The antitrust cases against Microsoft in the United States and

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					CentrePiece Summer 2007

The antitrust cases against Microsoft in the United States and
Europe have been the most high profile implementation of
competition law in the last 20 years. Christos Genakos, Kai Uwe
Kühn and John Van Reenen look at the key economic issues,
notably what they imply for the conduct of competition policy in
high-tech industries dominated by rapid innovation.
                                                                       CentrePiece Summer 2007

The European
versus Microsoft:
competition policy in
high-tech industries

                    n the various Microsoft cases,        Windows client PC operating system
                    antitrust authorities in the United   without Windows Media Player.’
                    States and the European Union             This degree of intervention is highly
                    (EU) took on one of the most          unusual and has led to a continued
                    valuable companies in the world       conflict about the implementation of the
         and its CEO Bill Gates, the world’s richest      remedies. The case also raises an
         man. After five years of investigation, in       important question about the conduct of
         March 2004, the European Commission              competition policy in high-tech industries
         held Microsoft guilty of abuse of its            dominated by rapid innovation.
         dominant market position under Article 82
         of EU law and imposed the largest fine           Market power
         ever for such an antitrust violation in          In the server case, which we focus on
         Europe: €497 million.                            here, the Commission’s basic argument
              The Commission found that Microsoft         was that Microsoft extended its market
         had abused its monopoly of personal              power from PC operating systems (of
         computer (PC) operating systems in two           which Windows controls over 95% of the
         ways: ‘deliberately restricting                  market) into a complementary market –
         interoperability between Windows PCs             that of the operating systems for work
         and non-Microsoft work group servers,            group servers. How did it do this?
         and by tying its Windows Media Player, a              For server operating systems to be
         product where it faced competition, with         effective, they must be able to
         its ubiquitous Windows operating system.’        communicate easily with the PC operating
         (Work group servers are computers that           system – what is known as ‘efficient
         allow people to share files and printing,        interoperability’. Microsoft’s control of the
         store and protect large amounts of data,         PC operating system meant that it could
         access the internet, etc.)                       limit the efficient interoperability between
              The Commission also demanded major          Windows and rival companies’ server
         remedies, including compulsory licensing         operating systems by manipulating the
         of intellectual property: ‘within 120 days,      interfaces responsible for connecting
         to disclose complete and accurate                Windows with other software.
         interface documentation which would                   The Commission argued that Microsoft
         allow non-Microsoft work group servers to        had both short-run (‘static’) and long-run
         achieve full interoperability with Windows       (‘dynamic’) incentives to ‘foreclose’ rivals
         PCs and servers’; and ‘within 90 days, to        from the server operating systems market
         offer to PC manufacturers a version of its       in this way. The dynamic reasons are

