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Environment and the diffusion of Clouds

A new general purpose technology as cloud computing can provide huge cost savings and more efficiency in large areas of the private sector (especially in fields as services and selected manufacturing sectors where ICT costs are relevant), and also of the public sector, including hospitals and healthcare, education and the activity of government agencies with periodic spikes in usage.  
Case studies in the private and public sectors suggest that cost advantages can be substantial. A few examples from a specific sector, the health sector, can exemplify the point (let us start from the most simple applications to move toward more relevant ones). One of the leading Italian hospitals, the Children’s Hospital of Bambin Gesù in Rome, has recently switched to an online solution for the email services of its 2500 employees (the switch took place in 2010 in less than four months, created large cost savings and allowed IT specialists to focus on other more relevant tasks for the hospital). Similar experiences are planned by the USL of Asolo in Veneto, which is also trying to use cloud computing to help more operative tasks. The Swedish Red Cross has improved the coordination of its intervention adopting a cloud computing solution which has reduced costs of about 20 % and enhanced communication in real time between its employers. A Russian cardiovascular centre, Penza, has adopted a cloud computing solution to coordinate activities, diagnosis and decisions on treatment and surgery between doctors around the country, with crucial gains for the patients. During the H1N1 pandemic, a global cloud computing tool was build and made available in a few days (based on the Microsoft’s Windows Azure platform) to centralize and provide information on the diffusion of the flu.
            Cloud computing is currently developing along different concepts, focused on the provision of Infrastructure as a Service (IaaS: renting virtual machines), Platform as a Service (PaaS, on which software applications can run) or Software as a Service (SaaS: renting the full service, as for email). In preparation for its development, many hardware and software companies are investing to create new platforms able to attract customers "on the clouds". Cloud platforms provide services to create applications in competition with or in alternative to on-premise platforms, the traditional platforms based on an operating system as a foundation, on a group of infrastructure services and on a set of packaged and custom applications. The crucial difference between the two platforms is that, while on-premises platforms are designed to support consumer-scale or enterprise-scale applications, cloud platforms can potentially support multiple users at a wider scale, namely at the Internet scale.
            The introduction of cloud computing is going to be gradual. Currently, we are still in the middle of a phase of preparation with a few services that can be regarded as belonging to cloud computing, often derived from internal solutions (turning private clouds into public ones). Amazon Cloud Computing was launched in October 2006, IBM’s Blue Cloud in November 2007, followed by cloud solutions by Google and Microsoft. Meanwhile, many large high-tech companies as Amazon, Google, Microsoft, Saleforce.com, Oracle and other CCP (Cloud Computing Providers) keep building huge data centres loaded with hundreds of thousands servers to be made available for customer needs in the near future.

Besides economic gains, substantial positive externalities are expected from cloud computing because of energy savings: the improvement of energy efficiency may contribute to the reduction of total carbon emissions in a substantial way (currently, ICT contributes to 2 % of global CO2 emissions).
The costs savings associated with the new technology can improve the PUE (power usage effectiveness) of the datacenters, which is the ratio between the power drawn by the datacenter facility and the power delivered to hardware (the difference being used for cooling the IT equipment). This ratio is around PUE = 2  in the average datacenters (for every kWh of energy which is used to operate hardware, there is another kWh of energy used to cool the same hardware), but it could go down to PUE = 1.1/1.2 with the outsorcing of certain activities to cloud computing solutions in separate datacenters, which can be built in colder regions (as they currently are in Ireland, Scotland and other cold EU regions) and with more efficient cooling systems (as in the Google’s project of a submarine datacenter). In a recent study on the environmental aspects of the move to cloud computing, Accenture (2010) estimates energy savings that are variable with the size of the organizations: up to 90 % for small ones with less than 100 users, between 60 % and 90 % for medium size organizations with up to 1000 users and 30-60 % for larger organizations with up to 10 thousand users: clearly this corresponds to large reductions in carbon emissions (by a third on average).
Beyond this, datacenters can be located in regions with low carbon emission factors. The gains can be larger (in terms of per-user energy use and carbon footprint) in case of small deployments, since these currently operate at low utilization levels (being idle during most of the day).
Of course, cloud computing can also contribute to reduce the emissions of non-ICT processes through its indirect impact. Therefore, larger cost savings and environmental gains are expected from the adoption of cloud computing in SMEs, and the coordination of policies for accelerating its adoption could be fruitful.

