International Think-Tank on Innovation and Competition
The Economic Implications of the CFI Ruling on the MS vs. EC Case
On September 17, 2007 the Court of First Instance concluded the Appeal of the Microsoft vs EU Commission case and essentially upheld the 2004 Commission decision, finding that Microsoft abused its dominant position both for bundling the operating system Windows with Windows Media Player (WMP) and for the refusal to supply interoperability information in the work group server operating system market. The fine of EUR 497 million was also confirmed, while the Court annulled parts of the 2004 decision relating to the appointment of a monitoring trustee, which have no legal basis in the Community Law.
Here, I will comment on this ruling and its consequences from an economic point of view. This implies that I will pay particular attention to the implications for consumer welfare. While there is a wide economic consensus on giving priority to the interests of the consumers and the same Commissioner Kroes has repeatedly emphasized this aspect, the Microsoft case is a clear example of an antitrust case in which the interest of consumers has played a marginal role. First, the case started and developed without a single consumer or any consumers’ association complaining about Microsoft conduct, just through the complaints of rivals of Microsoft in different markets - in a similar way to what happened in the US vs. Microsoft case. Second, economic analysis of the interests of the consumers has played virtually no role in the discussion of the case emerging from the official documents - somewhat differently from what happened in the US case. Third, the outcome of the case was to punish Microsoft for distributing for free a product and to force Microsoft to disclose its patents and trade secrets. Even if I was a skilled politician, I would find it hard to explain to an average citizen and PC user why this decision could be in ones own interest. Of course, the magic formula for which Microsoft has been punished for abusing its quasi-monopolistic position could be used, but unfortunately what is behind the Microsoft case is quite different, and requires a more detailed analysis. My discussion will concentrate on the CFI ruling, focusing first on the bundling part of the case, which is the weakest and the most surprising after what happened in the recent years, and then on the interoperability part.
The reasoning of the Commission, substantially adopted by the CFI ruling is based on the following points:
1) media players would be separate products from OSs, therefore OSs and media players would characterize two distinct markets: a primary market for OSs and a secondary one for media players;
2) Microsoft is the leader of the primary market with an extremely large market share, therefore Microsoft is a dominant firm; Microsoft has engaged in pure (not mixed) bundling, therefore consumers would have no choice to obtain their optimal bundle;
3) the bundling strategy of the dominant firm may foreclose competition in the secondary market, therefore it would represent an abuse of a dominant position. In particular, potential foreclosure would occur through an indirect network mechanism:
3.1) content providers would choose to encode in a single media format and software developers would develop their technologies to be used on a single media format to save in costs;
3.2) the ubiquity of WMP obtained through bundling would lead content providers and software producers to limit their applications to WMP to reach the maximum percentage of consumers;
3.3) all consumers would use exclusively WMP since this would allow most of the content to be available.
Each one of these points is problematic.
Contrary to the claim in point 1), the fact that virtually all PCs (including those with other OSs than Windows) are sold with media player functionalities shows that there is not consumer demand for OSs without media player software, therefore there is not a distinct market for OSs without media players. Focusing on the existence of consumer demand for media players and emphasizing the existence of a separate market for media players (with the notable feature that its equilibrium price is zero), the Commission has ignored the recent evolution of the software market establishing a distinction that does not exist anymore. Whether or not consumer demand exists for the tied product is the wrong question to determine whether there are two distinct markets; the correct question is whether there is any significant consumer demand for the tying product without the tied product. Unless the analysis focuses on this question, there is a danger that the mere existence of consumer demand for the tied product may prevent the emergence of efficient tying arrangements and end up protecting suppliers of tied products at the expense of consumers and innovation. To exemplify our doubts, notice that, while there is clearly consumer demand for shoelaces, this should not mean that shoes and shoelaces are distinct products for the purposes of tying analysis. This issue can only be addressed by asking whether there is consumer demand for shoes without shoelaces.
Moreover, in the case of technical integration of two products that were previously distinct, the distinct products test itself may not be helpful for understanding market dynamics because, by definition, this test is backward-looking. A better approach in these cases would be simply to ask whether the company integrating the previously distinct products can make a plausible showing of efficiency gains in the interest of consumers: since technical tying is normally efficient, market leaders would be able to continue producing innovative products benefiting consumers without running systematic risk of incurring in the prohibitions on tying. None of this has been taken in consideration in the Microsoft case. Finally, since tying usually enhances price competition, it should never be abusive when it is standard commercial practice, which is also indirect evidence that such tying generates efficiencies, or that there is no demand for the unbundled product.
Ignoring altogether the efficiency rationale of bundling in an innovative and rapidly evolving sector, the Commission has clearly rejected the traditional approach to bundling associated with the so-called Chicago School (see for instance of Richard Posner, from the University of Chicago). On the contrary, the points 2) and 3) show that the Commission has entirely adopted one of the thesis of the so-called post-Chicago approach to antitrust (see in particular the theory of bundling of Michael Whinston, from Northwestern University): this theory suggests that bundling is used by a dominant firm to foreclose competition by a rival in the tied product market. The defense of Microsoft has been largely based on stressing the technological nature of the integration of Windows and WMP and the speculative nature of the indirect network theory. In reality, the reasoning of the Commission has other major problems that have emerged only indirectly in the case, and that brings us straight to the interests of consumers, which should be always the priority.