CentrePiece Summer 2007

probably most important, as Microsoft was                                          over 60% in 2001. By this point, Novell,                            The Commission's
clearly concerned that a strong presence                                           the combined UNIX platforms (IBM,                              remedy for foreclosure
of rivals in server operating systems could                                        Sun, etc.) and Linux could muster only                         was to ask Microsoft to
threaten the profits it enjoyed from its                                           about 10% each in market shares. The                             reveal information to
Windows monopoly of the PC market in                                               Commission argued that at least some of                         enable server vendors
the future.                                                                        Microsoft’s swift rise to power was due to                         to connect properly
     For example, customers could reduce                                           anti-competitive actions.                                               with Windows
their reliance on PCs by running                                                       There has been much debate over
applications like spreadsheets, database                                           whether Microsoft was dominant in the
management and banking software mostly                                             work group server market. But the key
on servers, leading to a decline of                                                issue in a ‘leveraging’ case like this is
Microsoft’s longstanding monopoly. By                                              whether Microsoft had power over PC                       not be willing to pay as much for a
extending the Windows platform                                                     operating systems. Given their 95%-plus                   Windows operating system due to its lower
dominance from PCs to servers, Microsoft                                           market share, even Microsoft’s lawyers did                performance with non-Microsoft servers.
could extinguish this future threat.                                               not try hard to contest this point.                       Instead of going to the expense of
     Various internal emails by Microsoft                                                                                                    monopolising the new market through
senior executives suggest that this strategy                                       Economic incentives to                                    reducing rivals’ quality, Microsoft could
was not the overzealous imaginings of                                              foreclose                                                 simply charge a higher price for its PC
Eurocrats. For example, in 1997, Bill Gates                                        So did Microsoft have an economic                         operating system and extract all the profits
wrote: ‘What we’re trying to do is use our                                         incentive to foreclose competition through                from the server market in this way.
server control to do new protocols and                                             leveraging? The key question is as follows:               Consequently, the Chicago argument is that
lock out Sun and Oracle specifically… the                                          when firm A, the monopolist (Microsoft in                 Microsoft must have benign reasons, such
symmetry that we have between the client                                           PC operating systems), faces firm B in a                  as its desire to end the excessive profits
operating system and the server operating                                          complementary market (server operating                    earned by other server vendors or the
system is a huge advantage for us’.                                                systems), in what circumstances will firm A               superior efficiency of Windows technology.
     This may have just been cheap talk,                                           exclude firm B from the adjacent market?                       The modern economic theory of
but as Figure 1 shows, Microsoft’s share of                                        Microsoft’s essential argument rested on                  foreclosure suggests many reasons why
the server operating systems market did                                            the Chicago School view that a                            this critique might break down. In
rise dramatically during the late 1990s:                                           monopolist does not have incentives to                    Microsoft’s case, it is useful to distinguish
from about 20% at the start of 1996 to                                             monopolise a complementary market since                   between dynamic and static incentives.
                                                                                   all profits can be extracted at least as
                                                                                   effectively by increasing the price of the                Dynamic incentives to
By degrading the ability                                                           monopoly product.                                         foreclose
of rival server operating                                                               The Chicago argument – known as the                  The lack of any long-run incentive to
systems to work with                                                               ‘one monopoly profit theory’ – is that                    foreclose in the ‘one monopoly profit
Windows, Microsoft                                                                 degrading interoperability would cost                     theory’ arises from the assumption that
‘foreclosed’ the market                                                            Microsoft lost revenues as consumers would                the monopolist has a permanent
                                                                                                                                             unchallenged position with no threat of
Figure 1:                                                                                                                                    future entry to the primary market. This is
The growth of Microsoft’s share in the work group server                                                                                     unlikely to hold for Microsoft’s position in
market 1996-2001                                                                                                                             the PC operating systems market.
                                                                                                                                                 Although in the short run it was
                                                                                                                                             protected by strong barriers to entry, in
                       80%           ■ Win/NT                                                                                                the longer run, there were a variety of
                                     ■ Unix                                                                                                  threats to Microsoft’s juicy stream of
                       70%           ■ Netware
                                     ■ Linux                                                                                                 profits. Consumers care about the
                       60%           ■ Other                                                                                                 software applications (spreadsheets, word
 Share of the market

                       50%                                                                                                                   processors, games, etc) that are written on
                                                                                                                                             a particular operating system. The main
                       40%                                                                                                                   competitive advantage of Windows is the
                       30%                                                                                                                   wide range of applications written on its
                                                                                                                                             platform (software developers write
                       20%                                                                                                                   programs to work on the most popular
                                                                                                                                             platforms). But major platform threats
                                                                                                                                             emerged in the late 1990s associated with
                       0%                                                                                                                    the growth of the internet.
                                                                                                                                                 One threat was that increasing






                                                                                                                                             numbers of applications could be delivered











                                                                                                                                             through servers. Server operating systems


                                                                                                            CentrePiece Summer 2007

                                                There are many reasons                        a high valuation on a complementary
                                                   for believing that the                     product (servers), whereas small firms do
                                                    remedy could have a                       not because the gains from sharing
                                                       positive effect on                     computing resources are much smaller. In
                                               industry-wide innovation                       this case, by monopolising the server
                                                                                              market and charging a higher price for the
                                                                                              PC and server operating systems bundle,
                                                                                              Microsoft is able to extract more profits.
                                                                                              Our research provides empirical evidence
                                                                                              that these short-run incentives exist and
                                                                                              that they have grown stronger over time.

