THE ECONOMICS OF POP-TARTS

Arnold Kling, "Arguing in My Spare Time," No. 5

To non-economists, Pop-Tarts are an abomination. Purists see them as junk food, which one finds in stores only because of the strong-armed marketing tactics of Kellogs, the creators of the product.

Economists look at Pop-Tarts differently. We are skeptical of the concept of "intrinsic" value, as opposed to market price. We presume that if people are willing to pay for Pop-Tarts, then that must be because there are some characteristics of Pop-Tarts that appeal to the marketplace. We are more likely to attribute their success to the combination of sugar, flour, fat, vitamin enrichment, and toaster compatibility. These characteristics meet the needs of kids to make their own hot breakfasts so that their parents can sleep or read the newspaper in peace.

There are purists who denounce Microsoft as vehemently as they revile Pop-Tarts. These critics see only copy-cat features and bloated code. Economists, noting the spectacular growth of the PC industry, the vibrancy and dynamism of the software industry, and the immense success of Microsoft products in the marketplace, presume that Microsoft is meeting a real market need.

Microsoft software typically offers:

--at least an adequate implementation of all the features that one would want in a particular application

--compatibility with many PC hardware add-ons (all I need to do to remind myself of the miracle wrought by Microsoft is look at the $600 device next to my computer that can fax, scan, print, and copy. It took only minutes to install this and get all its functions working on my PC.)

--some degree of integration with other software

--attractive pricing

--a degree of reassurance that products will not become "orphans"

This combination of characteristics is not easily matched by other software companies. Software programs with these characteristics necessarily are complex. Writing them is somewhat difficult, and testing them is extremely challenging. Microsoft excels at managing the complexity of software programs that are feature-rich and compatible with other hardware and software.

Many people like to develop software. Hardly anyone enjoys testing or writing documentation. However, without adequate testing and documentation, a software company ends up primarily in the service business, because users require one-on-one help in order to accomplish what they cannot do with the software on their own. The service business is a viable model, but the profit margins are much lower than the margins in the product business.

Few software companies can polish their products well enough to make the leap from service business to product business. Microsoft has learned how to make this leap with a broad array of products, each of which is highly complex. One should not under-estimate this achievement.

The Game Lasts More Than One Move

With apologies to Robert Fulgum, everything I ever learned about competition I learned by playing Othello(tm owned by Pressman toys). Othello is a board game somewhat like Chess or Go, and it has a small fraternity of competitive players, of which I am one.

When I was at my peak, I might have played at 65 percent of optimality. That is, 65 percent the time I played the correct move for the given position. The 65 percent figure is a guess, because it is impossible to prove that a move is correct (except for positions near the end of the game, when one can use a computer to determine the optimal move by brute force.)

At that time, the world champion of Othello might have played at 75 percent of optimality. If this is correct, and the world champion and I had played 100 games, how many would I have been expected to win?

If you think that 75 percent of optimality vs. 65 percent of optimality should lead to a fairly small difference in games won, you are assuming implicitly that the game only lasts one move. In fact, because each player makes 30 moves, the cumulative effect of a seemingly small difference in accuracy is such that I would be fortunate to win 5 games out of 100 against the world champion.

Suppose that a game lasts N moves. I win when I play correctly for more moves than the world champion. As N becomes large, the small per-move advantage of the world champion compounds until my chances of winning nearly vanish.

Software development is a multi-move game. Even the best players make many mistakes. But the game lasts long enough that the chances of victory for an inferior player are not high.

Many people argue that Microsoft wins with inferior software and superior marketing tactics. However, Microsoft software usually is superior in some dimensions, even though it may be inferior in others. My mental model of Microsoft is that, like the world champion in Othello, it makes fewer mistakes than its competitors.

I'm imagining re-casting the famous Monty Python pet store routine, with the part of the obtuse pet store owner played by the touts at Hambrecht & Quist and Morgan Stanley, the news media, and now the Justice Department. The part of the stiff parrot would be played by Netscape Communications.

Netscape went into a product slump last year. As they would be the first to admit, Internet time is measured in dog-years. Thus, they had the equivalent of a 7-year slump.

The software market in which Netscape competes can broadly divided into two categories: the client software (Web browser) used by the individual to view the Web; and the server software (Web server) used by content providers to deliver Web applications to users. My assessment of this market is that Netscape's failure to win is well deserved.

