licensing of intellectual property to enable interoperability between Windows PCs and work group servers and competitor products. Microsoft's Appeal of the decision was heart by the European Court of First Instance in April 2006 and a decision is expected by the end of the year.
A common element in both cases has been the substantial involvement of competitors of Microsoft on the side of the antitrust authorities, something that usually can create suspicion on the fact that a firm is really behaving as a monopolist rather than as an aggressive competitor. In a neat article on Business Week, Robert Barro (1998, Why the Antitrust Cops should Lay off High-tech) noticed that "[a] sad sidelight in the Microsoft case is the cooperation of its competitors, Netscape, Sun and Oracle Corp., with the government. One might have expected these robust innovators to rise above the category of whiner corporations... The real problem is that whining can sometimes be profitable, because the political process makes it so. The remedy requires a shift in public policies to provide less reward for whining. The bottom line is that the best policy for the government in the computer industry is to stay out of it." Nevertheless in the European case Sun, Oracle, Novell, IBM and the Free Software Movement are active sides against Microsoft.
The technological conditions in the software market are well known. Producing software (whether it is an operating system or a particular application) takes a very high up-front investment and a constant marginal cost which, as well known, is close to zero. The entry conditions in this market are more debated, but there are good reasons to believe that even though entry into the software market may entail large costs, it is substantially open, i.e. endogenous. First of all, there are already many firms producing OSs (as IBM, Red Hat, Oracle, Sun, Apple, HP, Compaq, Data General,...), and even more potential entrants -- think of the giants in adjacent sectors of the New Economy (hardware and telecommunications in particular). Second, it is hard to think of a market which is more "global" than the software market: demand comes from all over the world, transport costs are virtually zero, the knowledge required to build software is easily accessible worldwide and competition is global. Nevertheless, it has been claimed that in the market for PC (or client) operating systems, the high number of applications developed by many different firms for Windows represents a substantial barrier to entry. Unfortunately, such a claim usually leads to misleading conclusions. It is true that competitors need to offer (and some do offer already) a number of standard and technologically mature applications upon entry to match the high quality of the Windows package, but the cost of offering these applications is unlikely to be prohibitive compared to the global size of this market. There are at least two reasons for this. First, notice that the alleged "applications barrier to entry" is often erroneously associated with thousands of applications written for Windows, while it is actually limited to a handful of applications such as word processing, spreadsheet, graphics and communications software, which really satisfy the needs of most active computer users (McKenzie, 2001). Second, the competitors of Microsoft should not (and the existing ones do not) even finance the development of all the needed applications: as Microsoft did in most cases, they should just fund and encourage other firms to write applications for their operating system (or have old applications originally written for other operating systems "ported to" theirs). Finally, it is important to emphasize that if we look at competition in the software market in a dynamic sense, that is competition for the market (as opposed to competition in the market), there is no doubt that the opportunity to invest in innovations for future, better software is widely open not only to large companies in the New Economy, but even to smaller ones.
Summarizing, the software market is characterized by high entry costs, constant marginal costs close to zero and substantially open access by competitors able to create new software. According to the new theory of market leaders these are the ideal conditions under which we should expect a leader to produce for the whole market with very aggressive (low) prices. Hence, it should not be surprising that, at least in the market for operating systems, a single firm, Microsoft, has such a large market share. We can see the same fact from a different perspective: since entry into the software market is endogenous, the leader has to keep prices low enough to expand its market share to almost the whole market. Notice that network externalities require these prices to be even lower because competitors could (and indeed try to) offer their alternative software at even lower prices to build their own network effects. Not by chance low prices in presence of network effects are very common and often extreme: most email services such as Yahoo or search engines as Google are free because this is the best strategy available for their leading suppliers under the constraint of effective competition. All these market leaders gain from collateral services, and, for sure, their leadership has nothing to do with dominance.
The extremely low price of Windows represents a double proof of our arguments above. Assume for simplicity that the marginal cost of producing Windows is zero, and that the price of hardware is constant and independent from the price of Windows. Standard economic theory implies that the monopolistic price for an operating system should be the price of the hardware divided by ε-1, where ε is the elasticity of demand for PCs (including both hardware and software): it means that a 1% increase in the price of PCs reduces demand by ε%. Now, the above relationship tells us that, if the basic price of the hardware is 1000 Euros, which is about the current average price for PCs, the monopolistic price for Windows would be 1000 Euros if ε=2, 500 Euros if ε=3, 333 Euros if ε=4 and so on. It would take really unreasonable values of demand elasticity to even get close to the real price of Windows, which is around 50 Euros. Moreover, this is a very conservative estimate of the monopolistic price. In the real world, we can imagine that the price of hardware is not independent from the price of Windows: if the latter would double tomorrow, hardware producers would be forced to reduce somewhat their prices (eventually switching to lower cost techniques and/or lower quality products). Even if this effect may be limited by the high level of competition in the hardware sector, it goes in the direction of increasing further the monopolistic price of Windows, that is, even beyond the real price of Windows.
What does all this tell us? Simply that Microsoft is not an unconstrained price-setter, while its prices are limited well below the monopolistic price to compete aggressively with the other firms active in the operating system market and with the potential entrants in it. Important economists have supported this position. Economides (2001) concludes in a similar fashion: "Microsoft priced low because of the threat of competition. This means that Microsoft believed that it could not price higher it if were to maintain its market position." McKenzie (2001) supports this view: "some firms with high market shares might act more like competitors than other firms in markets where they have much smaller market shares. The reason is that the threat posed by potential competitors in a highly concentrated market can be more constraining than the competitive threat of actual competitors in less-concentrated markets".
What the post-Chicago approach suggested about leaders in markets with price competition was that they should be accommodating and exploit their market power, setting higher prices than competitors, or otherwise engage in predatory pricing and, after having conquered the whole market, increase prices. But in the last 10-15 years of global leadership, Microsoft has done neither of these things. It has been constantly aggressive, as any firm under the threat of competitive pressure would be. The theory of market leaders has shown that a market leader in these conditions would price above marginal cost in such a way to compensate for the fixed costs of investment and obtain a profit margin (over the average costs of production) thanks to the economies of scale derived from the large (worldwide in the case of Microsoft) scale of production. Its (quality adjusted) price should be slightly below that of its immediate competitors or just low enough to avoid that they can exploit profitable opportunities increasing their prices. Where other theories cannot, the theory of market leaders can make perfect sense of Microsoft's large market share, large profits and relatively low prices in a global and open market.
