Friday, December 19, 1997

Rich Karlgaard, editor, Forbes ASAP magazine, and Gary Reback, partner, Wilson Sonsini Goodrich Rosati, examine the Department of Justice charges that Microsoft is violating anti-trust laws by keeping competitors out of the market, stifling technological innovation, and denying consumers a choice of products.

Recorded on Friday, December 19, 1997

ROBINSON Welcome to Uncommon Knowledge. I'm Peter Robinson. Our show today involves one of the biggest, most powerful and, some would say, most domineering companies in America- Microsoft. Now, a century ago the American economy depended on this, oil. And one man, John Davidson Rockefeller, and his company, Standard Oil, controlled some 75 per cent of the entire market for oil. Today the American economy depends instead on computers, computers and the software that runs them. Now, here's a popular item. If you have a PC, the chances are very good that you use this, one of Microsoft's products, Windows. And today, one man, Bill Gates, and his company, Microsoft, control some 80 per cent of the world-wide market for operating systems. Like John D. Rockefeller before him, Gates has made himself and his closest associates rich, staggeringly rich. Gates' own worth is upward of 35 billion dollars, giving him the title that Rockefeller once held, "The Richest Man on Earth". Gates shares something else in common with John D. Rockefeller, a little trouble with the United States government. In 1911, the Supreme Court found Rockefeller's Standard Oil in violation of anti-trust laws and ordered the company broken up. Today, the Department of Justice has hauled Microsoft into court charging, once again, anti-trust violations. With us, two guests. Gary Reback is a partner in the Silicon Valley law firm Wilson, Sonsini. Reback is convinced that Microsoft is indeed in the wrong. Rich Karlgaard is Editor of Forbes ASAP, the high-tech magazine. Karlgaard believes the government should leave Microsoft alone. So the question before us, will Microsoft be able to fend off this government attack or is it curtains for Windows?

ROBINSON Are Microsoft's current marketing practices helping or hurting the American consumer?

REBACK Microsoft's current marketing practices are most definitely harming consumers, the economy, and competitors. Microsoft's current marketing practices are based on a policy of buying exclusion, keeping competitors out of the marketplace, eliminating consumer choice by making sure that distribution channels won't offer consumers an alternative to the Microsoft product.

ROBINSON Hurting or helping consumers, Microsoft?

KARLGAARD There is no evidence that their actions have ever hurt consumers. I will grant Gary the point that they've hurt competitors but that's what competition is all about. It's a most peculiar monopoly when prices are dropping and customers seem to be happy for the integration that Microsoft provides. Nobody wants to go back to the era of separate print drivers and fonts.

ROBINSON What Rich is talking about now is consumers versus competitors and that's exactly what I'd like to focus on for just a moment.


ROBINSON He says there is no evidence that Microsoft has hurt consumers and I have to say the trajectory of the past ten years, I speak now as a layman, as a user of computers, and it's one piece of software after another, the prices keep coming down...

REBACK No, no. Stop. No, no.


REBACK The price of the operating system that Microsoft monopolizes has gone up tenfold over the past ten years. The cost of the operating system to OEM's used to be...


REBACK An OEM is a computer manufacturer. It used to be...

ROBINSON That would be a Hewlett-Packard or a Compaq?

REBACK Packard-Bell, Compaq. Used to be $4; it's now $50. To the best customer it's $35 and Microsoft has announced further increases that it intends to employ in the future. These costs are hidden by Microsoft in the cost of the computer and this additional technology is bundled-in by Microsoft. In theory, your technology, better technology is put out of business because consumers have no independent access to it.

ROBINSON Okay, now that's a classic monopoly behavior: you establish dominance in the marketplace and then start jacking up prices. So if I'm Hewlett-Packard or Compaq and I'm buying the operating system from Microsoft to install on my computer to sell to Peter Robinson for Christmas...


ROBINSON ... the price I've been paying to Microsoft for the operating system has been going up and up and up...

REBACK And, Peter, the price of hardware during that period of time has remained stable or gone down. Why? Because hardware is a competitive environment. We have a number of hardware manufacturers and they have to compete with each other for consumer sales.


KARLGAARD Well, look it. Let's just put this into context. The average PC costs anywhere between $1500 and $2500. Now, the delta, from $5 to $35, a delta is $30...

ROBINSON A "delta" meaning a change or...

KARLGAARD A change against the context of a $1500 to $2500 machine is, to use a phrase often heard in the computer industry, mouse nuts.

