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the Software View: Software market dynamics (Part V)
Welcome back, gentle reader. I read some funny, interesting anecdotes concerning Microsoft in the September 14, 1998 issue of BusinessWeek magazine. An article about the new Microsoft president, Steve Ballmer, states that Financial analysts, though, are losing patience with Microsoft's profitless Web ventures (MSN, Sidewalk, Slate, etc.). "Red West should be called Red Ink," scoffs David Readerman of NationsBanc Montgomery Securities Inc. - referring to the red brick satellite offices where those businesses are located in Redmond, Washington. Oops factor. Then there was the Janet Reno incident. Last fall, in front of reporters, Steve Ballmer made the colossal blunder of sneering "To heck with Janet Reno!" after the Justice Department sued Microsoft. That comment made headlines and hurt Microsoft's already battered image. It cost Microsoft dearly. Ballmer says he deeply regrets the comment. "That's the way I am," he says. "I have to work on being a better version of myself."
Also, in the September 21, 1998 issue of BusinessWeek, they write that Scott Vesey at Boeing may testify in the Microsoft anti-trust lawsuit about how Microsoft pressured Boeing to abandon Lotus' e-mail software, even after it had scored highest in the aircraft maker's technical evaluations. Steven McGeady, a vice-president at Intel, will likely be asked about a meeting in which Bill Gates pressured Intel to cease certain software development projects and withhold support for Sun Microsystems' JavaTM. James Barksdale, president of Netscape, will be asked about a 1995 meeting where Microsoft allegedly tried to persuade Netscape to leave the Windows browser market to Microsoft.
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Now, dear readers, on with this week's episode of the Software View!
With this issue, I conclude a multi-part exploration of the dynamics of Internet software markets.
James Aley writes, "Anyone who's taken freshman economics knows how economists cherish the concept of diminishing returns. It's one of those theoretical pillars that keeps the dismal science dismal: The more you make or sell, the harder it gets. If there are profits to be had in, say, the dog food business, you won't be the only one fighting for the spoils, and whatever spoils there are to start with won't last long.
But there's a problem with the diminishing-returns version of the world. Sometimes, markets do just the opposite of what diminishing returns says they should, and all the rewards gravitate toward one winner at the expense of everyone else - and sometimes that winner doesn't even have the best product. How did we end up with the awkward QWERTY configuration on our typewriters and computer keyboards? Why did VHS become the standard for videocassette recorders, when Betamax was the better technology?
In other words, in some cases, the more someone makes or sells something, the easier it gets. Obviously, something other than diminishing returns is going on in the economy - namely, increasing returns. This insight can explain many otherwise puzzling phenomena in the modern world, and a growing school of thought has formed around increasing returns. The idea may become as central a tenet of modern economics as supply and demand, and is already well on its way to achieving buzzword status. Microsoft's Bill Gates, for instance - never far from the cutting edge - devotes a good chunk of his book, The Road Ahead, to increasing returns, although he refers to the idea as "positive feedback." This concept has also been called a "virtuous cycle".
ACCORDING TO ONE of the foremost theorists of this new school, W. Brian Arthur, an economist at both Stanford and the Santa Fe Institute, increasing returns is essentially the tendency for something that gets ahead to get further ahead. "The more people use your product," he says, "the more advantage you have - or, to put it another way, the bigger your installed base, the better off you are."
The QWERTY keyboard, named for the first six letters in the upper row, is a simple example Arthur uses to illustrate this principle. QWERTY didn't become standard because it was more efficient than other possible layouts. In fact, the configuration was designed to slow typists down, because early typewriters kept jamming. The historical event that made this inefficient layout ubiquitous was Remington Sewing Machine Co.'s decision to manufacture its typewriters using QWERTY. Remington made a lot of typewriters and the configuration eventually achieved "lock-in." The more Remington typewriters that were on people's desks and the more typists got used to the layout, the less willing users would be to switch to a different one. The larger the population of crack QWERTY typists, the more important it became for aspiring typists to learn to use it. And we've muddled along ever since.
The most extreme examples of the way increasing returns works in the real world today appear in the computer software business, where establishing a big user base is the key to success. It's the reason that Microsoft wins virtually every market share battle it enters, even when its products aren't necessarily the best. Microsoft set a standard for personal computer operating systems that "locked in" and consequently gave it a huge advantage in selling its spreadsheet and word-processing software.
Other characteristics of the software business, and high technology in general, amplify the effects. First, there's the upfront cost of development. High-tech products require enormous investment in Research and Development, but once the products are ready to roll, manufacturing costs are relatively low. Microsoft, Arthur says, spent hundreds of millions developing Windows 95, but it costs Microsoft almost nothing to make more copies. And in fact, the more copies the company puts on the shelves, the more it sells, because the more people use Windows 95, the more software gets developed for it. The more software is available, the more people buy Windows 95.
Complicating all this, says Arthur, is that despite lock-in, increasing returns doesn't necessarily lead to stability. VHS may have beaten out Betamax, but some other totally new technology may overtake VHS someday, like watching movies via the Internet.
To those in the high-tech world, the idea that a marketplace can become a frantic winner-take-most game isn't exactly news. (William Gurley, a computer analyst at CS First Boston, titled a recent report, "Stunningly Obvious: The Secrets of Software Economics.") You might even say that reduced to it's simplest form - "Unto every one that hath shall be given" - this nugget of economic wisdom is clear to most people by age 9.
