Is Microsoft a monopoly? If so, why does it matter?

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Why do we need government? One of the most important answers to that question is that we need government to compensate for "market failures."

The United States economy is based on the presumption of a free market. This means that individuals and groups are free to do the work they choose to do, provide goods and services of their choosing and to spend money on the things they want. The government, for the most part, does not limit the range of goods and services available or set the prices that are charged for them. The amount of money an individual or business can charge for a product is set by the supply and level of demand for that product. Popular products that are scarce will have higher prices than unpopular and readily available products.
Free market- Perfect market where free competition exists. Existence of many buyers and sellers such that no individual buyer/seller can influence the market demand, supply and price. Equilibrium price and output are set by market demand and supply.
Laws of Demand and Supply- High demand and low supply of a product result in high prices while low demand and high supply result in low prices.

For the most part, the market produces economic outcomes that are efficient and fair. However, there are some instances in which the market fails. Economists generally include on the list of market failures monopolies, the under-provision of public goods, externalities, incomplete markets, information shortages and high unemployment and inflation rates.

When the market functions properly, competing individuals or businesses provide the same (or similar) goods and services to consumers. Because consumers have a choice, providers will lower their prices to win consumer dollars. The interplay of competition to supply a good or service and consumer demand for it will set a fair and efficient price in a free market. However, when there is no competition (and only one individual or business provides a good or service) the market cannot set an efficient price. In such instances, a monopoly is said to exist.
In a PC market, many firms produce homogenous goods of the same quality. Consumers are indifferent to the sources of the goods, resulting in a high price elasticity of demand for the good. Faced with such fierce competition, firms need to lower their prices to increase total revenue.
Allocative efficiency is achieved in a PC market since marginal cost equals price at the profit-maximising output.

However, economists maintain that a monopoly does not exist simply because there is only one provider of a good or service. For example, in the Microsoft case, the Windows operating system is enormously popular, but the potential for a competing firm to provide a similar product exists. In fact, Macintosh is a small but important competitor in the computer and operating system market. Linux has also emerged in recent months as a viable alternative to Microsoft Windows.
Reason as to why Microsoft continues to innovate through R&D despite having monopoly power. Emerging firms such as Macintosh and Linux are producing products that may be substitutes for Microsoft Windows. The availability of such substitutes may eventually drive Microsoft out of the industry if it becomes X-inefficient.

But is Microsoft's market share (about 90%) so massive that it can behave like a monopoly? A monopoly can set prices artificially high because it has no serious competitors to force it to do otherwise. It can also arbitrarily limit the supply of the good or service it provides to create scarcity and drive prices up. In either case, the monopoly collects a "rent" on its domination of a particular sector of the economy. This rent represents income above and beyond the efficient price it could charge for its product in a competitive market environment.
Allocative inefficiency exists in monopoly when the firm charges a price that is higher than the marginal cost. There is a loss in consumer surplus as compared to the price charged in a PC market.

Legally, a monopoly or "trust" exists when an individual or firm can explicitly force competitors out of business by slashing prices, buying up and hoarding supplies, bribery or intimidation (Clayton Antitrust Act of 1914). Earlier this year, a federal judge ruled that Microsoft has, indeed, engaged in many such practices on the basis of its monopoly power in the computer operating systems market. Discussions between Microsoft, the U.S. Department of Justice and the Attorneys General of several states are ongoing to decide what, if anything, should be done to Microsoft given this ruling.
Barriers to entry- controlling key factors of production and engaging in predatory pricing to drive out competitors.

Many observers have argued that to break up Microsoft would send the wrong message to individuals and businesses in the United States. If a company produces a product that is so good that everyone wants to buy it, should that company be punished? But dividing the company into two or three smaller companies, others have argued, would force Microsoft to compete on a more level playing field with other software companies. Moreover, they argue, with competition, the quality of software would improve and prices would probably drop.

High demand for Microsoft’s products is a major factor contributing to the high prices of the products.
With more software companies and greater competition, the demand for software will become more price elastic, leading to a drop in prices to increase total revenue. However, firms will carry out R&D to produce better quality software so as to differentiate their products from others, making their demand more price inelastic. Higher prices may then be set to increase total revenue, but it is likely that this price will still be lower than the price set by a monopoly, given a contestable market.

Perhaps a lesson can be drawn from the break up of American Telephone and Telegraph (AT&T) in 1983. The government had actually protected AT&T's market domination during the first half of the 20th Century because of AT&T's commitment to make telephone service universally available in the United States. However, by the 1980s, many critics argued that the company was so large and monopolistic that competition had been stifled and consumers were being deprived of choice in the long-distance telephone market. In response, the Courts forced a breakup of the company into seven regionally based "Baby Bells" (Southwest Bell, Southern Bell, etc.).

The AT&T case is similar to the Microsoft case in one very important respect. The early Antitrust laws in the United States were motivated by consumer protection. Recent applications of the law, however, have been more focused on providing opportunities for other businesses and corporations to compete with large monopolistic companies such as AT&T and Microsoft. In the AT&T case, and in the Microsoft case, potential competitors have played the leading role in legal challenges, with consumers as the supporting cast.
Primary reason for application of anti-trust laws is to encourage new firms to enter the industry while consumer welfare has become secondary.

As a matter of legal and economic fact, Microsoft is at least "monopolistic." It has such a commanding share of the operating systems market that it can, in many respects, behave like a monopoly. But is that necessarily bad for consumers? It is manifestly bad for Microsoft's competitors, just as AT&T's dominance was bad for its competition. After AT&T was broken up, companies like MCI and Sprint emerged as major competitors in the long-distance telephone service market.

Arguably, consumers have benefited as well from the breakup of AT&T with long-distance rates well under ten cents a minute. While potential competitors would most likely benefit from a breakup of Microsoft, it is not entirely clear that significant benefits would be immediately realized by consumers. If recent stock market reactions to initial rulings in the Microsoft case are any indication of what would happen if Microsoft were broken up, the short term results for consumers (and the economy) might be very negative. As in every instance that the government decides to intervene in the economy, a good deal of caution and care is in order.

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Yanjun :)