The Chicken-or-the-egg problem and Google's Dominance

The dominant firm in online advertising is currently being investigated by a number of antitrust authorities. As usual, the problem is "the chicken or the egg" dilemma: has Google reached its dominance only with merit (innovating) or are there abuses that strenghten its dominance? Analyzing this market, it emerges that possible abuses may concern both search and display advertising, with particular reference to preferential treatment for Google’s own services in its free (‘universal’) search, manipulation of the opaque bidding system for  sponsored links, and exclusivity clauses for advertisers.

In November 2010 the European Commission has started an investigation on potential abuses concerning the preferential treatment for Google services in its free search engine, the manipulation of the pricing system for the sponsored links, and exclusivity clauses or other restrictions for advertisers using Google services. Complaints have been also filed in front of the US, German and Italian authorities, mainly regarding unfair competition with publishers and other content providers. The French competition authority has also carried out a consultation concluding in December 2010 that Google holds a dominant position both in search-related advertising and contextual advertising and that “competition law can apply limits to Google's actions and provide a response to the competitive stakes brought to light by the actors, without the need to implement sector-wide regulations.” Some constraints to the activity of Google have been decided also in Italy in January 2011, but the main antitrust debate will take place at the EU level. For this reason it is important to understand the structure of online advertising and reasons for which Google may be engaged in abusive conducts.

Companies spend over US$ 600 billion worldwide on brand recognition annually. Today, only around 13% of that total is spent on online advertising, which is an entirely separate market destined to grow rapidly over time. As well known, Google is the leading search engine in the world, with a global share of search traffic around 85 %, against 7 % for Yahoo! and 4 % for Bing, but with even higher market shares in Europe. Beyond this, Google dominates the lucrative business of placing text ads next to search engine results. Google AdWords accounts for about 70 % of search advertising revenue worldwide. Payments are based on so-called Vickrey auctions between advertisers on the keywords that match the content of the webpages or searches: charges are typically for each click on the ad, and the highest bid for each keyword association wins (with the price given by the second highest bid). The auction process is made more complex by the different places where the ad can appear on the search page (on positioning auctions see Varian, 2007, Position auctions, International Journal of Industrial Organization, and Edelman, Ostrovsky & Schwarz, 2007, Internet Advertising and the Generalized Second-Price Auction, American Economic Review), and remains largely obscure to advertisers and competitors. The lack of transparency of this pricing and ranking scheme could easily hide abusive forms of exclusionary behaviour, predatory strategies against competing services specialised in providing users with specific online content (price comparisons), price discrimination or even exploitative pricing toward selected advertisers. For instance, an exclusionary behaviour was identified by the French national competition authority  when Google suspended the AdWords account of a French company providing online services (Navx); Google was subsequently forced by the competition  authority to re-establish the account. These and other forms of manipulation of the pricing system for the free and sponsored links should be carefully investigated at EU level. In the last 2 years Google has introduced new services, some of which raise serious concerns about copyright protection (Google Books), privacy (Youtube and Google Maps) and/or  antitrust law. This is particularly evident in terms of predatory pricing or free riding against content providers, whose information is freely aggregated and displayed by Google News. On this front, the Italian and French competition authorities have obliged Google to guarantee that press publishers will be able to request and obtain exclusion from Google News, but without being de-listed from the general search. Similar agreements should be extended to the rest of Europe.

Besides search advertising, the second field of dominance of Google is in display advertising. Google leads the industry in directly placing banner ads on third-party publishers, accounting for three quarters of the direct channel, that is, the valuable ad inventory that large web publishers directly negotiate with the advertisers. Of course, a lot of the advertising space available on large websites and all of the space available on small websites cannot be sold in direct negotiations. Therefore, most advertising is typically sold through indirect intermediaries that buy the so-called “remnant” ad inventory from publishers and sell it to advertisers. Google plays a major role also in this market for intermediation services, providing a vertically integrated platform between online web publishers and advertisers: Google's AdSense reaches more than 80 % of the ad revenue in the indirect channel with integrated ad networks. The Google platform targets advertising to the relevant websites (so-called “contextual advertising”) and pays the web publishers with a percentage of its revenues, but in the absence of any audit or data certification available for the same publishers. Meanwhile advertisers buy inventories from the platform through a bidding system characterized by the same lack of transparency mentioned above.
Through these services, Google controls at least 80 % of the worldwide market for advertising, and, as confirmed by the sector inquiry by the French antitrust authority, is protected by high barriers to entry.

