The Sensible Way to Dismember Microsoft

Fortune issue: May 29, 2000

First Principles

The Sensible Way to Dismember Microsoft

By N. Gregory Mankiw

Having convinced Judge Jackson that Microsoft is an abusive monopoly, the U.S. Justice Department wants to split the software behemoth into two companies--one for the operative system and one for application programs. Even assuming the trial court's findings are right, the remedy is wrong.

To see why, consider a simpler example. Place yourself in the days of the Flintstones, and imagine that some young dropout of Harvrock University invents the first footwear. He patents his invention and starts a company to sell the new product--Monopoly Shoe, known as MS.

Shoes quickly become the rage, and MS's founder becomes the richest man in Bedrock. But then MS gets greedy. It starts packaging socks with its shoes--claiming that the bundle benefits consumers. Then MS discourages shoe retailers from carrying competitors' socks.

The government of Bedrock, wanting to preserve competition, files a suit asserting that MS is trying to extend its monopoly from one market to another. MS disputes the claim, but the judge sides with the government.

Now comes the hard part: What should Bedrock do to MS? It might break the monopoly into two companies--one that sells black shoes and one that sells brown shoes. Because black and brown shoes are substitutes, the new companies would compete. The price of shoes would fall, and consumers would be better off. However, the government's lawyers plan to split MS the wrong way--creating two companies, but one sells left shoes and the other sells right shoes.

The split makes matters worse. Consumers now have to deal with two monopolies that will charge a higher combined price than the single monopolist did. Why? Monopolists that produce complements, like right and left shoes, fight one another for a bigger share of the profits. The right-shoe maker will raise prices without regard for demand of left shoes. The left-shoe maker will follow suit. A single monopolist takes the interdependence of the two into account--selling a lot of right shoes stimulates demand for left ones--and that keeps a lid on prices.

Even Fred Flintstone could see the moral of the story: The government's proposal to break up Microsoft creates two companies that produce complementary products--operating systems and applications. In the past Microsoft kept the price of Windows low because it stimulated the sale of computers and its application programs. Similarly, it kept the prices of applications low because doing so increased operating-system demand. But once the company is broken up, each part would have an incentive to raise prices.

The Justice Department claims that the two companies would eventually develop new products and compete with each other. This outcome, however, is far from certain. A better solution would give the new companies substitutable products from the beginning--each would have the right to sell its own version of Windows. One company might become dominant in the long run, for the market for operating systems may well be a natural monopoly. But at least the industry would start with competition.

There is, however, a simpler solution--both in Bedrock and in Seattle. In our parable, the government could get rid of the monopoly by revoking the inventor's patent and letting anyone start a shoe company. The analogous real-world remedy is to make Microsoft release the source code for Windows. If Windows were in the public domain (as Linux is), new companies could offer their own improved versions. Microsoft would lose the profits from its past innovations--a penalty for its past sins. The company would remain intact, however, and could revise its version of Windows without restriction. Bill Gates would keep his highly touted "right to innovate."

Of course, he and other Microsoft shareholders would be a lot poorer. But, heck, that's the cost of losing.


N. GREGORY MANKIW is an economics professor at Harvard and the author of Principles of Economics.