The economic rationale of the Commission is based on the idea that a monopolist in a primary market would bundle the primary good with a secondary good to strengthen price competition and to induce the exit of a rival which is exclusively active in the secondary market; the ultimate purpose of the monopolist would be to extend its monopoly power to both the primary and the secondary market. This idea is well known between economists and it is associated with the post-Chicago approach to antitrust, and in particular with the famous work of Whinston (1990): bundling for predatory purposes is indeed a realistic possibility and in theory it may induce harm to consumers. Nevertheless, it is also well known between economists that this theory does not work when (Etro, 2007):
1) the secondary market is characterized by rapid and endogenous entry and evolving technological conditions;
2) product differentiation which allows multiple secondary goods to be consumed with the primary good.
Under these conditions, bundling has the usual role of strengthening price competition, but the constant competitive pressure (both effective and potential) in the secondary market does not allow the bundling firm to increase the prices, and the level of product differentiation allows the rivals to maintain large market shares. As a consequence, the only reason for which bundling occurs is a normal form of healthy competition, which induces a reduction in the price level for both the bundle and the secondary goods, does not deter entry, and increases consumer welfare.
In other words, while the Commission would be correct in endorsing the post-Chicago theory to bundling cases in which a monopolist in a primary market faces a single competitor in a secondary market and induces the exit of the latter through bundling, the Commission is erroneously applying the same theory when the secondary market satisfies conditions a) and b) above. I will now point out the reasons for which these conditions are indeed satisfied in the Microsoft case.
First of all, the last decade has witnessed a rapidly evolving composition of the market for media players, with constant introduction of new and better products by multiple firms. Currently the most used media player is not even WMP, but Flash by Adobe, which is the media player commonly used to watch videos on YouTube. Competition is quite strong, to the point that the price of all the most used media players corresponds to the marginal cost, which in this market is zero, and the buying costs for consumers are also close to zero since these products can be freely downloaded in a few seconds online.
Second, the supply of media players is characterized by a substantial product differentiation, with some media players that are developed for audio content, some that are better for video contents, others for music content, and still others that are ideal for storing music files, and so on. Not by chance, most consumers have multiple media players and use different media players for different purposes and for different contents. Also for these reasons, content providers and software developers provide content and applications that interoperate with all the most used media players: this is what allows the maximum percentage of customers to be reached.
Consequently the bundling strategy of Microsoft could be simply seen as an aggressive and competitive strategy of a market leader active in a secondary market where entry is indeed endogenous. Moreover, in these markets the standard strategy is to provide free software to enhance network effects and earn from externalities associated with the use of the software (a typical strategy in multisided markets). For instance, in the case of digital media platforms, Microsoft looks for network effects on licenses of its OS, Real earns from content subscriptions, Apple from sales of digital audio and video devices (the iPod and, in perspective, the iPhone) and Adobe from Flash server sales. This implies different levels of platform integration and interoperability with different platforms. As Evans et al. (2006) noticed: "At one extreme is Apple. Its iPod/iTunes platform is integrated into the hardware and content-provider sides of the media platform, and its doesn't interoperate with any other platform. At the other extreme is Microsoft, whose media platform is integrated into neither hardware nor content and which interoperates with all other media platforms that allow it to do so. In the middle are vendors like RealNetworks, which limit interoperability - but not completely - and integrate - but only partially - into the content provider side." Even if these companies adopt very different business models, competition is quite intense because multi-homing is common practice: end users typically use multiple media players, and also PC manufacturers typically install multiple competing media players at their will (while this is not the case for digital music devices and mobile phones).
I will now move to the interoperability part of the case, which requires a wide premise on the role of intellectual property rights in the New Economy. In Etro (2007) I discussed the role of market leaders in innovative markets and the importance of the protection of IPRs in stimulating investment in R&D and technological progress. Both aspects are quite relevant in the understanding of the dynamics of the software market and the Microsoft case. The software market is a major example of an industry where competition is mainly for the market, and in such a case large market shares by single firms are a typical outcome. The counterpart of this, of course, is that these industries can exhibit catastrophic entry where innovators can replace current leaders quite quickly. In such an environment, it is exactly when competition is open that leaders have incentives to invest deeply to retain their leadership. On the contrary, when competition for the market is limited, technological leaders are able to have a quiet life, invest less in R&D and accept the risk that someone will come up with a better product. When competition for the market is open, this same risk is too high and incumbents prefer to accept the challenge and try to innovate first: paradoxically, competition leads to a more persistent leadership.