On both the client and server side, Netscape has been innovative. The concepts that they developed helped to open up new markets. However, once these markets appeared, Netscape did not evolve to serve the values of the customers.

This is not an uncommon phenomenon in software. The spreadsheet market was opened up by Visicalc, but it was Lotus 1-2-3 that succeeded in exploiting this market.

On the client side, Netscape took the view that Web browsers must constantly be enhanced through upgrades and "plug-ins," which are additional software tools that can be downloaded and installed. This was a reasonable model in 1995, when the market for Web browsers was in the "early adopter" phase. However, in the mass market, consumers want to download information, not browser tools. Moreover, Web content developers want to reach the broadest audience possible, and there is considerable resistance to incorporating features on Web sites that limit one's audience to people with particular browsers or add-ons.

Many consumers use old versions of browsers, even though they can be upgraded at no charge. Evidently, the cost of downloading, installing, and learning new software is higher than these consumers are willing to bear. Consumers value stability in the browser. Web developers value the breadth of their content markets. If Netscape ever intended to earn revenues from regular browser upgrades, then this was a mis-reading of the market. Most people would pay NOT to have to upgrade.

In fact, it is people's resistance to downloading a new browser that saved Netscape last year. If inertia were not a factor, Netscape's browser share probably would have fallen even faster.

Microsoft's Internet Explorer is superior in at least two important respects. It crashes much less often (I have to shut down Netscape 4.0 several times a day, or it locks my machine). Also, it implements important new standards more effectively. In fact, our Web site has some pages that we use internally for administration which were coded to specifications in Netscape's online documentation but which only work with Microsoft Explorer.

In the server market, Netscape's failure was much more pronounced and more damaging to the company. Many people never expected Netscape to make money selling browsers, but a lot of us thought that they could earn revenue from servers.

There is a site called Netcraft (www.netcraft.com) that allows one to track the server market. Netscape's market share fell in 1997, from 12 percent early in the year to just over 10 percent by the end. Microsoft shot up, but that was mostly at the expense of some smaller companies that got to the NT market before Microsoft itself had a Web server for NT. Netscape's most troublesome opponent in 1997 was not Microsoft, but Apache, the server developed as collaborative freeware. In 1998, the server products that are attracting the most attention are the Java Web Server from Sun, Microsoft's Internet Information Server, and Apache. Netscape has not launched a successful server product since 1995.

The reason that Netscape is losing market share in the server market is simple: no one can get their core server product, Enterprise 3.0, to work. The product is poorly documented and it does not function properly. Its features are very clever, but there are no useful manuals to help one get started using it. On Netcraft, I could not find a single high-volume site using Enterprise 3.0. Even the Netscape Web site does not use Enterprise 3.0, which tells you something about their testing process, or lack thereof.

Our web site, which uses Enterprise 3.0, crashes every 20 minutes, taking two minutes to re-start each time. I was not particularly disappointed when the first person that I called at Netscape could not help, but as I progressed further through technical support the depth and breadth of incompetence I found at the company was really staggering. With Netscape unable to fix the problem, my only choice is to convert to a different server, a painful process that I have just begun.

Netscape set up private "newsgroups" for people who use their servers. In fact, I believe that you have to pay to access the newsgroups (or at least you used to have to pay). However, the company then ignores these discussion groups, because, as one Netscape staffer told me, "People on the newsgroups don't know how to program."

Dismissing frustrated users as people who "don't know how to program" says a great deal about the corporate culture at Netscape. Any software company that adopts such an attitude is not going to be around very long.

The Web server market is very much up for grabs. The basic Microsoft platforms (Windows 95 and Windows NT) are regarded by many experts as inferior to Unix. More importantly, Microsoft may not be able to use the approach of providing a large, feature-rich product to drive out leaner, more specialized software. A web server must be able to perform in a high-stress environment, and that calls for lean, efficient code rather than "bloatware."

However, the rivalry between Netscape and Microsoft is totally fictitious, a concoction of the media. Microsoft, Sun, Oracle, and many smaller companies have well-developed processes for testing and improving their software products. Netscape still has not shown that it has the organizational processes and culture needed in the business of commercial software development. Microsoft losing to Netscape would be like the Green Bay Packers losing to Swarthmore.