Agata Adamczyk Piotr Dybka Microsoft Agata Adamczyk Piotr Dybka

The Background Microsoft controls over 90 per cent of the market for PC operating systems, this monopoly protected by a powerful ‘applications’ barrier to entry. Microsoft’s leading market position as OS provider allows it to leverage its market power from its primary market into the secondary, complementary market for workgroup server OS - Microsoft has the ability to reduce the interoperability of rival vendors of workgroup server OS because it controls the interfaces (protocols and Application Programmer Interfaces known as APIs5) of the PC OS.

The growth of Microsoft’s share in the workgroup server market 1996–2001 Source: Lyons (2009)

Microsoft falls short of antitrust laws On March 24, 2004, after five years of investigation, the European Commission held Microsoft guilty of a violation of Article 82 (refusal of interoperability information) of the Treaty to Exclusionary Abuses through: restricting deliberately the interoperability between Windows PCs and non-Microsoft workgroup servers; tying its Windows Media Player (WMP), a product where it faced competition, with its ubiquitous Windows operating system; and imposed the fine of €497M.

The Remedies The Commission also demanded major forward- looking behavioral remedies: ‘within 120 days, to disclose complete and accurate interface documentation which would allow non-Microsoft workgroup servers to achieve full interoperability with Windows PCs and servers’; ‘within 90 days, to offer to PC manufacturers a version of its Windows client PC operating system without Windows Media Player’.

Microsoft’s incentives to monopolise the workgroup servers OS market The Commission argued there were both static and dynamic incentives to foreclose rivals from the workgroup server market. The dynamic reasons probably most important as Microsoft clearly concerned that a strong presence of rivals in the server OS market could threaten the profits it enjoyed from its Windows monopoly of the PC market in the future. E.g. by running future applications mostly on servers, customers could reduce their reliance on the PC OS functionality by effectively substituting server functionality for PC functionality.

The Timeline (I) Dec’98 Aug’00-Aug’03 Nov’03-Mar’04 Dec’98: complaint by Sun Microsystems against beta versions of Windows 2000. The complaint revolves around the limited interoperability of Windows with the OS of other server vendors due to a switch to proprietary communications protocols. Aug’00-Aug’03 Aug’00: the EC issues a Statement of Objections against Microsoft taking up the complaints. Aug’01: second Statement of Objections adding the WMP issues. Aug’03: third Statement of Objections refining some of the issues. Nov’03-Mar’04 Nov’03: The EC Oral Hearing Mar’04: the Commission issues its Decision finding Microsoft in violation of Article 82 and imposes the remedies. A Monitoring Trustee appointed to oversee rthe implementation of the remedies.

The Timeline (II) Dec’04 2006-2007 Feb’08-Jun’12 Microsoft appealed against the Decision in front of the Court of First Instance. It also sought interim relief, which would have suspended the implementation of remedies until a judgment on the appeal. However, the application was rejected by the Court in December 2004. 2006-2007 Microsoft was fined another €280.5M for failing to supply complete and accurate interoperability information. The appeals case was heard by the Court in 2006. On 17 September 2007 the Court upheld the Commission’s decision in just about every part, although it did annul the role of the Monitoring Trustee. Microsoft chose not to appeal. Feb’08-Jun’12 On 27 February 2008 the Commission fined Microsoft a further €899M for failure to comply with the 2004 Decision. In June’12 The General Court of the European Union turned down Microsoft's request to dismiss a €899M fine levied in 2008, though it did cut it slightly – to €860M. The company has already booked provisions in its financial statements for the fines and penalties.

Server operating systems In the late 1980s the new PC client/server computer architecture has been introduced Processing power became more decentralized, distributed between PCs with their own operating systems and increasingly powerful servers linking them together. Most computing is performed on the multi-user networks in which users communicate through ’clients’ and where most of the activity is done by the ’servers’ The clients may take many forms – intelligent, such as a desktop computer or dumb terminal – ATM machine.

Server operating systems There are two main types of servers – workgroup servers and large Enterprise servers. Workgroup servers are used to perform basic infrastructure services needed to enabling sharing resources in the network, eg. authorization and authentication of users, file service etc. There is a growing need to manage growing amount of data that are critical for the organization. Inventory control, online reservations or banking transactions require large enterprise servers. Large Enterprise server are usually much more customized so they rely less on the ready solutions and therefore the case is focused on workgroup servers.

