Creative insecurity: the complicated truth behind the rise of Microsoft.

Back in 1983, Forbes ran an article called "If they're so smart, why aren't they rich?" It was about how inventors rarely reap big financial rewards from their creations, and it started like this:

"Here are some names you are not likely ever to see in The Forbes Four Hundred [list of the richest Americans]: Franklin Lim. Gary Kildall. Bill Gates...."

Oops.

The world's richest man wasn't always so. During the last round of high-tech excitement - the personal-computer boom of the early 1980s (which was followed by a traumatic shakeout) - Gates looked like a smart programming geek whose business savvy was dwarfed by the marketing whizzes at Apple: "Their Apple Corp.," wrote the anonymous Forbes author, "has been among the most successful at packaging a product that sells and then selling it at an attractive price."

Therein lies a tale. As the Justice Department and a half-dozen state attorneys general push forward antitrust actions against Microsoft, it's worth considering how the company got where it is and what that suggests about the strengths and limitations of markets.

There are two main fables told about Microsoft: It has become the dominant, standard-setting software company, and made Gates a multibillionaire, because a) it makes wonderful products and expresses all that is good about a capitalist system or b) it cheats. Both fables turn up especially strongly in statements by people who lack deep knowledge of the industry, and each serves the interests of an industry faction.

The truth, however, is more complicated. Considered without regard to price, ubiquity, or compatibility with inexpensive hardware, many Microsoft products are mediocre at best. I am happily writing this article using an obsolete Macintosh operating system and WordPerfect, both of which I find superior to even the latest versions of Windows and Word. Great products did not make Microsoft number one. Good-enough products did.

That uncomfortable truth offends moralists on both sides of the Microsoft debate. The company's fans (and its spin doctors) want to tell a simple tale about virtue triumphant - with virtue defined, Atlas Shrugged-style, not only as astute business decision making and fierce competition but also as engineering excellence. Its critics use the same definition. If the products are less than great, they suggest, the only way to explain the company's success is through some sort of sleaze. Or, alternatively, through the innate flaws of the market.

So what really happened? How did Microsoft end up ruling PC operating systems and, through them, software in general?

At the risk of simplifying a complex story (if only by reducing it to two players), the bottom line is this: Apple acted - and continues to act - like a smug, self-righteous monopolist. Microsoft acted - and continues to act - like a scrambling, sometimes vicious competitor.

That pattern shows up most clearly in pricing strategies. Microsoft's approach, throughout its history, has been to charge low prices and sell an enormous amount of software. True to form, the company is currently in trouble with the Justice Department for charging too little - nothing - for its Internet Explorer, by including it in Windows. (The technical legal dispute is over whether Explorer is a "feature" of Windows, as Microsoft maintains, or a separate product that is an illegal "tie-in" and thus violates a consent decree Microsoft signed in 1995.)

The low-price strategy makes sense on two levels: First, it approximates marginal-cost pricing, since software, once written, costs very little for each additional copy. Anything above that incremental cost, however small, is profit. Second, and more significantly in this case, lower prices mean more customers. And the more people who use a particular kind of software, the more desirable it is for others to use it too. Although translators help, switching formats is messy and inconvenient. This "network externality" is particularly important for operating systems and Internet browser formats, since software developers and Web site designers have to pick a standard for which to optimize their products.

As Gates told Wall Street Journal reporter Jim Carlton in an interview for Carlton's new book Apple: The Inside Story of Intrigue, Egomania, and Business Blunders, "Momentum creates momentum. If you have volume, then people write apps. If people write apps, you have momentum."

But if you think you already have a monopoly, you don't worry about momentum. While Apple executives theoretically knew they had competition, they acted as though they didn't. Back in 1983 Apple may have been "selling [its computers] at an attractive price." But the coming of the IBM clones made Apple's prices look downright hideous. In the face of ever-stronger competition, the company insisted on pricing the Macintosh to maintain at least 50 percent profit margins; its "50-50-50 rule" told managers to keep margins up to maintain the stock price.

Customers who paid their own personal money for Macs might be able to justify the high price simply because the computers were fun and easy to use. But business managers who paid Apple prices for any but the most specialized applications, notably graphics-intensive work, were either fiscally irresponsible or just plain dumb. Apple's pricing strategy handed the vast business market to computers running Microsoft operating systems, first DOS, then Windows.

Microsoft, of course, doesn't sell computers. It's in the software business. You can get its operating system (and run its applications) on all sorts of different machines, whose manufacturers compete intensely. That competition drives down consumer costs, even as machine features get better all the time.

Apple didn't want that sort of competition. It not only kept its own prices high but refused to license its software to any other computer maker. That meant even fewer people used its operating system, which further dampened its momentum. Apple, in fact, acted like the ultimate "tie-in" monopolist. You not only couldn't buy parts of its software separately; you couldn't buy them at all without forking over thousands for an Apple-made machine. And Apple has never been particularly good at manufacturing.

After the company tepidly began licensing a couple of years ago, Mac clone makers did what Apple had feared: They cut into its revenue. But they also expanded the market, and they made the fastest computers ever to carry the Mac operating system. They gave Apple money for its software, even as they bore the costs of manufacturing and distributing their machines. And they gave consumers more choice, more alternatives to Windows. If I were an antitrust regulator looking for conspiracies, I'd be wondering just how coincidental it was that Microsoft invested $150 million in Apple just about the time Steve Jobs announced that the company was ending the clone program.

