SYNOPSIS: The proposed Microsoft breakup is ill-advised and inefficent.

Baron Wilhelm von Gates was the lord of two castles, each commanding a strategic bottleneck along the Rhine. From these castles he was able to demand money from all the travelers who passed by. This made him wealthy, but also much disliked. Eventually the Holy Roman Emperor was persuaded to curb the robber baron's power; he split up the Gates domain, giving one of the castles to the baron's nephew.

But the results of this breakup were not quite what the emperor's legal department had promised. In fact, travelers complained that things had gotten even worse. Not only did they now face the nuisance of dealing with two different robber barons, but they said they were paying more for each trip than they had before.

Herr von Gates himself had undoubtedly been humbled: even the combined income of the baron and his nephew was less than that of the baron alone before the breakup. But this diminished revenue was the result not of lower tolls but of reduced business. Uncle and nephew blamed each other, each charging that the other was being greedy and hence discouraging river traffic altogether.

And both were right. Before the breakup, von Gates had an incentive to exercise restraint in his extortion: better to keep the tolls low enough that river commerce was not impeded. But once he had been forced to give up the downstream castle, the baron knew that any restraint on his part would simply give his nephew an opportunity to raise his own demands -- and his nephew made the same calculation. So their combined tolls became too high even for their own good (indeed, they were on the wrong side of the Laffer curve, though barons didn't know about such things).

In other words, whether or not the baron had in fact abused his power, the ill-considered imperial response only made things worse, punishing not just the baron but everyone else.

I won't try to push this parable (actually just a colorful version of a standard textbook model) any further. But it is relevant. In the last few days the Justice Department, outraged by the lack of contrition among Microsoft executives, has apparently decided to seek a "horizontal" breakup of the software company -- that is, to split it into one company that sells the Windows operating system (the upstream castle) and another that sells Microsoft Office and other applications (the downstream castle). What the parable suggests is that such a "remedy" is deeply problematic.

We're not talking about guilt or innocence here, just practicality: even if you believe that Bill Gates has broken the law, you don't want to impose a punishment that hurts the general public. And even strong critics of Microsoft have worried that a horizontal breakup would have a perverse effect: the now "naked" operating-system company would abandon its traditional pricing restraint and use its still formidable monopoly power to charge much more. And at the same time applications software that now comes free would also start to carry hefty price tags.

Of course, Microsoft could be not only broken up but also subject to price controls. But the government seems unlikely to be willing to take on that role.

Why doesn't the government instead imitate the breakup of AT&T, with a "vertical" division of Microsoft that creates multiple sellers of Windows (so-called "baby Bills")? The answer is that Microsoft is not AT&T. Each baby Bell was left with a clearly defined piece of the former company's business. By contrast, if several companies were given the right to sell Windows, their competition would probably drive the price of the operating system almost to nothing; this would amount to an expropriation of intellectual property rights. Maybe you think that Microsoft deserves that fate; but it is not a precedent to set lightly.

And we might also mention that precisely in order to avoid that kind of profit-destroying competition, rival baby Bills would surely try to differentiate their products, possibly leading to loss of the one undisputed advantage of Microsoft's dominance: a uniform standard that allows many kinds of software to interact freely.

Even if you believe that Bill Gates and associates deserve to be punished, it's important to think these things through. Let's hope we're not about to cut off our own noses to spite Microsoft's face.

Originally published in The New York Times, 4.26.00