Network Drama

Steven R. Postrel from the April 2000 issue

(Page 2 of 2)

More basic than this debate between the "frictionless serial monopoly" and "lock-in" interpretations is the question of whether the relevant markets should be expected to display network effects in the first place. Most word processors, for example, can read files created by other programs. The cost of learning to use a new word processor is not that great, and most users are familiar enough with these products not to need that much help. Given these conditions, it is not clear that this market presents a very good test of network lock-in theory.

In other words, if Liebowitz and Margolis' interpretation of the data is correct, does that mean that network theory is not applicable to these markets, or does it mean that the theory is applicable, but its unrealistic restrictions on entrepreneurial behavior cause it to make false predictions? If the latter, what business strategy not included in the network models leads to the observed result? For polemical purposes--get your stinking Justice Department off my spreadsheets!--the answers might not matter, but from the standpoint of understanding high-tech markets they seem crucial. The same concern applies to the Betamax-VHS battle: Was Sony's failure to lock in the market a sign that network effects are unimportant in the case of VCRs, or proof that they can be overcome by entrepreneurial creativity? Does Liebowitz tell his managerial economics students that network effects are mostly a myth and should be ignored, or does he coach them on how to overcome them if they have a superior product starting from an inferior market position?

An important lesson to be learned from episodes of standards competition is that the outcome depends not simply on management's ability to create superior products but also on its skill at planning production capacity, setting prices, choosing marketing techniques, and so on. A strong argument can be made, for instance, that the Macintosh operating system did not fail to become the dominant standard because of its intrinsic technical drawbacks, as Liebowitz and Margolis claim in a surprisingly casual treatment. Rather, Apple's management team didn't understand the importance of network effects and therefore overpriced the product, underpromoted it to business users, and failed to expand hardware production capacity sufficiently.

Jim Carlton's meticulously reported 1997 book Apple: The Inside Story of Intrigue, Egomania, and Business Blunders includes a 1985 memo to Apple CEO John Sculley from none other than Bill Gates, at that time dependent on selling Macintosh applications software for a large chunk of his profits. The memo recommends that Apple allow other manufacturers to produce the Mac, so that Apple would "have the independent support required to gain momentum and establish a standard." Gates' advice was rejected, with the results for Apple that we see today: It has about 3 percent of the worldwide PC market. A world where network effects are pervasive may be a world of men, not laws, as far as technology choices are concerned.

One of the bizarre aspects of Liebowitz and Margolis' book's reception was a September 17 New York Times report that the publisher, The Independent Institute, had received more than $200,000 from Microsoft without trumpeting the fact. Even though the Times reported that the authors had no idea of their publisher's funding arrangements, the article strained to leave the impression that the "secret" funding somehow called into question the validity of their research. REASON's readers will find the suggestion particularly amusing, since the authors presented their views on the economic issues relevant to the Microsoft case in these pages several years ago (see "Typing Errors," June 1996). In fact, a little research by the Times would have shown that the authors first published their views back in 1990.

If the book's publisher is guilty of any-thing, it is failing to provide better editorial guidance. Three of the first five chapters, which are primarily theoretical, are put together from a number of the authors' previous writings and don't relate very well to the empirical analysis of software markets. And rather than present a coherent point of view about the importance of network effects and the appropriate assumptions to make in modeling different sorts of markets, Liebowitz and Margolis engage in what debaters call "straight refutation," meaning a strategy of objecting to every assertion made by an opponent without regard to the internal consistency of one's own position.

Thus, the book repeatedly criticizes the lock-in models for assuming that consumers behave myopically in choosing technologies to buy, picking the current leader rather than anticipating that everyone might be better off with a newer, currently less popular alternative. But many of these models feature consumers who are not only forward-looking but correctly predict the market equilibrium; it is Liebowitz and Margolis whose formal models assume that consumers are completely myopic, looking only at current market share in deciding which network to join. Similarly, the book equivocates about whether software markets constitute natural monopolies, questioning the idea in the first chapter and proclaiming it in the last. The theoretical sections make a point of distinguishing between "fixed" and "flexible" standards, with the latter evolving and not being subject to lock-in, but the authors never apply these ideas in their empirical analysis of software, even when those programs feature quite a bit of backward compatibility between new and old versions.

These flaws aside, Winners, Losers, and Microsoft serves a useful purpose not merely in throwing cold water on the idea that markets routinely pick inferior technologies and in providing the first thorough summary of what really happens in software markets, but also in forcing the reader to confront the difficulties of applying scholarship to public policy. The authors make a compelling Hayekian argument that if scholarly analysis of voluntarily adopted institutions and practices seems to reveal opportunities to improve matters through regulation, the odds are that something important was left out of the analysis. Too bad that the antitrust tragicomedy seems to be proceeding heedless of this wisdom. The show, it seems, must go on.