REBACK It's not mouse nuts overall, Rich. It amounts to hundreds of millions of dollars of monopoly rents that people are paying to Microsoft for no good reason other than their preclusive practices.

KARLGAARD No good reason? What they've done is standardize the industry. They've kept it from being a cacophony. Most customers are happy that they've done that. They can go to a single provider...

REBACK I don't know what you're talking about.

KARLGAARD Well, a Hart & Teeter poll showed that by a margin of four to one, people polled in the United States who are computer users are happy with Microsoft.

ROBINSON That's ordinary consumers?

KARLGAARD Ordinary consumers.

REBACK The polls that I've seen in recent weeks - I mean there was an article, for example, in the San Francisco Chronicle comparing Microsoft's behavior unfavorably to that of the Dallas Cowboys. I don't think Microsoft enjoys the kind of perception that you seem to suggest it does.

ROBINSON We're talking about basically monopoly theory and anti-trust law. How big is Microsoft? What is Microsoft's share of sales and operating systems?

REBACK In excess of 95 percent of all PC operating systems, in excess of 80 percent of all operating systems on any computer sold anywhere in the world. Over 80 percent...

KARLGAARD Let me add a couple of other facts. How big is the American software industry? It's in the hundreds of millions, hundreds of billions of dollars per year in revenue. What are Microsoft's revenues, 12 billion dollars?

REBACK And their gross margins are in excess of 90 percent. I represent monopolists and I've never seen numbers like that. Those are not numbers that come from a competitive environment. Those are monopoly rents.

KARLGAARD Has the software industry not grown when Microsoft has become dominant? Is the software industry not growing at 20 percent compounded a year? I mean, we've got the fastest growing part of the American economy.

REBACK And the largest part of that growth overwhelmingly has gone to Microsoft. That's the concern.

KARLGAARD Oh, that's baloney. That's baloney.

REBACK That's the concern. That is not baloney. That is true.

ROBINSON Alright, let me jump in. Gary says Microsoft's behavior is bad for consumers, Rich says it's only bad for competitors. But when will competitors ever respond?

ROBINSON Why has the marketplace if these guys are jacking up their price again and again and again for the operating system, if Microsoft is behaving that way, why has the marketplace not called forth competitors, people who are willing to undercut them in price? Rich?

KARLGAARD They're happy with Microsoft. They're happy that Microsoft has come along and integrated an industry that was full of cacophony and too many choices. I mean you can have choices that drive you crazy when you have to install your own printer fonts, printer drivers and your own fonts. It's convenient. Customers rewarded Microsoft for doing that.

ROBINSON All right. So the market place is simply rewarding Microsoft for doing a better job...

REBACK Why then, in the recent government submissions, do we have sworn testimony by computer manufacturers saying that they wanted to load other software on their computers not made by Microsoft and that if they did that they were told by Microsoft that their contracts for the operating system would be terminated? This isn't fiction. This is sworn testimony by Compaq, by Micron, by Gateway. This is not consumer choice. This is Microsoft sticking it to the computer manufacturer to make sure customers don't have a choice.

KARLGAARD Gary, I am not going to contest...

ROBINSON You don't deny the fact that...

KARLGAARD I'm not going to contest, Gary, on some of these items. My difference with Gary on these is where you, where the solution is found to these problems and going all the way to the Justice Department which then has a de facto effect on U.S. economic policy is the wrong thing. Whenever you get the government involved, the odds are overwhelming that they are going to do more harm than good.


KARLGAARD If these can't be litigated on a in a civil level.

ROBINSON My turn. You guys are bright and moving fast. You both agree Microsoft is huge. So far...

KARLGAARD No, I contest that.

ROBINSON You contest they're huge?

KARLGAARD Yes. We're talking about the information technology industry in the United States...

REBACK They control the gateway architecture.

KARLGAARD They've got a billion dollar a year industry when you throw all hardware, software, semiconductor, a trillion dollar industry. Microsoft is a what, 12 billion dollar company in revenues?

REBACK In market cap it exceeds that of the big three auto makers combined. Why? Because ir produces 90 percent gross margins because it controls the gateway architecture.

KARLGAARD Well who are you to say, who are you to put an arbitrary limit on what somebody can make as a gross margin? I mean, it's bizarre.

REBACK I'm not putting an arbitrary limit on it. I'm merely pointing out the fact that-

KARLGAARD I didn't know that high gross margins were against the law.

ROBINSON Okay, again let me consolidate. You say that the relevant measure here is not the outcome...

