High Technology Industries: Competitive Issues and the Microsoft Case

Salient structural features of high technology industries Product and price differentiation Bundling Switching costs and lock-in Supply-side economies of scale Demand-side economies of scale Standards

You cannot purchase Excel or PowerPoint as stand alone applications—you must purchase Microsoft Office. Operating systems bundled with internet browser software. The practice of selling two or more distinct goods together for a single price.

Switching costs and “lock-in” Switching from Windows to Linux means changing document formats and software applications. We will have to train employees to use the new platform.

Economies of scale 0 € Quantity/time Average Cost Manufacture of software involves substantial development costs but negligible marginal cost

Network effects A good exhibits network effects if the demand for the goods depends on how many other people purchase it. Examples: fax machines, picture phones, .

Size of network Willingness to pay Demand curve Supply curve Network Effects and Demand 0 “Critical mass” area N* Willingness to pay begins to diminish at network size N* due to “network congestion” effects.

The Microsoft case Microsoft Corporation v. U.SMicrosoft Corporation v. U.S. 530 U.S (2000) The Antitrust Division of the DOJ won Sherman section 1 and section 2 convictions against the software giant. section 1 section 2

Acronyms and definitions OS: Operating system (e.g., Windows) OEM’s: Original equipment manufacturers (e.g., Dell, Compaq, Gateway). IAP’s: Internet access providers (e.g., Yahoo, AOL). ISV’s : Independent software vendors. Software vendors not affiliated with Microsoft or Apple. API’s: Application programming interfaces. “These are synapses at which the developer of an application can connect to invoke pre- fabricated blocks of code in the operating system. These blocks of code in turn perform crucial tasks, such as displaying text on the computer screen. Because it supports applications while interacting more closely with the PC system's hardware, the operating system is said to serve as a ‘platform.’” Judge Jackson’s Finding of FactFinding of Fact

Case Background Microsoft’s antitrust troubles began in Mr. Gates signed a consent decree in 1994 to settle an earlier filing by the DOJ. This suit targeted operating system licensing policies that rivals claimed blocked entry into the market.

Terms of the 1995 consent decree 1 1 Federal Judge Sporkin rejected the decree but he was overturned by the Federal Court of Appeals in Hear Audio explanation (wav)Audio explanation 1.Per-processor licenses. PC makers previously paid Microsoft royalties for every PC shipped, regardless of whether they sell it with Microsoft software. This arrangement meant PC makers paid double to install a rival operating system. Microsoft agreed to discontinue this practice. 2.Long term licenses. Licenses that lasted three to five years made it tough for for rivals to get PC makers to use a new operating system. Microsoft agreed that licenses should be one year with an option to extend for an additional year. 3.Minimum commitments. Microsoft offered incentives to PC makers to commit to purchase a fixed number of systems in advance, crediting any shortfall to actual sales in the next year. The arrangement effectively lengthens contracts and excludes rivals.

DOJ Antitrust chief Joel Klein felt that Microsoft violated the 1995 agreement by bundling its browser software with its Windows operating system. This provided the impetus for the later filings.

The DOJ ComplaintDOJ The DOJ ComplaintDOJ 1.Microsoft violated section 1 of the Sherman Act by bundling it browser software with its Windows operating system.section 1 2.Microsoft illegally monopolized the market for desktop operating systems, in violation of section 2 of the Sherman Actsection 2

2-part test for illegal monopoly The Supreme Court of the United States set forth two-part test in the Grinnell decision The offense of monopoly under section 2 of the Sherman Act has 2 elements:Grinnell decision section 2 1.The possession of monopoly power in the relevant market; 2. The willful acquisition and maintenance of that power as distinguished from growth or development as a consequence of a superior product, business acumen, or superior product.

Judge Jackson agreed the DOJ market definition— ”Worldwide licensing of Intel-compatible operating systems.” Microsoft had “at at least a 95 percent” share for this definition. Market definition

Merely showing monopoly power in the relevant market is not sufficient. The government must give evidence of “willful acquisition and maintenance” of monopoly power.

The applications barrier Hear audio explanation (wav)audio explanation “[T]he applications barrier would prevent an aspiring entrant into the relevant market from drawing a significant number of customers away from a dominant incumbent even if the incumbent priced its products substantially above competitive levels for a significant period of time.” Judge Jackson stated in his Finding of Fact:Finding of Fact

The middleware threat Mr. Gates viewed middleware (the Java programming language and Netscape browser software) as rival platforms for ISV’s. Gates feared middleware would bring down the applications barrier. applications barrier Hear Brown’s comments (wav)Brown’s comments

The government alleged that Microsoft designed its licensing agreements with OEM’s and IAP’s so as to preserve the applications barrier. This was also its objective in giving away Internet Explorer for free.applications barrier Evidence of ‘willful acquisition and maintenance... “

The OEM Channel Licensing agreements with OEM’s stipulated pre- installation of Internet explorer. Internet Explorer icon must appear on the desktop after the initial boot-up sequence. OEM’s prohibited from pre-installing Netscape browser software.

The IAP Channel Microsoft offered IAP’s valuable “real estate” on the Windows desktop in exchange for their agreement to distribute Internet Explorer exclusively. Hear audio explanation (wav)audio explanation If an IAP was already under contract to pay Netscape a certain amount for browser licenses, Microsoft offered to compensate the IAP the amount it owed Netscape. Microsoft also reduced the referral fees that IAPs paid when users signed up for their services using the Internet Referral Server in Windows in exchange for the IAPs' efforts to convert their installed bases of subscribers from Navigator to Internet Explorer.

3-part test for illegal tying 1.“The seller must possess power in the tying product market." Effective tying entails leveraging a dominant position in the tying product market to achieve a dominant position in the tied product market. 2.“There must be a substantial threat that the tying seller will acquire market power in the tied-product market. If... the tying arrangement is likely to erect significant barriers to entry into the tied product market, the tie remains suspect.“ 3."There must be a coherent basis for treating the tying and tied product as distinct." a a Jefferson Parish Hospital District et al. v. Hyde [466 U.S. 2 (1984)]. Jefferson Parish Hospital District et al. v. Hyde

Certainly Microsoft had monopoly power in the tying product market (test 1). Also, it threatened to close off a substantial share of the browser segment (test 2). So the remaining issue was : were Windows and Internet Explore “distinct products.”

Microsoft’s attorneys claimed that Windows and Explorer were “functionally integrated.” In fact, they shared files so that if you uninstalled Explorer, Windows would not function properly. But Princeton computer scientist William Felton (a prosecution witness) showed this problem could be easily corrected. He demonstrated Windows would run just fine without Explorer

The election of George W. Bush was lucky for Microsoft. The new regime at Justice was prepared to reach a settlement that most observers believe is favorable to Microsoft. The November 2, 2001 Settlement. Click here to view the terms of the settlement reached between the Justice Department and Microsoft.terms of the settlement reached between the Justice Department and Microsoft.