Trampling on the theory of path dependence

Microsoft's judges may decide that consumer approval rather than illegal tactics led to the company's power.

Microsoft looks as if it may evade the dismemberment ordered in the finding sent up by Judge Thomas Penfield Jackson. Not only have federal appeals court judges shown some sympathy for the company's case, but the Bush administration may also revise antitrust policy and offer it a settlement. Microsoft stock's recent rise reflects these new prospects.

But what about the underlying theory that convinced Judge Jackson that Microsoft needed dismantling in the first place? He leaned repeatedly towards an economic idea known as path dependence.

The position that the appeals court or the Justice Department take on this issue will do much to determine Microsoft's fate. Path dependence is also a key part of modern monopoly theory generally, so has a bearing on other antitrust cases.

So what precisely is it? Path dependence says that a company may gain an overwhelming advantage in a market if it manages to establish an industry standard before anyone else. That standard then becomes so powerful that it becomes a barrier to better challengers. The company, in short, creates an impregnable monopoly.

The textbook example here has long been the qwerty keyboard. Its critics argue that it is less efficient than other key arrangements. Their position is that it has dominated for a century merely because one of the first manufacturers of the manual typewriter, E. Remington, adopted it early on, ensuring that it would become the standard. Path dependence emphasises, sometimes close to exclusively, the competitor as victim. Consumers are part of path dependence theory too - but only indirectly; they lose because the competitor does.

Bunkum, say two professors of economics, Stan J. Liebowitz of the University of Texas at Dallas and Stephen E. Margolis of North Carolina State.* Markets are meritocracies where good products win, be they mouse traps or operating systems. An item's success is due more to its quality than to any industrial predation.

Start with the qwerty keyboard. The professors argue that qwerty was hardly the competition-free gladiator that received wisdom makes out. It turns out that there were 51 rivals to Remington's qwerty at the outset. Remington's qwerty prevailed not because of market share alone but also because qwerty typists won at much-publicised typing contests.

Then there is the showcase argument against qwerty: DSK, a keyboard arrangement patented in 1936 by ergonomics expert August Dvorak. Dvorak tested DSK in Chicago schools and found data indicating its superiority. In the second world war, DSK was pitted against qwerty at the US Navy. Recruits who had once performed at a measly 32 words a minute speeded up to a masterly 56. Yet the old qwerty standard still prevailed.

Messrs Liebowitz and Margolis have unearthed evidence to show that DSK's superiority is something of a fable. For one thing, as it turns out, the co-author of the landmark Navy study was Dvorak himself. And later studies failed to replicate the pro-Dvorak evidence.

Another supposed paradigm of path dependence is the famous Beta-VHS war. Sony's Beta, the argument runs, was a good product. But through sheer market aggression, RCA, the US distributors of VHS, managed to make VHS the US standard and so obtained an enduring monopoly.

But this, the professors note, is an incomplete account. While the technology of the two products was identical, Sony took a fateful step in crafting its cassettes. It believed portability would be the most attractive feature for the cassette. It made its product smaller - but with a playing time of only one hour, in contrast to VHS, which could handle full-length films. Filmgoers, as it turned out, became big video customers. VHS won.

In the Microsoft case, the company's advantage is Windows' superiority and not Microsoft's scheming. Messrs Liebowitz and Margolis criticise Judge Jackson's view that Microsoft did social damage by bundling its browser, Internet Explorer, in the Windows package. This may have hurt Netscape, a competitor, as the latter loudly claimed. But there is little evidence that it hurt the consumer, at least not in the long run.

The authors offer a telling example from an older industry giant, car manufacture. In the old days, US carmakers sold vehicles without the rustproofing necessary in bitter climates. Cautious buyers then took their new purchases to rustproofing specialists for treatment. Later, carmakers incorporated rustproofing into their own product.

This may have hurt America's big rustproofing company, Ziebart. It even disrupted car owner habits temporarily. But car owners in the long run were not unhappy to receive a road-ready product. Or, as the authors put it, "a rule that compels a look at consumer perception as though frozen in time will be harmful".

Given the failings of path dependence, why its prevalence as a way of looking at the world? Messrs Margolis and Liebowitz argue that path dependence survives because it is an argument that suits some of the biggest players in the global antitrust drama: competitors. Jack Welch of General Electric complained last week in a different context (the European Commission's review of GE's plan to merge with Honeywell), of regulators being more concerned with competitors than consumers.

But while competitors have much to lose in battles against strong companies, it is not necessarily true that their defeat is also the consumer's. That is a valuable warning at a time when vigorous antitrust action has become the norm.

* Winners, Losers and Microsoft. J. Liebowitz and Stephen E. Margolis. The Independent Institute

© Copyright 2001 Financial Times

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