Technical issues - interoperability Interoperability is the ability of making systems and organizations work together. Commission gave several examples, where it believed Microsoft limited interoperability, e.g. security services that are based on protocol Kerberos Kerberos is a public protocol and its main idea is that there is a special server (intermediary) that gives a Kerberos ticket enabling to enter the system (after verification). Windows 2000 server will permit access to the requested services only if the ticket is in the W2000 format.

Technical issues - interoperability Microsoft argued that interoperability was ’good enough’ – much information was disclosed, there were also ways of getting around those problems by installing ’bridge’ software or reverse engineering. The key issue is that those solutions were very rare and their performance was essentially never satisfactory. Interoperability restrictions by a dominant firm like Microsoft can then only be justified by efficiency benefits that are gained from restricting the access to protocol information.

Market definition The really key issue in this case was not the workgroup server OS market, however, but rather the market for PC operating systems. The Commission’s theory asserted that Microsoft had monopoly power in PC OS and used this to leverage into other markets. For PC OS it appears clear that there is little substitutability between Windows and other operating systems. Part of the reason comes from an application network effect. There are a large number of software applications (e.g. Office-type word processing, spreadsheets, etc.) that are written specifically to the Windows APIs. This means that these programs cannot easily be made to run on an alternative operating system, creating for users an enormous cost of switching the operating system.

Market definition Microsoft pointed to the possibility of a disruptive entrant that could change the whole face of computing. They argued that the risk of such potential entry disciplined their behaviour. However, the example of Linux shows the opposite – Linux achieves low penetration rates on PCs despite being priced very competitively: at zero price. Is there a separate market for workgroup servers? Microsoft argued that software running on enterprise and workgroup servers had to be considered perfect substitutes in terms of physical characteristics. They pointed to their own software that they used indistinguishably on any type of server.

Market definition Evidence was presented that Microsoft in fact price discriminated between workgroup, web and enterprise server OS by offering different licenses at very different terms. Linux finding a niche primarily on web servers also supported another important point on market definition. Web servers are not subject to the interoperability problems with Microsoft’s PC OS that workgroup servers are.

Key economic issues – incentives to foreclose

Key economic issues – incentives to foreclose Microsoft’s essential argument rested on the view that a monopolist in one market will never have anticompetitive incentives to leverage (one monopoly profit theory). Degrading interoperability would cost Microsoft lost revenues as consumers would not be willing to pay as much for a Windows OS for their PC due to its lower performance with non-Microsoft servers. Moreover Microsoft could simply charge a higher price for its PC OS and extract all the rents from the server market in this way. Consequently, the entry of Microsoft into the server market must have benign reasons, such as its desire to end double marginalisation (the excessive profits earned by oligopolistic server vendors) or the superior efficiency of Windows technology.

Key economic issues – dynamic incentives to foreclose Microsoft case is based on the assumption that the monopolist has a permanent unchallenged position with no threat of future entry in his primary market. But it is not the case – vide Browser Wars. Microsoft monopolised the market for web browsers by giving away Internet Explorer, but it position was weakened by the Netscape. Netscape posed a threat to Microsoft not because it cared about profits of browsers per se but rather because software developers were increasingly writing applications for Netscape interfaces (in conjunction with Java) rather than Windows interfaces.

Key economic issues – dynamic incentives to foreclose In the Microsoft case the mechanism is well established due to the applications network effect. Shifts in share towards Microsoft in the server market (current and expected) will mean that developers will start switching away from writing to non-Microsoft interfaces. Customers will shift away from rivals because there are fewer applications and this will further reduce developers’ incentives to write software. The dynamic arguments work even though, in the short run, the monopolist may suffer some losses.

Key economic issues – dynamic incentives to foreclose In the context of the Microsoft case, consider the idea that there are two types of customers, large firms (which are less sensitive to the price of the PC OS) and small firms (which are very sensitive to the price of the PC OS). The price discrimination is fairly limited as large companies might pretend that they are small. But monopolizing the server market and charging a higher price for the PC and server OS bundle, the PC OS would in turn effectively ‘restore’ second-degree price discrimination in the primary market.