                                                                                              Software markets are fast moving and
                                                                                              highly innovative: many new economy
                                                                                              advocates have argued that European
                                                                                              competition law is inadequate in such
                                                                                              markets. In particular, Microsoft argued
                                                                                              that the proposed remedies 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. Whatever the
                                                                                              supposed short-run gains, they argued
                                                                                              that the long-run costs in terms of lower
typically run on open standards, so           writing to non-Microsoft platforms.             innovation by Microsoft would swamp
software developers could use these           Customers will shift away from rivals           these purported benefits.
standards rather than Windows. This           because there are fewer applications and             These are difficult areas as the
meant that the server operating system        this will further reduce developer’s            Commission was under no legal obligation
could become a potential non-Microsoft        incentives to write software. This              to consider the effects on innovation,
platform, directly challenging the            applications network effect makes               despite their economic importance.
stronghold that Microsoft had created on      foreclosure arguments much more                 Nevertheless, the Commission argued
PC operating systems. If applications only    plausible than in other industries.             that: ‘a detailed examination of the scope
needed a slimmed down version of a PC                                                         of the disclosure at stake leads to the
operating system, customers would not         Static incentives to foreclose                  conclusion that, on balance, the possible
need to buy expensive Windows                 The dynamic arguments for foreclosure           negative impact on Microsoft’s incentives
upgrades.                                     work even though, in the short run, the         to innovate is outweighed by its positive
    Effectively, a platform based on a        monopolist may suffer some losses. But          impact on the level of innovation of the
server operating system could have            these arguments are even more                   whole industry’.
become a potential competitor for the         compelling when there are short-run                  To assess this claim, we must
Windows operating system. One way to          incentives to foreclose. One such incentive     investigate the Commission’s remedies and
prevent this danger was for Microsoft to      is the ability to price discriminate more       their likely impact on innovation incentives
monopolise the server market – even if this   effectively in the monopoly market              on Microsoft, on its rivals and therefore on
meant sacrificing profits in the short run.   (PC operating systems) by dominating            the market as a whole. The Commission
    The key idea in dynamic foreclosure       the complementary market (server                asked Microsoft to reveal information
theory is that an action that shifts short-   operating systems).                             necessary to allow rivals to interoperate
run market share can have long-run                 In Microsoft’s case, imagine that there    with the Windows platform. This amounts
benefits to the monopolist through            are two types of customers: large firms         to a compulsory licensing remedy. The
depressing rivals’ incentives to invest and   (which are less sensitive to the price of the   Commission conceded that Microsoft
innovate. In many cases, these arguments      PC operating system) and small firms            could charge a reasonable fee for such
may be suspect as there is no obvious         (which are very sensitive to the price of       licenses, reflecting the intellectual property
mechanism whereby this could take place.      the PC operating system). A monopolist          embedded in the information.
But in Microsoft’s case, the mechanism is     would like to charge a high price to the             There is an important distinction
clear and well established due to the         large firms and a low price to the small        between demanding information to
‘applications network effect’. Shifts in      firms. Microsoft finds this hard to do          enable interoperability compared with
share towards Microsoft in the server         because the large firm can always pretend       imitation. The Commission wants the
market (current and expected) will mean       to be a small firm.                             former to enable other firms to connect
that developers start switching away from          But imagine that large firms also place    to Windows in the same way telecom

