This paper aims to make a public statement about the strategy implemented by Microsoft in order to reinforce its market power across the networked users of Windows Operative System, and Xbox Games Console. It is presented an economic view that supports the anticipating (not predatory) position assumed by Microsoft against its direct competitors.Externalities, Microsoft, Software Industry, Regulation Policies

Carlos Osório

João Leitão

English

Research Papers in Economics

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D
G
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João Leitão
Carlos Osório
Externalities of the Microsoft’s
Network Goods
TEXTO PARA DISCUSSÃO DGE-07/2002
Junho 2002
Departamento de Gestão e Economia (DGE)
Universidade da Beira Interior
Pólo das Ciências Sociais e Humanas
Estrada do Sineiro
6200-209 Covilhã
PORTUGAL
TLF: 275 319 600 / FAX:275 319 601
http://www.dge.ubi.pt2
EXTERNALITIES OF THE MICROSOFT’S NETWORK GOODS
João Leitão
University of Beira Interior (UBI),
Department of Business and Economics, Covilhã, Portugal.
jleitao@fenix.ubi.pt
Carlos Osório
University of Beira Interior (UBI),
Department of Business and Economics, Covilhã, Portugal.
cosorio@alpha2.ubi.pt
ABSTRACT
This paper aims to make a public statement about the strategy implemented by
Microsoft in order to reinforce its market power across the networked users of Windows
Operative System, and Xbox Games Console.
It is presented an economic view that supports the anticipating (not predatory) position
assumed by Microsoft against its direct competitors.
KEYWORDS
Externalities, Microsoft, Software Industry, Regulation Policies.
1. INTRODUCTION
The case of US versus  Microsoft, dated 1998, has been much discussed among
economists all over the world. The reason for this paper is to make a public statement
about the charges against Microsoft’s initiative of making a kind of market foreclosure,
which affected direct competitors.
Remember that Microsoft has been accused of executing a vertical foreclosure, by
integrating the Internet Explorer (IE) browser on the Windows Operating System, in
competition with the Netscape browser.
In 1995, when Microsoft announced that it would distribute its new Internet Explorer
browser free of charge, it prevented the success of Netscape’s initial business plan of
charging consumers for the use of this graphic software.
After this procedure, Microsoft was accused of executing a type of strategy that is based
on the exploitation of network externalities and practice of predatory pricing, which
imposed restrictions on original equipment manufacturer’s (OEMs), Internet Content
Providers (ICPs), and Internet Service Providers (ISP).
The impact of this strategy was felt at two different levels; on the one hand, it was
ensured that new personal computer users would have access to a previously installed
version of IE; on the other hand, the Netscape browser could not be installed on those
machines.3
2. IE: INFORMATION GOOD
In the present text, the IE it will be called as information good, because, this kind of
good is clearly free, and in the present digital context it should be considered as a public
good.
Considering the large number of antitrust cases, that have been judged by the Federal
Trade Commission, in US, an analogy can be found with the case US versus Microsoft,
where it was considered that the information good’s (IE) offers an acceptable
mechanism to stimulate demand for Windows.
By taking the IE as information good, it may be considered that information goods
include everything that can be digitalized, or codified by a flux of bits.
Information goods establish an interaction between two fundamental and
complementary elements which are information (software) and supporting infrastructure
(hardware).
This relationship provides the likelihood of strongly dependent utilities, which originate
from the interaction between the producer’s utilities (in a conscious way) and
consumer’s utilities (in a non deliberately conscious way), which contribute to a large
degree of mutual satisfaction.
A browser has, in fact, three basic features of a public good. First, this kind of good is
indivisible and independent on the quantity consumed by a set of consumers, it is
always possible to include additional users, and this practice will not reduce the
individual satisfaction degree or the collective satisfaction degree of the initial set of
users.
Second, the browser makes exclusion impossible, since the quantity produced of this
kind of information good, has to be accessible to the additional users who wish to use it.
Third, the integrated functioning of the web makes the rejection of this kind of
information good impossible, since there is a necessity for all the current users of Web,
to use this kind of information good, even if they do not want it.4
3. PRICING OF NETWORK GOODS
It should nevertheless be stressed that the marginal cost of an additional copy of IE,
could be negative, because the production cost of the copy is nearly zero, and the cost of
the “Webgrafia” 
1 of the consumer profile may imply a saving of costs for the producer.
This costs saving, which is due to the elimination of the costs associated with market
research, leads to the possibility of implying negative marginal costs.
Figure 1 – Pricing of Network Goods
Furthermore, the information obtained by the process of “Webgrafia”, may create an
extra benefit, by the additional profits that can be achieved introducing new
complementary products.
In fact, a negative price may be set, because by setting a price equal to zero, above the
marginal cost, a mark-up should be obtained which could lead to the availability of
alternative program applications for Windows, taking into account the optimal
trajectory of increasing profit.
Another form of vertical restraint which could be observed was the use of bundling,
which began with the offer of Windows 98, including the IE as an integrated component
of this version of the Windows Operating System.
                                                