Remedies and innovation (I) Microsoft argued that the proposed remedy of forced disclosure of interoperability information would have a severely negative effect on innovation as it would lead to the wholesale ‘cloning’ of Microsoft’s valuable intellectual property. Microsoft argued that, whatever the supposed short-run gains, the long-run costs in terms of lower innovation by Microsoft would swamp these purported benefits.

Remedies and innovation (II) The Commission claimed, however, that the possible negative impact on Microsoft’s incentives to innovate is outweighed by its positive impact on the level of innovation of the whole industry.

The Remedies: innovation vs imitation The remedy in the form of unbundling did not actually require release of Windows’ source code. In fact, Windows’ source code was not what the rival server vendors wanted in any case. Instead they were after a detailed technical description of the interfaces to enable them to design their own code to interoperate with Windows. The description of the remedy as allowing ‘cloning’ is therefore inaccurate.

The Remedies: incentives to innovate (I) Under the remedy, rivals would no longer have to incur costs to overcome barriers to client-server interoperability created by Microsoft’ s disclosure policy. The remedy essentially reduces the cost of rival innovation and should, therefore, increase innovation incentives. The remedy may lead to some reduction in Microsoft’ s incentive to invest as it decreases the expected market share and increases price competition from now higher quality rival products. However, unlike its rivals, Microsoft will still obtain substantial profits from general operating system innovation in the PC OS market, where it will continue to enjoy a monopoly position. There is therefore little reason to expect that Microsoft’s incentives to innovate on OS solutions would fall substantially.

The Remedies: incentives to innovate (II) Through innovation a firm can escape harsh competition with rivals and secure rents for a transitory period. This effect will tend to increase the investment incentives of all firms, including Microsoft. Finally, Microsoft may change the quality as well as the quantity of its R&D. There could be positive effects on quality because Microsoft will no longer have incentives to block innovations that raise quality but have high interoperability with non- Microsoft servers.

The WMP case By bundling Windows Media Player with the PC OS, Microsoft assured ubiquity on the desktop, a property that rivals have to struggle with. This gives Microsoft a competitive advantage and market power in the market for encoding software that has nothing to do with the actual quality of its product. A remedy for this case could have come from ordering total unbundling and prohibitions on exclusivity contracts with original equipment manufacturers of PCs. However, instead of an unbundling measure the Commission forced Microsoft to sell a version without Media Player but also allowed selling a version with Media Player. Microsoft then has incentives to sell both at the same price.

Summary Microsoft was found to be in violation of Article 82 of the Treaty of Rome through abusing its dominant position. On 17 September 2007, Microsoft lost their appeal against the European Commission's case. The €497 million fine was upheld, as were the requirements regarding server interoperability information and bundling of Media Player. On 27 February 2008, the EU fined Microsoft an additional €899 million (US$1.44 billion) for failure to comply with the March 2004 antitrust decision. On 27 June 2012, the General Court upheld the fine, but reduced it from €899 million to €860 million.

Question Which one of the following is an example of a possible natural barrier to the entry of new firm into an industry? Issuing a patent Economies of scale Licensing of professions A public franchise

Question Consider an industry consisting of a cartel of three firms and a single price-taking outside firm. Which of the following changes make it more difficult to maintain the cartel agreement? an increase in the elasticity of market demand entry by a second non-member firm, reducing the cartel’s share of industry output an increase in the elasticity of the non-member firm’s supply curve all of the above

Question Why according to ’one monopoly theory’ a monopolist would never have any anticompetitive incentives to leverage on other markets? This theory doesn’t state that monopolist would not leverage on other markets. Monopolist can simply charge more for its product and extract his rents this way. Charging lower prices to leverage would imply losses. Monopolist would have to have superior technology to be able to leverage. B and C are correct.

Question What was, according to the Department of Justice, the main reason that Netscape (and other browsers) posed a threat to Internet Explorer? They offered better quality They could decrease Microsoft profits Developers were increasingly writing applications for their interfaces rather that Windows. All of the above.

Question Which statements about the Network effects are true? These are the effects that one user of a good or service has on the value of that product to other people. They can create positive feedback loop between the number of people and availability of the product (or its extensions). They can generate additional barriers to entry. All of the above.