A first source of these is due to the importance of scale in search, and the huge lead time that the dominant player has because of the massive amount of data it can draw on to improve its organic search, which is due to the high volume of the search queries that are made and to the fact that Google is a laggard in the industry with respect to the anonymisation of user data (nine months versus for example Bing’s six months).

A second source of barriers to entry is peculiar to the field of display advertising: alternatives to Google can be hardly offered to publishers using Google’s services. Switching to a different publisher tool involves high sunk costs in terms of substantial investments in software, in training the staff, coding all of the publisher’s web pages, creating novel datasets, transferring ad campaigns to the system and so on, with all the associated business risk.

This leaves space for multiple potential abuses by the dominant firm, including exploitative pricing on advertisers (with negative indirect consequences on all sectors depending on advertising), exclusivity clauses for advertisers using Google services and restrictions that Google can place on advertisers that wish to use the services of competing platforms.

For these reasons, an in-depth investigation by the EU antitrust authority is welcome to solve this chicken or the egg dilemma, that is to discern if Google reached its dominance only with merit or there are abuses that strenghten its dominance.

On IBM Mainframes

Now that the Microsoft saga has ended, another important antitrust case may soon emerge in the New Economy, this time around a well known but largely undisturbed monopolistic position, that of IBM in the mainframe market.

Even if the mainframe represents a relatively small percentage of server shipments, rigid demand by corporate and government customers worldwide along with technological peculiarities on the supply side make the mainframe market a largely separate and self-contained market which provides products that are not substitutable with standard Linux, UNIX or Windows servers. For half a century, IBM has been the meritorious leader of this market. However, in the last few years, IBM has reached a position of near-monopoly by refusing to license its software for use on other mainframe computers and to provide information to ensure interoperability with its architecture. Indeed, IBM now owns almost the entire base for IBM-compatible mainframes and has virtually eliminated any substantial entry pressure. It is calculated that around 90% of mainframe applications use native IBM mainframe operating systems and run on IBM hardware.

While a wide leadership is typical of markets characterized by network effects, dominance such as that exhibited by IBM goes beyond the effects of standard network externalities for the lack of any residual entry pressure. In past decades, mainframe customers benefited from the effective competition provided by manufacturers of hardware compatible with IBM architecture, such as Hitachi, Amdahl, Comparex, PSI and T3 Technologies, and from the potential entry of other producers and software developers. However, in the last several years, IBM has gradually moved toward a policy of bundling and integration of its hardware and software products, thereby becoming the only company selling IBM-compatible mainframes. This has allowed IBM to constantly increase its prices for mainframe solutions, against a declining trend in the rest of the industry.

The dominance of IBM has been closely observed by both the American and European competition authorities. The European Commission started to focus on IBM after receiving complaints from a small company, Platform Solutions, Inc. (PSI). In 2006, when Hewlett-Packard was about to buy PSI and enhance competition in the mid-range framework market, IBM stopped licensing to PSI and filed a patent suit against it. To terminate the legal proceedings against PSI, IBM had to buy this company in 2008. Moreover, at the beginning of 2009 IBM faced a second complaint from another smaller rival, T3 Technologies, which accused IBM of preventing the sales of rival mainframe hardware through bundling of its operating system with its hardware, and withholding the intellectual property rights needed for interoperability. At the end of March 2010, DG Competition received a third complaint from TurboHercules, a Paris-based open-source company whose request to license z/OS was declined by IBM. Hercules is a “mainframe emulator” (developed in 1999), which is a program that allows software designed for IBM computers to run on other types of computer hardware, including personal computers. The alleged abuse by IBM would be to prevent customers from using Hercules by tying IBM's mainframe operating system to IBM hardware. Finally, even the Department of Justice has started a broader preliminary investigation of IBM's dominance last autumn, also citing the experiences of T3 and Hercules. Given the absolute dominance of IBM in the market, the impossibility of entry and, for the European case, the related precedent of the Microsoft case, it appears likely that these preliminary investigations will turn into a new antitrust case of primary importance.