1 Set of techniques used in the classification and quantification of some characteristics that may help on
the design of the consumer (user) profile.
P
Cmg
X
The dashed segment represents the
mark-up (P-Cmg) which includes the
cookies’ value and the valuable
information for the development of
program applications for Windows.5
Without forgetting the classic argument that this procedure presents as a source of
barriers to entry, starting on a rational basis, it should be stressed that the services
integration, including the browser and the operating system, provided a unified
experience, and was sometimes, more efficient, for the final users, since its availability
provided access to all the users, in the same way as to the resident information on the
Web.
The methodology used in the evaluation of the antitrust cases, especially in high
technology industries, is based on the observation of the producers’ market power, in
other words, on their capacity of setting prices above marginal cost, for long periods of
time.
In the case of the Software Industry, we should take into account that the market
boundaries are extremely fuzzy, and the leader is often threaten by competitors that
absorb other software categories, or by competitors that are able to move from other
related industries, in order to capture some specific and highly differentiated markets.
As we may observe, there are plenty of possibilities to enter in this industry. However,
the temporal question assumes here an important role, because everything depends on
the length of time that Microsoft could maintain the price above the marginal cost.
As the software industry only makes sense if it is thought as an integrated and
complementary platform, labelled usually as a “hardware-software” system, which is
characterized by the effects of network externalities, we may assume that Microsoft
only responded, by anticipating the present scenario which is dominated by the revealed
preferences of the consumers. Furthermore, the consumers rewarded the Operating
System that permits them to run all the applications programs they want to use, in an
interface that allows them to reach positive externalities, and reduces the opportunity
costs by using other Operating Systems.
4. XBOX: THE NEW CHALLENGE
Nowadays, Microsoft is facing other big challenge with the Xbox games console. Last
year, the Microsoft’s chief executive officer estimated that his company will loose $ 125
on each machine sold. Due to this situation, Xbox might not break even within five
years.
Microsoft has therefore been accused of predatory pricing, and developing a kind of
market foreclosure by covering only some games’ software producers in the exclusive
pack which is presently offered to the consumer network.
In turn, the retailers are promoting sales of Microsoft games in exchange for more
favourable distribution of consoles, and in fact the most software bundled with Xbox
belongs to Microsoft.
The main principle is simple; the consumers may choose the games they want to include
in their Xbox. Obviously, they will include on their preferences the more advertised6
games, and the games that count with more network users, in order to play it on the
Cyberspace.
Microsoft does not make the choice, but induces the consumer to do it. The Xbox’s
long-term success is guaranteed if Microsoft is keeping in mind that consumer buy
consoles, but who sells consoles is the software. Then, Microsoft expects to reach
increasing returns to scale, with unit’s cost sharp reductions.
5. CONCLUSION
We are in the “Age of Access”,…. so the improvement of conditions to access to
information, should not be penalized, since the improvement of these conditions,
reduces information asymmetries, and lowers the transaction costs associated with any
kind of operation established between two interdependent economic agents.
Presently, when we launch onto to the market new information goods, we have to take
into consideration that information is a real productive factor, and make clear the nature
of the induced benefits, which may be generated by the individual satisfaction of the
consumers, more and more expressed by a collective consumer network.

Externalities of the Microsoft’s Network Goods

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Externalities of the Microsoft’s Network Goods

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