Moreover, when entry is endogenous, innovation by leaders creates a virtuous circle that also has important implications for the way we can evaluate such a market. The endogenous persistence of the technological leadership has a value that creates incentives for all firms to invest even more, which in turn strengthens the same incentives of the leader to invest and retain its leadership, and so on. In other words, persistence of leadership is a source of strong competition for the market (through investments in R&D to replace the current leader), and, given that leaders have higher incentives to invest as long as the race to innovate is open, we can also conclude that strong competition for the market is a source of persistence of leadership. This circular argument may appear paradoxical, but is the fruit of a radical distinction between static and dynamic competition: once more, there is no consistent correlation between market shares and market power in dynamic markets.
The endogenous multiplicative effect of the value of leadership that we have just summarized implies that in dynamic markets the rents of a leader may be spectacularly larger than those of its competitors, and the market value of a leadership may be extremely large even if the market is perfectly competitive in a dynamic sense. In our view, this is something not too far from what we can see in the software market and in the leadership of Microsoft, but also in many other high-tech sectors.
The source of the value of innovation, the starting point of the chain of value that we just described, must be a fundamental rent associated with innovations and protected through IPRs. Hence, all forms of IPRs are the ultimate source of leadership, innovation and technological progress. As we already noticed, the role of patent legislation is exactly to trade off the benefits of patents in terms of incentives to innovate with the costs related to temporary monopolistic pricing. In our opinion, there is no reason why antitrust authorities should interfere with this legislation when patent protection appears inconsistent with other goals. And even if these goals are legitimate and relevant, introducing a discretionary evaluation of IPRs would create uncertainty and jeopardize the investment, which, after all, goes against the ultimate objective of the same antitrust authorities. Nevertheless, in the Microsoft case the EU Commission has taken this dangerous direction, asking Microsoft to disclose a wide amount of technologies.
At the beginning of 2007 (Statement of Objections of March 1st), the Commission has asked to make them available royalty free unless they have an innovative nature (meaning that they involve an inventive and novel step compared to the prior art). Finally, it has started questioning the same innovative nature (and with it the license pricing) of most technologies that Microsoft was forced to disclose, technologies which are also covered by many patents approved by US and EU patent offices. This creates an even stronger contradiction between patent law and antitrust policy in the EU, and also a substantial divergence between the US approach to IPRs and the EU approach, with the former much more careful in protecting IPRs and promoting R&D. Unfotunately, the CFI ruling of September 17, 2007, has substantially approved the Commission approach.
In high-tech sectors, patents and trade secrets often cover fundamental inventions, and protecting those inventions amounts to promoting innovations that today are the main engine of growth. In some fields, however, there maybe, at least apparently, a trade-off between trade secret protection and "interoperability" between products - broadly speaking, this is the ability of heterogeneous information technology systems, components and services to exchange and use information and data, especially in networks. Interoperability is important in the PC industry and, as we have seen above, the level of interoperability has strongly increased in the last decades. Problems arise, however, when interoperability is confused with "interchangeability" or with a right to clone the innovations of the competitors.
For instance, take in consideration the leading on line search engine in the world, Google. We may look at Google's patented innovations, starting with the 2001 patent on the invention of the PageRank, but we would need to know its trade secrets to fully discover the mechanism of its precious algorithms. Forcing disclosure of such trade secrets may help software companies and websites to interoperate with Google even better than they already do, as it would allow other search engines to improve their performances compared to that of the leading search engine. But after that, surely, few companies would invest huge resources and take substantial risks to create a better search engine or other brilliant ideas like Google when they can just free ride on others' ideas and/or they can't be sure of their return. The same argument would apply for the trade secrets of Microsoft or Apple on the source codes of their OSs and to many other trade secrets of innovative leading companies. Any forced disclosure of similar trade secrets represents an expropriation of legitimate investments and establishes inappropriate legal standards with perverse effects on the incentives to innovate.
Fortunately, giving up the precious role of IPRs in promoting innovations is not the only way to solve interoperability challenges. The market can do it much better: valuable ideas can be selectively commercialized on a voluntary basis through licenses, for instance under RAND (reasonable and non discriminatory) terms, a type of licensing typically used during standardization processes to promote the rapid adoption of standards and new technologies and to encourage entry. The RAND terms include a definition of reasonable royalties, and can include further restrictions as field-of-use clauses (that allow licensees to utilize a patented technology in a use that is directly related to the implementation of the standard), reciprocity clauses, or limits to sublicensing. The Nobel prize winner Ronald Coase (1960) has clarified that whenever there is social value to generate, the market will properly allocate all the property rights. This is also true for the intellectual property rights: market mechanism can allocate them efficiently, insure the accessibility of the information that fuels interoperability and acknowledge legitimate ownership rights of the innovators, so as to enhance R&D investments.
In conclusion, also in this field, markets can properly balance the short run and long run interests of consumers better than policymakers: promote innovation, enable an efficient degree of interoperability and select the best standards. It would have been better to leave the ruling of intellectual property protection and of its limits to the legislative level rather than creating an important precedent for which antitrust authorities could force firms to reveal their IPRs, as recently happened in the Microsoft case.