Looking in more detail at the last European complaint, TurboHercules has accused IBM of abusing its dominant position in the mainframe market through the bundling of its hardware and software to exclude entry on both sides and through refusal to license information for interoperability. The latter concerns the interfaces needed to allow other software to interoperate with IBM’s products and to run customers' applications on less expensive computers utilising multiple operating systems. According to Roger Bowler, the original developer of the Hercules project and chairman of TurboHercules, “Hercules is an innovative open-source technology that could benefit many mainframe customers. But IBM is preventing customers from using Hercules by tying IBM's mainframe operating system with IBM hardware. This conduct prevents TurboHercules from providing its product to mainframe customers desiring an open-source solution. We originally wrote to IBM requesting that it license its mainframe operating system to customers, on reasonable and fair terms, for use with Hercules in certain circumstances. Not only did IBM deny our request, but it now suddenly claims, after ten years, that the Hercules open-source emulator violates IBM intellectual property that it has refused to identify.” In reply, IBM has accused the French company of infringing almost two hundred patents, including two that were in the famous list of 500 patents that IBM pledged not to use against open source developers since 2005. As a collateral effect, this opens new, heavy doubts in the open source community about the credibility of the widely celebrated commitment of the largest patent holder in the world (IBM holds about 50 thousand patents) to support open source software - see the Intellectual Property Watch (April 20, 2010).

In its complaint, TurboHercules is asking the European Commission to order IBM to end tying and make available its interfaces and protocols. The similarity with the issues underlying the recent Microsoft cases is all too evident. Nevertheless, two major differences should be noted. First, Microsoft was not accused of tying its operating system with hardware. Rather, it was accused of tying its OS to two basic software applications already facing substantial competition in their respective markets: Windows Media Player is one of the many media players available (such as Flash, RealPlayer or Quick) and is not even the most used one, and Internet Explorer faces many competing browsers and has been losing market shares to Firefox and new entrants such as Google Chrome over the last few years. Second, the interoperability information that Microsoft was recently forced to licence by the European Commission was protected by intellectual property rights and was never intended to be shared with the open source community. IBM, on the other hand, has pledged to share such information with the open source community, at least until now. Despite these differences between the IBM and Microsoft cases, the many similarities suggest that IBM may have a hard time defending its position against the last complaint in front of the European Commission.

On Standardization Agreements by F. Etro and E. Tarantino

The new draft of the Guidelines on the applicability of Article 101 of the Treaty on the Functioning of the European Union to horizontal co-operation agreement (to be finalized by the end of 2010) set-up the legal framework to analyze different agreements between firms that can be exempt from the application of Art. 101 against collusive agreements. Besides R&D, production, purchasing and commercialization agreements, a crucial category analyzed in the Guidelines is given by standardization agreements, which are aimed at defining technical and quality requirements with which certain products or processes may comply. The role of these agreements is quite important in the private sector because of their impact on the innovative activity of high-tech firms (think of the crucial role of standards in ICT) and in the public sector for public procurement (think of the debate on the European Interoperability Framework, currently under discussion at the EU level to set common rules on the procurement of e-Government services by public authorities). The draft Guidelines acknowledge the importance of Standard Setting Organizations (SSOs) in promoting innovation, competition, technology adoption and interoperability, however they also stress that the discussions among competitors in SSOs may result in anticompetitive practices.

Representatives of firms participating in SSOs repeatedly meet to reach consensus on the rules that define a standard. In the ICT sector, such workshops are necessary to select the best technologies to include into a technology platform, and they contribute to promote R&D investment, organize the innovation activity in a common direction and develop new technologies typically protected by patents. The selection of the most efficient standards and the incentive to R&D are therefore the main benefits from standardization agreements.

After determining the composition of a standard, bilateral negotiations take place between the holders of patents that are essential to the standard and final adopters. Consensus is sometimes reached only several years after the workshops begin, and in the meanwhile firms may start the production phase by following the indications emerging from the conversations at the certification consortium. This implies that patent holders have a strong bargaining position at the negotiation stage and in extreme cases there can be the risk of the so-called hold-up: investment by others is limited ex ante because it could be exploited by the patent holders ex post.

The standards certified by SSOs in the ICT industry include the Wi-Fi protocol, the ADSL and the SDRAM technologies. Although there are many instances of peaceful resolution of issues between parts, few antitrust cases on both sides of the Atlantic testify that harsh competitive tensions can influence the process of ICT standards’ definition (FTC v. Rambus, FTC v. N-Data, EC v. Rambus and EC v. Qualcomm). As acknowledged by the Guidelines, these tensions arise from the conflicting interests driving firms with different business models, with companies slotting in along a spectrum going from pure innovators to pure manufacturers, with many falling somewhere in-between the two poles.
Pure innovators raise most of their revenue from the technology market; they are interested in having their patented technologies included in a new standard and in gaining the associated licensing revenue. Manufacturers in SSOs are often vertically integrated; they join certification bodies to achieve coordination among industry participants and have a clear interest in paying low rates for standard’s technologies.