Such explanations aren't necessary, however. Apple screwed Mac lovers all by itself. Far from the marketing whizzes of 1983 conventional wisdom, its executives were enamored with the cult of the machine, too hung up on the beauty of their product to understand that consumers actually cared about many other things: price, plenty of software, and compatibility with other systems. Quality is not one-dimensional.

Apple's arrogance left computer users with less choice than they might have had - or, perhaps, with more. After all, if Apple had slashed prices early on and taken the business market seriously from the start, it could well have ended up in a Microsoft-like position, but without having to share its market with clones. Microsoft would then have been mostly an applications company, selling Excel and Word to Mac users, and we'd be hearing about the evil, anticompetitive actions of Steve Jobs.

That seems unlikely, however, and the reason is revealing. Apple's all-in-one-box strategy was inherently brittle. It offered too many margins of error and too few margins of adjustment.

The same company wrote the software and made the machines. So if the computers caught on fire, as they sometimes did, or the manufacturing plants couldn't keep up with Christmas demand, there was no alternative outlet for the Mac operating system. Software sales dropped too. No competitive sales force could go after business users while Jobs and company were chasing public schools. All new ideas had to come from within the same closed system. (For a discussion of related issues, see my Forbes ASAP article "Resilience vs. Anticipation," available at www.reason.com/opeds/vpasap082597.html. While Apple is based in Silicon Valley, its self-sufficiency strategy more closely resembles those of the minicomputer companies based around Boston.)

Microsoft's partner-dependent system proved far more resilient as the industry changed. The company didn't have to do everything itself, and it could reap the benefits of innovations by others, whether in manufacturing, assembly, distribution, or applications software. Instead of the best minds of a single company, it enlisted the best minds of hundreds. And while Microsoft depended on its partners to build the market, in time they came to depend on Microsoft. The irony is that by making alliances and competing furiously - by not acting like a monopolist - Microsoft wound up reaping the benefits of a near-monopoly on its operating system.

It is emphatically not true that "when you buy a computer, you already are without any choice as to the operating system," as Microsoft critic Audrie Krause said on Crossfire. Both REASON's production department and I personally will be buying new Macs in the next few months. Translation software makes it relatively easy to go from one operating system to another. Nowadays, it's possible to function reasonably well with an operating system that controls only 5 percent of the new-computer market.

The great fear of Microsoft's critics is that the company will wind up controlling everything, foisting mediocre-to-poor products on an unwilling public at ever-higher prices. It's impossible to disprove that hypothetical scenario. But history, and Microsoft's own intense paranoia, cast doubt on it. Just when its quasi-monopoly looks secure, something new - Netscape's Web browsers, Sun Microsystems' Java programming language - pops up and makes Microsoft scramble to maintain its position. So far its resilience has served it well, but the critics' scary scenario relies on more than successful scrambling. It requires absolute security, no future challengers. And that looks unlikely.

Consider the smoking gun memo cited by Assistant Attorney General Joel Klein at the press conference announcing the Justice Department suit. An internal Microsoft document, it told marketing managers to "Worry about the browser share as much as Bill Gates does, because we will lose the Internet platform battle if we do not have a significant user-installed base. The industry would simply ignore our standards. At your level, that is at the manager level, if you let customers deploy Netscape Navigator, you lose the leadership on the desktop."

I will leave it to the attorneys to divine what it means not to "let customers deploy Netscape Navigator," but one thing is clear: This is not a company that thinks like a monopoly. It is always running scared. There's always the possibility that something new could come along and destroy its franchise.

Microsoft didn't get where it is by creating perfect products. It benefited as much from its competitors' mistakes as from its own considerable acumen. And it isn't shy about leaning on suppliers and intermediate customers, such as computer makers, to get its way. In the eyes of its critics, its success is therefore proof that something is amiss in the marketplace.

But the market doesn't promise perfection, only a trial-and-error process of discovery and improvement. The fallible human beings who create products make mistakes. They let their egos and preconceptions blind them to what people really. want. Or they just don't know enough, or adjust fast enough, to produce the right goods at the right time. That some of Microsoft's strongest current competitors - Sun and Oracle - are gripped by an anti-PC ideology, when customers love the independence and flexibility of personal computers, does not bode well for them.

What is striking about the story of Microsoft is how adaptable the company has been. Gates's original vision of "a computer on every desk and in every home, running Microsoft software" didn't specify what sort of software or who would make the computers. It was an open-ended, flexible idea that built a resilient company.

What Microsoft has delivered is pretty much what most people want: a way to use computers easily, for many different purposes. Its software isn't always elegant, but that's the criterion of programming elites, not everyday users. And though Microsoft is clearly the big kid on the block, it has enabled, and encouraged, lots of other software developers. Microsoft accounts for a mere 4 percent of industry revenue. As Eamonn Sullivan of PC Week notes, "A lot of companies are making a lot of money on the ubiquity of Windows, providing users with a lot of choice where they want it - on their desktops. That isn't the expected result of a monopoly."

From 1969 to 1982, the Justice Department carried on a similar trust-busting crusade against IBM, which had behaved in many ways just like Microsoft. (An earlier antitrust action against IBM had been settled by a consent decree in 1956.) Millions of dollars were transferred from the taxpayers and stockholders to lawyers and expert witnesses. Enormous amounts of brain power were dissipated. Having to monitor every action for possible legal ramifications further constipated IBM's already-centralized culture.

The suit was a complete waste. Whatever quasi-monopoly IBM had was broken not by government enforcers but by obscure innovators, working on computer visions neither IBM nor the Justice Department's legions of lawyers had imagined. Big Blue is still big, though it's smaller than it once was. But nobody thinks it could control the world. The world, it seems, is beyond that sort of control.