Increasing Returns to Scale in the Software Industry

Nobel-prize winning economist Kenneth Arrow was solicited to provide expert advice on the economics of the Microsoft case. In his statement to the court he writes:

The analysis of the Department of Justice and the amici curiae brief agree that the software market is peculiarly characterized by increasing returns to scale and therefore natural barriers to entry. Large-scale operation is low-cost operation and also conveys advantages to the buyer. Virtually all the costs of production are in the design of the software and therefore independent of the amount sold, so that marginal costs are virtually zero. There are also fixed costs in the need to risk large amounts of capital and the costs associated with developng a reputation as a quality supplier. Further, there are network externalities, in particular, the importance of an established product with a large installed base and the related advantage of a product that is compatible with complementary applications.