CentrePiece Summer 2007

regulators force fixed line incumbents to            to R&D, as any innovation will be spread        ■ A further effect may also contribute
share their network with mobile phone                over a larger number of units sold. The           strongly to increased innovation
operators, even if the incumbent also                remedy essentially reduces Microsoft’s            incentives. Through innovation, a firm
offers these services.                               tax on rival innovation and should                can escape harsh competition with rivals
    If the remedy allowed imitation – for            increase incentives to innovate.                  and secure profits for a transitory period.
example, a complete copy of the key                ■ Rivals no longer have to incur costs to           This effect will tend to increase the
security features of the PC operating                overcome technical barriers to                    investment incentives of all firms,
system – there would be a stronger                   interoperability created by Microsoft’s           including Microsoft. Economic research
concern over innovation. Consequently,               disclosure policy. Overcoming such                is somewhat ambiguous on the net
the remedy did not require release of                barriers is innovation of a sort, but it is       impact of all of these effects, but on
Windows source code – Microsoft’s                    duplicative and socially wasteful.                balance, it is believed that intensifying
‘crown jewels’.                                                                                        competition will usually lead to increased
    Interestingly, Windows source code is              There are several potential effects             innovation.
not what the rival server vendors                  of the remedy on Microsoft’s incentives           ■ Finally, Microsoft may change the quality
wanted. Instead, they were after a                 to innovate:                                        as well as the quantity of its R&D. There
detailed technical description of the                                                                  could be positive effects on quality
interfaces to enable them to design                ■ First, with better disclosure, rivals will be     because Microsoft will no longer have
their own code to interoperate with                  able to compete on a level playing field.         incentives to block innovations that raise
Windows. Microsoft’s description of                  To the extent that this reduces the               quality but have high interoperability
the remedy as allowing cloning is                    expected market share and increases               with non-Microsoft servers. There is
therefore inaccurate.                                price competition from now higher                 some evidence that Microsoft has
                                                     quality rival products, the remedy may            sacrificed its own innovative potential to
The impact on innovation                             lead to some reduction in Microsoft’s             protect the Windows desktop monopoly.
incentives                                           incentive to invest. But unlike its rivals,       This was known within Microsoft as the
What are the likely effects of the remedy            Microsoft will still obtain substantial           Windows ‘strategy tax’ – the need
on industry incentives to invest in                  profits from general innovation in the PC         to close down research lines that,
research and development (R&D)? For                  operating systems market, where it will           although leading to innovative
Microsoft’s rivals, there are two effects:           continue to enjoy a monopoly. There is            products, could potentially weaken the
                                                     therefore little reason to expect that            lock-in of Windows.
■ Having interoperability information                Microsoft’s incentives to innovate on
  increases the value and sales of their             operating systems solutions would                   In summary, there are likely to be
  products. This will increase rivals’ returns       substantially fall.                             positive effects on rivals’ innovation from
                                                                                                     the remedy and ambiguous effects on
                                                                                                     Microsoft’s incentives. While the eventual
                                                 Competition policy can deter
                                                                                                     outcome is uncertain, it is far from clear
                                                  anti-competitive behaviour
                                                                                                     that the remedy will reduce industry-wide
                                                   without the need for ever
                                                                                                     innovation. On the contrary, there are
                                                           taking legal action
                                                                                                     many reasons to believe that it could have
                                                                                                     a positive effect on aggregate innovation.

                                                                                                     Interoperability at what
                                                                                                     Following the Commission’s decision, the
                                                                                                     most contentious issue has been the
                                                                                                     conditions under which the interoperability
                                                                                                     information should be licensed and
                                                                                                     what information was necessary to achieve
                                                                                                     full interoperability. The Commission left
                                                                                                     the exact conditions out of its initial
                                                                                                     decision because it involved intricate review
                                                                                                     of technical information, which was
                                                                                                     delegated to an independent
                                                                                                     monitoring trustee.
                                                                                                          Microsoft’s initial suggestions were
                                                                                                     unacceptable to the industry, the
                                                                                                     Commission and the independent
                                                                                                     monitoring trustee appointed to oversee
                                                                                                     the remedy. Microsoft proposed that the
                                                                                                     interface information could only be