KARLGAARD You'd indict all pharmaceutical companies.

REBACK Not all because there are no monopolies in that space.

ROBINSON Hold it, fellers. You'd say that the relevant measure here is the overall technology industry of which Microsoft is this big. You say the relevant measure is its direct competitors and operating systems of which, alas, there really aren't any, They're this big. They're a huge amount of it. You assert and you don't deny that Microsoft has sharp elbows. Right, you don't deny any of that?

KARLGAARD Right. Let me tell you, Peter, as a loyal Macintosh user I wish Apple would have had those kind of sharp elbows. They would be a healthier company today.

REBACK This is not a matter of sharp elbows. It's a matter of unfair and improper business practices.

ROBINSON And illegal behavior.

REBACK Illegal behavior as charged by the government.

ROBINSON All right. Now this is the point that Rich started to make-

Microsoft is accused of violating the nation's anti-trust laws. But the laws are a century old, do they still apply?

ROBINSON We have anti-trust law, a body of law that's somewhat over a century old in this country. It arose around the turn of the century when there were huge steel combinations that led to the formation of U.S. Steel, when there were railroad combinations, when the chemistry - the chemical industry was being consolidated by DuPont and it shook up the American body politic. A body of law sprang into being to deal with it. My question is, in principle, is that the correct way to deal a century later with an entirely new industry or should we simply let the market work its wonders? Somebody sooner or later will come up to deal with it, to compete with these guys.

REBACK You know, Peter, this is not the first time...

ROBINSON I'm being naive.

REBACK You're not being naive. You're asking the right question. This is not the first time the American legal system has confronted new technology under our anti-trust laws. This same problem occurred when the newspapers tried to squelch new technology called radio. It went up to the Supreme Court. The Supreme Court said that was illegal under the anti-trust law. The same thing occurred when the oil industry as monopolized by Rockefeller tried to squelch the new technology of long-distance pipelines produced by a well-funded start-up called Tide Water. It goes to the Supreme Court; the Supreme Court says it's illegal. Our laws aren't antiquated and as proof of that I would note that the judge's recent opinion in the Microsoft case in which Microsoft repeatedly made the same assertions, "These laws shouldn't apply to us. They're old. They're antiquated. This is a new age." And the judge said this looks to me like classic anti-competitive behavior. There are Supreme Court cases on point like Eastman Kodak, it looks to me like you're violating the law.


KARLGAARD Well, look. I have no problem with anti-trust law. I think it has served the U.S. very well. What I, what my difference with Gary would be over the fundamentals that drove the industrial era versus the information age. Anti-trust law worked because we were talking about industries that were defined by scarcity: oil in the ground, railroad tracks, very, very high capital costs, very high barriers to entry. The software industry is an industry of abundance. It is code. The only thing that limits the creation of software is the imagination of man and to sort of apply these kinds of anti-trust rules that were developed in a world of scarcity and apply them to a world of abundance where there are low barriers to entry, where imagination and ingenuity are the only barriers, it seems to me rather absurd.

ROBINSON Okay, but what about the principled point that Rich is making now that we're in a new era?

REBACK But see, I'd like to take issue with that because I believe he's wrong on both counts. If you go back to Standard Oil and you study the history of that time you'll find that the barriers to entry there in the refinery business were very low. It cost less to make a refinery than it did to lay a mile of railroad track. Conversely, there's been ample showing that because of network effects in these industries, it is virtually impossible to enter the operating system market even with superior product. Why? Because Microsoft has engaged in preclusive practices with these computer manufacturers and consumers are locked into the installed base of operating systems and applications they've built such that Microsoft can extract monopoly rents. Nothing new about this. All the practices that Microsoft has engaged in were engaged in by John D. Rockefeller.

ROBINSON Bill Gates and the people around him are rich, very rich. Are they also a little afraid?

ROBINSON You're a journalist in Silicon Valley. You're a lawyer whose been dealing with Microsoft for some years now. What is their game? Why are they behaving the way that they're behaving. What do they see for the next decade for their company?

KARLGAARD Well, look, they are very aggressive players. They do have a tremendous market cap. And in order to sustain a market cap like that you have to grow at a certain rate. You have to exceed peoples' expectations, so Bill Gates and his people are driven by growth. Now I would make...

ROBINSON They're actually, in a funny way although they are some of the richest people, Bill Gates is the richest man in the world, they are actually quite desperate, aren't they?

KARLGAARD Well, see...