The different incentives that characterize the licensing stage can alter the outcome of the technology adoption phase and give rise to inefficient outcomes. This happens, for example, when integrated manufacturers sign cross-licensing contracts and exclude from a standard the technology of a pure innovator even though its inclusion would increase social welfare. Exclusion can arise because, from the point of view of manufacturers, cross-licensing preserves product-market and licensing rents, while contracting with pure developers is efficient from the technological point of view but leads to rents’ dissipation because of hold-up. This creates a bias in favor of cross-licensing that is welfare detrimental when the pure developer’s input is very efficient.

The normative implication is that standard setting consortia should adopt a policy of early licensing commitments for the essential patents to fix the hold-up problem and let integrated companies design the standard more efficiently. These commitments should not be anchored to vague definitions of fair, reasonable and non-discriminatory (Frand) terms, which do not reflect the nature of existing SSOs and contradict the same nature of the IPRs (which deliver market power by definition). The market should be allowed to set whatever licensing terms arise out of the early negotiations.

However, so far a policy of early-licensing commitment has received only timid support from SSOs, mainly because of firms' fear of antitrust authorities' intervention. The Guidelines seem to support the employment of an ex-ante licensing policy by SSOs when they state that “if standard-setting organizations provide for ex ante disclosures of most restrictive licensing terms, this will not lead to a restriction of competition within Article 101(1)” (# 287).  However, they also specify that “[p]rior to the adoption of the standard, agreements by IPR holders on the licensing terms they will disclose also constitute restrictions of competition by object within the meaning of Article 101(1)” (#267). The difference between the two expressions, and in particular between “licensing terms” and “most restrictive licensing terms” (emphasis added), is small but substantial and calls for an interpretative effort that clearly introduces uncertainty on the enforcement of the law by the Commission.

The ambiguity of the Guidelines generates two risks. First, the potential beneficial effects of ex-ante disclosure of licensing terms would likely not be realized because of SSOs’ member firms fear of being punished for anticompetitive coordinated practices. Finally, and this is a general problem of the part of the draft Guidelines concerning SSOs, a dangerous bias against proprietary technologies could implicitly emerge even if it is clear that this would be highly detrimental to innovation and technological progress in ICT sectors and to efficient decisions in public procurement.

Looking at Competition in a the Baroque Art Market

Prices of old paintings may give the impression that little can be rationalized in this market. The Wedding at Cana by Veronese was commissioned in 1563 for a wall of the nave of the Venetian church of S. Giorgio Maggiore for 324 silver ducats. It is, and was at the time, considered a masterpiece for its imposing composition, the splendid contemporary costumes, and the luminous colors, probably not because of its size (about 70 square meters) or for the number of human figures depicted (more than fifty major ones), which were largely agreed with the commissioners. Today we find it at the Louvre Museum, right in front of another painting whose size is much smaller, but whose value is hardly so: the portrait of a single human figure, the Monna Lisa by Leonardo. Less known than the original painting by Veronese are its copies: one by the minor painter Zanchi for a private collection was paid 1000 ducats in 1671, more than the double of the original, even taking inflation into account! Another of the three great masters of the XVI century in Venice, Jacopo Tintoretto, had a long and brilliant career, but he never managed to be paid as much as the rival Titian for his works. In 1583 he reached his highest fee (400 ducats) for a Nativity commissioned for the Escorial building by the king of Spain Philip II: apparently, Tintoretto did not even put much effort in this work, since his less talented son Domenico painted most of it. In 1625, an art dealer who was contracting an altarpiece by Cerano in Milan told the patron that the painter would have probably accepted about 250 ducats, but also that if Cerano were to go to Rome he would be paid the double: because, he added, Rome is "where you go to get rich". However, at the beginning of the century, the fees for the revolutionary paintings by Caravaggio were extremely low. Meanwhile, the more fashionable Guido Reni was starting a successful career that would have made him the best paid painter of the century in Italy. One of his last altarpieces, the Adoration of the Shepherds (1640) for the Certosa of S. Martino in Naples, was paid the record price of more than 3000 ducats: each figure depicted cost more than an average altarpiece by ordinary painters, including Caravaggio, whose fame came only centuries later.
In spite of all these confusing anecdotes, a look at the contracts on commissions for oil paintings of historical subject (religious and mythological) between 1550 and 1750 (from the late Mannerism to the entire Baroque age and the Rococò period), recently collected by the monumental art historical research of Spear and Sohm (2010), can provide a different view, suggesting that economic conditions and profit maximizing behaviour were crucial determinants of the contracts between these painters and their patrons, and that a strong competition between painters was affecting the equilibrium prices as we could expect in a full fledged market economy. We know this because most commissions were formalized in detailed contracts signed in front of notaries with validity throughout Italy, and defining the price and the mutual responsibilities of the artist with his workshop and of the patron. A lot of these contracts (or related documentary evidence) survived until today, which allowed Laura Pagani and myself to analyze this market with econometric techniques (see Etro, F. and L. Pagani, 2010, The Market for Paintings in Baroque Venice, WP 191, University of Milan, Bicocca, Dept of Economics).