                                                                                                                 CentrePiece Summer 2007

purchased as one bundle and specified a           Microsoft has had some impact since it is        empirical discussion over whether the
license fee for each rival software copy          prospective and hence gives the                  behaviour has in fact occurred, whether it
shipped in the order of magnitude of the          Commission power over future versions            could be justified in terms of efficiency,
Microsoft software itself. This would have        of Windows.                                      and whether there has been any material
clearly continued the exclusionary effect              Although caution is always warranted        effect on the marketplace as a result of
simply through high prices.                       before intervention, antitrust authorities       this behaviour. This was the case with
     Many industry insiders doubted that          cannot take a completely laissez faire           Microsoft where evaluation was possible.
any innovation of significance was                approach to innovation markets. Much of          Furthermore, Microsoft’s exclusionary
embedded in the interfaces themselves.            the positive impact of competition policy is     mechanisms were lent credibility by the
They argued that just changing the                through deterring anti-competitive               internal emails, the kind of evidence that
language of the interface would not be a          behaviour without the need for ever              is rarely seen.
substantive innovation that had material          taking legal action. And since software                Unfortunately, although foreclosure
value and that therefore it should not            markets are replete with examples of             may be easier to detect in a case over
be compensated.                                   similar issues, the case may have                abuse of monopoly power compared with
     Indeed, to the extent that Microsoft         contributed to higher deterrence against         a merger, remedying the problem is much
has innovation embedded in processes              anti-competitive exclusionary behaviour.         harder. In a merger, there is always the
that use the interfaces, such innovations              A second observation concerns the           clear choice of simply blocking the
should not matter for the assessment of           status of foreclosure theory. Part of the        proposed transaction. Remedies for an
the license fee because the interfaces            Commission’s case was an explicit                existing monopolist are harder to frame
themselves do not constitute the                  consideration of economic incentives and         and even harder to enforce.
innovation. Typically such information in         an analysis of the effects of the remedy on            The Commission and Microsoft have
other software sectors is licensed at only        innovation. These are clearly important          been wrangling for a long time over the
nominal fees.                                     from an economic perspective, even               terms of the disclosure remedy and it is
     Another contentious issue was the            though European legal practice is often          still not perceived to be effective.
amount and type of information that               ambivalent about getting into these issues.      Microsoft’s main rivals have reached out of
Microsoft had to provide. To interconnect              Despite the difficulty of bringing          court settlements, so the concern may be
with Microsoft’s software, rivals needed          empirical evidence to bear, consideration        that smaller firms and potential new
information about how exactly the                 of innovation and foreclosure was                entrants could be the main parties to
interface works. When the trustee found           unavoidable in making a credible                 suffer. We are unlikely to have heard the
that Microsoft was not giving sufficient          economic case. One of the challenges             end of this case.
information to make this possible, the            facing modern economics is to develop
Commission stepped in with a ‘statement           guidelines for the type of empirical
of objection’ and eventually a further large      evidence that could be used to test the
fine for non-compliance. But this tug-of-         likelihood of foreclosure being a problem
war has led to considerable delay in the          in different markets.
effective implementation of the remedy.                The Commission has been much
                                                  criticised in its use of foreclosure theory in
Conclusions                                       merger cases. For example, the proposed
What more general lessons can be learnt           merger of General Electric and Honeywell
from the Microsoft case about antitrust           was blocked after it had been cleared by
enforcement in high-tech markets and              the US authorities, only for the judgement       This article summarises ‘The Incentives of a
elsewhere? First, it is worth remembering         (although upheld) to be severely criticised      Monopolist to Degrade Interoperability:
that the case has gone on for nine years          by the Court of First Instance in 2005.          Theory and Evidence from the Personal
with four statements of objections issued         And in 2002, the Court actually                  Computer and Server Market’ by Christos
and still no final resolution. This is partly a   overturned the Commission’s blocking of          Genakos, Kai Uwe Kühn and John Van
reflection of the complexity of the               the Tetra/Sidel merger in 2001, which was        Reenen, CEP mimeo, and ‘Some Economics of
technical issues, the legal necessity of          based on ‘over-speculative’ theories.            European Commission versus Microsoft’ by
due process and Microsoft’s financial                  In a sense, foreclosure theory in a         Kai Uwe Kühn and John Van Reenen,
strength. Many of its server rivals have          merger case is inherently speculative.           forthcoming in Cases in European
long since died.                                  Opponents of the merger must produce             Competition Policy: The Economic
     An obvious problem is that the legal         arguments that a particular type of              Analysis edited by Bruce Lyons (Cambridge
timescale is so long compared with the            foreclosure behaviour is more likely to          University Press).
rapid evolution of these markets. By the          occur as a result of the merger, although
time a remedy is in place, the marketplace        there are no exclusionary practices in the       Christos Genakos, a research associate in
has moved quickly beyond the problems             pre-merger situation.                            CEP’s productivity and innovation
over which the case was fought: even if                The evidential position is better in an     programme, is at Cambridge University.
the judgement and remedy are                      abuse of dominance case because the              Kai Uwe Kühn is at the University
appropriate, is it ‘too little too late’?         exclusionary behaviour is already alleged        of Michigan. John Van Reenen is director
In our view, the Commission’s decision on         to have happened, so there can be an             of CEP.


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