ROBINSON The market forces them...

KARLGAARD Well, you know, you live and die by this kind of market cap. All of your, they have out of their 24,000 employees, 21,000 have stock options. They pay slightly under the market for their employees but the employees get rich through stock, the appreciation of their stocks.

ROBINSON And it the market turns, if the market turns against them they could be in deep trouble very fast.

KARLGAARD That's right, and I would argue that the marketplace is going to do what Gary is advocating through the legal system anyway. It has been the history of this industry that companies get to a size and hubris sets in and they fight too many battles on too many fronts and they come toppling down. In 1985, nobody would start a company that competed in any way against IBM. People were terrified of IBM. People used phrases like "The dinosaur will flip its tail and crush a 300 million dollar company," the dinosaur being IBM. What happened? 1992, the company almost ran out of money.

REBACK They were also subject to a consent decree in the United States and one in Europe and they have adhered to that consent decree in Europe.

KARLGAARD That wasn't what brought them down, Gary. What brought them down was hubris.

REBACK That may be your view. Actually I think what brought them down is they made a terrible strategic mistake in licensing Bill Gates' operating system.

KARLGAARD Among many mistakes they made.

REBACK But the fact is that they have operated since the early 1980's under a consent decree in Europe which is no different from the kind of restriction that Microsoft ought to have to operate under here and no one has suggested that it's hobbled IBM or restricted consumer choice in any way. As a matter of fact, just the opposite.

KARLGAARD I am shocked to hear you bring up western Europe as some kind of model for our economic system. This is a continent that has been mired in 1 percent growth while the U.S. has completely run away with the information economy and all its spoils in the 90's.

REBACK But what does that have to do with the IBM consent decree, Rich? Come on. Let's face it.

KARLGAARD We could apply any kind of law that western Europe has applied. I think it's a very poor model.

REBACK This is no different from the consent decree that was imposed on Microsoft, on IBM in the United States nor is it different from the consent decree that was imposed on Parke-Davis in the pharmaceutical industry.

ROBINSON What do consent decrees do? Tell me what a consent decree does.

REBACK Well, they basically require adherence to the law like the one that's being imposed currently on Microsoft. In the cases that we're talking about here, they make sure that a customer or a company that is in control of a gateway like an operating system makes data available to competitors that build things on top of that operating system and they do it in a timely manner and an efficient manner so that the best products can be bought to market at the right time and give consumers the best choice.

ROBINSON Illegal business practices undermining consumer choice, on and on. What does Gary want?

ROBINSON What exactly do you want to have happen to Microsoft? You've just named one item. They have to tell other people in the industry about their operating system. They have to share the inner-most secrets of their code.



REBACK Oh no. No. Their code is their code.

ROBINSON What do they have to share?

REBACK They have to share the access points. They have to configure... the access point to an operating system is like the plug on the wall and application programs are like and electric razor or a hair dryer What's been going on here is Microsoft controls the electric power grid and keeps switching the voltage and the amperage and the configuration of the wall plug and people who make applications can't make their applications run with the operating system. So what we're saying is when Microsoft tells it's own people what that interface, what that plug's going to look like, they have to tell the rest of the world at the same time. That's one very important point.

ROBINSON What else? Name, say, the next two items on your list.


ROBINSON How else do you want them to behave?

REBACK I want them to stop buying preclusion. Another...

ROBINSON By which you mean?

REBACK By which I mean what has been shown in the government case where they condition the grant of the operating system on not loading a competitor's product, that I believe is classic, preclusive, anti-competitive behavior.

ROBINSON So I'm again, I'm Compaq. I need to license from you, Microsoft, your operating system in order to sell my computer, but before you will permit me to license your operating system you also force me to say, what?

REBACK That you have to take everything that I put in my operating system package whether is's part of the operating system or not. So the record has shown that they force computer manufacturers to take browsers when they'd rather have some other browser. They force OEM's, computer manufacturers in one case, to take A.O.L., something that they didn't even make themselves because they had a contract with A.O.L. They forced the computer manufacturer to take that product over a competing product that the computer manufacturer had contracted out for himself.

ROBINSON But as the purchaser of this Compaq or Hewlett-Packard computer, gosh, what's wrong? I'm getting more ane more and more and more bundled into my machine. I mean I can remember the days when you bought a computer and then had to go out and figure out which software to get. Now it's so much simpler. I get so much in one bundle.

