(FORTUNE Magazine) – The two college dropouts most responsible for unleashing the PC revolution rarely see each other anymore, though they say that they're still friends. At FORTUNE's invitation, Bill Gates and Steve Jobs met for a Sunday evening in late July to discuss the prospects for the tumultuous industry they shaped. Gates, 35, left Harvard in 1975 to co-found Microsoft. His big break came in 1980, when IBM asked him to provide the operating system -- the program that manages a computer's inner workings -- for its now famous PC. Jobs, 36, who left Reed College to sojourn in India, is best known for co-founding Apple Computer. He led the development of the Macintosh, a computer much easier to use than IBM's somewhat nerdy PC. Gates has imitated many features of the Mac's software with a popular PC program called Windows. Since the mid-1980s the men have taken dramatically different paths. Gates, who owns more than $4 billion of Microsoft stock, remains a workaholic bachelor and an omnivorous reader -- he has read several biographies of Napoleon. He has built Microsoft into the world's largest and most profitable PC software company. It hasn't all been rosy. Microsoft's relationship with IBM soured this year, mainly because the two couldn't agree on an operating- system strategy for future PCs. And the Federal Trade Commission recently began investigating Microsoft's practices. | Jobs has been less visible but just as busy. In 1985 he started Next, aiming to build the personal computer of the 1990s. Next's first machine appeared two years ago. Its basic software, NextStep, makes the machine unusually easy to customize; IBM was so impressed it licensed NextStep for its own computers. Despite the dazzling technology, the going has been slow at Next. For one thing, IBM never put NextStep on the market. But lately business has picked up -- 10,000 systems rolled out of Next's automated plant during the second quarter. Jobs has other reasons to smile. He and wife Laurene, who married earlier this year, are expecting their first child in September. FORTUNE associate editor Brenton R. Schlender put the questions at the meeting. Beneath the conviviality, Jobs and Gates each had a business objective. Jobs lobbied for Gates to develop software for the Next computer. And Gates, whose company is being sued by Apple for allegedly pirating Macintosh software features, was hoping to learn more about the product's origin.

What did you think when the PC appeared ten years ago?

Jobs: When IBM entered the market, we did not take it seriously enough. It was a pretty heady time at Apple. We were shipping tens of thousands of machines a month -- more computers than IBM was total. Even so, a lot of people think IBM invented the personal computer, which of course isn't true.

Gates: A lot of people think Apple did, and that isn't true either. Our first program was for the Altair ((a mail-order kit sold in 1975)).

Does Microsoft's control of PC operating systems stifle competition in the industry?

Gates: There's not one element of the industry that's not competitive. There are people who are cloning Intel's chips; there are people who are cloning my operating system; there are many, many people who make PCs; and for every software application there are lots of people competing. There is no competitive imperfection.

Jobs: How come nobody has successfully competed with you? I'm not accusing you or Microsoft of anything. I'm not even saying it's necessarily bad. I'm just saying it's an interesting contrast. When I zoom back and look at this, there are hundreds of people making PCs, and hundreds of people writing applications programs for them . . .

Gates: Right.

Jobs: But they all have to travel through this very small orifice called Microsoft to get to one another. +

Gates: It's a very large orifice! ((Laughs.))

Jobs: But it's only one company.

Gates: Are you saying there's something wrong with our popularity? My approach to the PC market has been the same from the very beginning. The goal of Microsoft is to create the standard for the industry. Nothing has changed.

What does the future hold for IBM and Apple? What do you think of their decision to collaborate on PC software?

Gates: It's surprising to me.

Jobs: Yes, we are confused about that.

Gates: ((Apple President)) Mike Spindler has said they want to turn Apple into more of a software company. If that's your goal, you don't go and give the half of the company that is the future of Apple software to a joint venture. What is Apple getting in return? Here's the part I don't understand: What is the contribution from IBM? The IBM name? Did Apple feel so bad about their own work that they had to have that?

Jobs: I truly believe the challenge for IBM is that they can't survive by selling the same thing you can buy from somebody else for 30% less money. Their cost structure doesn't allow them to compete with companies that don't do massive amounts of R&D, that don't have twice as many employees as they need, et cetera, et cetera. So IBM has to do one of two things: One, suffer continuous erosion of its market share until eventually it goes out of business, which I hope doesn't happen. Or two, come up with some way to add value. In my opinion the way to make your machines unique is with unique software.