Economists - especially economic theorists - have long known about increasing returns; they just never did anything with the idea. (The great British economist Alfred Marshall, who laid the foundation for much of modern economics, wrote about the phenomenon in his seminal textbook published in 1890.) It took the advent of high tech and the personal computer for increasing returns to get the respect it deserves.
Mainstream economists shunned the idea of increasing returns for both methodological and ideological reasons. Practically, increasing returns turns out to be exceedingly difficult to deal with mathematically; it muddies the mechanics of supply and demand, which in classical theory meet at a final price that clears the market. Ideologically, increasing returns runs against a general point of departure for orthodox economists: that, other things being equal, market forces automatically yield the best possible outcome - the best product at the best price - and no one runs away with the market because the minute you make a profit, someone else sees an opportunity and enters the fray.
INCREASING RETURNS isn't completely mainstream yet - it isn't taught as part of standard introductory economics courses. But at least the mere mention of the concept no longer causes economists to grimace and inhale sharply. Arthur's work has provided much of the mathematical rigor needed to make the idea legitimate. Significant contributions also come from Stanford's Paul Krugman, and Paul Romer at the University of California at Berkeley - two of the young turks among modern macroeconomists. Krugman's work has concentrated on how increasing returns plays out in international trade and challenges another deeply held conviction of economists: that free trade among nations always produces the best economic outcome. Romer has been working the concept into his theories of general economic growth.
Increasing-returnists are not looking for a complete rewrite of economics textbooks, just a few new chapters. The fact that increasing returns exists does not mean that diminishing returns doesn't. Far from it. In a published article in the Harvard Business Review, Arthur argued that the two phenomena will always coexist and are complementary. Most businesses, especially mature ones, from dog food to steel to oil, will forever remain in the competitive and unforgiving world of diminishing returns. But the new thinking about increasing returns helps us to understand why the Microsoft's, Merck's, and Intel's of the world operate by rules that economists either had long believed impossible or had chosen to ignore."
W. Brian Arthur is Citibank Professor at the Santa Fe Institute and Coopers & Lybrand Fellow. From 1983 to 1996, he was Dean and Virginia Morrison Professor of Economics and Population Studies at Stanford University. He holds a Ph.D. from U.C. Berkeley in Operations Research, and has other degrees in economics, engineering and mathematics.
Arthur pioneered the study of positive feedbacks or increasing returns in the economy - in particular their role in magnifying small, random events in the economy. His ideas have come much to the public eye with the recent legal case of the U.S. Department of Justice versus Microsoft. His work on increasing returns won him a Guggenheim Fellowship in 1987 and the Schumpeter Prize in Economics in 1990. Arthur is also one of the pioneers of the new science of complexity. His main interests are the economics of high technology; the "new economy" and how business evolves in an era of high technology; cognition in the economy; and financial markets.
Arthur was the first director of the Economics Program at the Santa Fe Institute in New Mexico; and he currently serves on the Board of the Institute. He is a consultant to Citicorp, McKinsey and Co., and Coopers & Lybrand, among others. He is a frequent keynote speaker.
Arthur spent much of the 1980's developing a theoretical framework for economic allocation under increasing returns, in particular studying the dynamics of lock-in to one of many possible equilibria under the influence of small, random events. (Several of his papers are collected in his 1994 book, Increasing Returns and Path Dependence in the Economy.) High technology operates under increasing returns, and to the degree modern economies are shifting toward high technology, the different economics of increasing returns alters the character of competition, business culture, and appropriate government policy in these economies.
The point that Arthur has emphasized and which is influential in the current debates about anti-trust policy is the dynamic implication of increasing returns. It is the concept of path-dependence, that small historical events, whether random or the result of corporate strategic choice, may have large consequences because of increasing returns of various kinds. Initial small advantages become magnified, for example, by creating a large installed base and direct the future, possibly to an inefficient and inferior technology. Techniques of production may be locked in at an early stage. Similar considerations apply to regional development and learning.
Small, chance, historical, random events can impose network externalities upon future freedom of choice. The economy gradually locks itself into a technology not necessarily superior to alternatives, not easily altered, and not entirely predictable in advance. There is a "founder" effect, and "history" becomes important. Small events, the mutations of history, are often averaged away. But, once in a while, they become all-important in tilting the economy into new structures and patterns that are then preserved and built upon in a fresh layer of development.
Microsoft's monopoly dominance in desktop personal computer operating systems and desktop personal computer productivity applications (Microsoft Office) allows it to successively take over more and more threads of the future web of technology, thereby preventing other companies from getting access to new, breaking markets. The tendency of anything that's ahead in market share to get farther ahead, or if something's falling behind in market share to get farther behind. Microsoft has some incredible assets: monopolies in desktop personal computer operating systems and productivity applications, billions of dollars of cash in the bank, high stock price, and some incredibly brilliant people. But, Arthur likes to use a metaphor that future software markets are a little bit like the land rushes in the 1880s, in Oklahoma or Kansas. Everybody starts off with their horses and buggies behind the same line. (But in high tech) there's only one prize: you take 85 or 90 percent of the market. Now imagine if you had won three or four of these races in succession and you parlayed your winnings into buying a sports utility vehicle instead of a horse and buggy. And just to make doubly sure, you hobble everybody else's horses at night. Well, then Arthur thinks that is cause for alarm. And, I believe it, as well.
Sincerely,
Mark Kuharich
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