REBACK You go into a computer store you have one desktop: Microsoft. One size fits all. That's not capitalism as I know it and that's not consumer choice.

KARLGAARD Why must all of these things go to the Justice Department? Why can't hardware manufacturers sue Microsoft? Why can't third party manufacturers...

REBACK What an enormous waste of resources. To give you an example, MCI sued AT&T and won and they won 800 million dollars and it did not one bit of good for the consumer until the government stepped in, imposed structural relief, and, as a result, we have this panoply of new technologies that we would have never had. Private lawsuits do not produce the result that we need to improve the state of affairs for consumers.

KARLGAARD So now we have - the market can't produce the best result, the private lawsuits.

REBACK Those are your words, not mine. If Microsoft...

KARLGAARD No, that's exactly what you said.

REBACK I did not.

KARLGAARD That's exactly what you said because earlier in this conversation you said that we've been locked into an inferior standard. What I'm hearing from Gary is that the marketplace cannot, does not allocate resources effectively, that it does not give consumers the right choice, that the marketplace, contrary to what Hayek said, is inferior to a collection of wise men in the Justice Department.

REBACK You know, if Microsoft played by the rules-

ROBINSON With rare exceptions, Microsoft has annihilated its competition. Can anything stop them?

ROBINSON A decade ago IBM seemed ruler of the Universe, a decade later IBM was on its knees stumbling to reinvent itself. Isn't the ultimate recourse really going to be the marketplace?

KARLGAARD Well, I would certainly argue that it is. I think eventually their fighting so many battles on so many fronts in giving the consumer an operating system that has 15 million lines of code are going to make them increasingly inevitable. You know, we're not that far apart on what we'd like to see as the outcome here. We would like to see many competitors coming in and the computer industry to continue to accelerate and create jobs and create wealth. These are good outcomes and I think we share that. I think that to bring the Justice Department in when the marketplace is going to affect the same result would be a big mistake because there are always unintended consequences when you get the federal government involved.

ROBINSON Is the Internet...

KARLGAARD I think Java from Sun, a client of yours, is a very dangerous threat to the...

ROBINSON Tell me what "Java" is.

REBACK Java is both a computer language and an operating system that runs on any platform fully compiled and is not keyed to the Microsoft architectural structure.

ROBINSON So that's death to Microsoft.

KARLGAARD Think of it as a virtual operating system.

REBACK If permitted to proliferate without the preclusive contracts and activities of Microsoft, the free market would have exactly the effect that Rich suggests.

ROBINSON Okay, but Microsoft presumably sees this as a threat and is doing everything it can to stomp it out, right?

REBACK That is correct. In other words, the market is already beginning to call forth, you can see the seeds of Microsoft's destruction before you at this moment already.

KARLGAARD Well, I can see them. I can see them and I would rather have the marketplace deal with Microsoft than the Department of Justice.

REBACK You know, the problem is that Microsoft can see them. If you look at the doc, Microsoft documents that the government has made public, they show that Microsoft itself in its internal deliberations recognized the threat that the browser enabled by Java had to Windows. Now, the way they responded to that threat was through all of these activities that are now under investigation, some of which have already been declared illegal by the judge.

ROBINSON Last question. Will Microsoft have met it's, have been humbled by the market within a decade or not, Gary?

REBACK The one point I agree with on the free market is that the more the government intervenes, the more business people begin to understand how Microsoft does business and the more loathsome they appear to other companies and the less willing companies are to do business with them. The more that comes out about Microsoft the more pressure there will be from the free market that will help to correct Microsoft's behavior. But they are not going to back off unless somebody wearing a robe tells them where the line is.

ROBINSON Nobody wearing a robe speaks over the next decade. Will the marketplace itself humble Microsoft?

KARLGAARD I think Microsoft will be humbled in the sense that their growth rates will slack off unless their market capital stagnates. So without Justice Department intervention, ten years from now I see Microsoft as having doubled or tripled or quadrupled its revenues but its market cap is going to begin to stay steady. Smart people are going to leave Microsoft because opportunities to become millionaires will lessen and Microsoft will become a big, cloddy company increasingly vulnerable to upstarts.

ROBINSON A big, cloddy company. Rich, Gary, thank you very much.

REBACK Thank you.

KARLGAARD Thank you.

ROBINSON If the American computer industry were a game of Monopoly, Bill Gates would already have Park Place and Boardwalk. The question is, will he lock up the rest of the board or will he be told, so to speak, to go directly to jail? I'm Peter Robinson. Thanks for joining us.

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