Gates: I said that back in the Seventies! ((Laughs.)) There's something else I don't understand. If IBM already held a license to your NextStep software, why did they get all this going with Apple rather than just come to you and expand their license?

Jobs: I really want to answer this question, but I've got to be careful what I say. It's not my purpose to alienate anyone at IBM.

Gates: We share this interest. ((Both laugh.))

Jobs: Somebody at IBM a few years ago saw our NextStep operating system as a potential diamond to solve their biggest and most profound problem, that of adding value to their computers with unique software. Unfortunately, as I learned, IBM is not a monolith. It is a very large place with lots of faces, and they all play musical chairs. Somewhere along the line this diamond got dropped in the mud, and now it's sitting on somebody's desk who thinks it's a dirt clod. Inside that dirt clod is still a diamond, but they don't see it.

Is the PC industry, which until now has been dominated by American companies, liable to get overrun by the Japanese?

Jobs: Computer companies fall on a spectrum of enthusiasm for manufacturing. On the left end are companies that look at manufacturing as a necessary evil, who wish they didn't have to do it. And at the far right you have people who look at manufacturing as a competitive advantage. Clearly a lot of the Japanese companies look at themselves that way. Unfortunately a lot of American companies look at manufacturing as a necessary evil. You can say the same thing about the way they see software. My opinion is that the only two computer companies that are software-driven are Apple and Next, and I wonder about Apple. Most computer companies would rather that software didn't even exist.

Gates: Good!

Jobs: It's good for Microsoft today. But unfortunately all those companies could give way to Japanese companies a few years down the road.

Gates: I think you give up too easily on Americans. You pick one dimension . . .

Jobs: I focus on manufacturing because I care about it. I've seen IBM's. I built Apple's and Next's, and I know what Sun does. Ultimately, I believe that most of the PCs will come from offshore. We're just not good enough at manufacturing.

Where will the key innovations come from? Established giants like Microsoft or upstarts like Next?

Gates: I contend technology breakthroughs can happen by extending what we already have. Let's take handwriting computers. The hardware is coming from PC-compatible makers like Dell Computer ((of Austin, Texas)) and NCR and some Japanese companies. The software will come either from Microsoft or from a U.S. competitor named Go Corp. ((of Foster City, California)). That's going to be a major breakthrough, and who do you give credit to?

Jobs: I think everybody gives credit to Go, but Go will be crushed.

Gates: That's one of the nastiest comments I've ever heard. I've been working on handwriting since long before there ever was a Go Corp.

Jobs: Really? I didn't know that. Most people would say that Go is the company that first tried to commercialize that technology.

, Gates: Well, Go hasn't shipped anything yet, and I'll ship my stuff before they ship theirs.

Jobs: My experience has been that creating a compelling new technology is so much harder than you think it will be that you're almost dead when you get to the other shore. That's why, when you take big leaps, like the Mac, or object- oriented programming, or handwriting recognition, you have to leave old technology behind. When Lindbergh was going to fly from New York to Paris, he had to decide what to take with him. There were a lot of demands. They fell into two categories -- things that would make his journey safer or more comfortable, and things that would increase his chances of making it to Paris. Weight was a real problem. He could take more gas, which would increase his safety, or he could take a compass, which would increase his chances of getting to Paris. Every time he came down on the side of increasing his chances of getting to Paris at the sacrifice of safety or comfort. That's why he made it.

Gates: Smart people like Steve ought to try to build things from scratch. That's a worthy thing. But every time it should be a test. Right now there's a test in handwriting PCs, in object-oriented operating systems, in multimedia computers. Those are the big questions for personal computing in the 1990s, and I'm the one who has to prove the validity of the evolutionary approach.

Jobs: It's true, your evolutionary approach with Windows is bringing to PCs great new technologies that Apple and others pioneered. But in the meantime -- and it's been seven years since the Macintosh was introduced -- I still think that tens of millions of PC owners needlessly use a computer that is far less good than it should be.