What we found is that we are in front of one of the first markets in modern history for which the basic laws of economics and rational behaviour apply and explain with a certain precision the prices of these paintings. After taking into account obvious price differences due to the different quality of painters as perceived at the time (whose proxy was their average annual income), we find a number of interesting relations between the price of paintings and quantifiable features often linked to demand and supply conditions. For instance, one finds a positive and concave relation between prices and size of the paintings, which reflects economies of scale in their production: ceteris paribus, one more square meter increased the price of the average painting by 9 %. Other relevant explanatory variables include the placement of religious paintings in the churches (demand was more rigid for altarpieces, commanding higher prices, and more elastic for paintings on the nave, which could be substituted with different decorations), or the institutional nature of the commissioner (the Ducal Palace in Venice or St. Peters in Rome wanted and obtained more quality by paying artists a little more than the ordinary market: a sort of efficiency wage mechanism).

More surprisingly, we find evidence of simple solutions to the moral hazard problem emerging between patrons and artists. Large commissions for oil paintings of historical subject required months or years of work and generated conflicts of interest for the simple reason that quality required time and effort, but could not be defined in a contract. We support the idea that patrons and artists adopted a typical solution to the moral hazard problem pointed out in the standard literature on principal-agent contracts (the informativeness principle of Holmstrom, 1979): prices were made conditional on measurable features of the paintings which were positively correlated with quality. In the case of historical paintings, this was possible through the number of human figures (as the more than fifty present in the Veronese’s paintings), which was not equivalent to the absolute quality of a painting, but was correlated with it for at least three main reasons. First, the subjects were biblical or mythological stories of man, women, saints, angels or mythological gods, where imagination and story-telling had a crucial function: therefore, one could safely conclude that the variety and complexity of the composition, summarized by the number of players, had a positive correlation with quality. Second, at the time there was a precise ranking in the aesthetic evaluation of subjects, with historical compositions, portraits, landscapes and still lifes in decreasing order of appreciation: a higher number of human figures was reducing the space available for other decorative subjects, and this was automatically enhancing total quality. Third, painters were often focusing their own effort on human figures, delegating less relevant parts to their own assistants: accordingly, a higher number of figures was a proxy for a wider direct intervention of the painters. What the data say is that, ceteris paribus, one more figure in the painting determined an increase of the price of 3 % in Venice and up to 16 % in the rest of Italy (notoriously, colour was more important in Venice and figure drawings in Florence and Rome).

Moving to macroeconomic aspects, we evaluate the impact of local demand shocks and aggregate demand shocks. Differences in local demand could be detected when looking at different destinations: demand was higher in big and rich cities as Venice compared to small provincial towns in the countryside. However, the mobility of painters was high, therefore we should expect that price differentials between high-demand and low-demand towns should be arbitraged away. Indeed, we find that prices in the countryside were much lower than in Venice, but, after controlling for paintings' and painters' features, all these differences disappear. The opposite holds for exports: paintings sent abroad were paid more, but simply because they were of different quality and painted by better artists than the others. Identical results emerge when we look at Rome, which was the leading international artistic centre during the Baroque age. Its prices were higher, but only because the best painters moved there. Taking into account all the differences, there was no way for a painter to earn more by changing the destination of his works. This suggests that entry in the local markets was endogenous and the opportunities for extra profits were eliminated through the mobility of painters.

While market forces appear to have been at work to induce price equalization in a largely integrated market, aggregate demand shocks exerted direct effects on prices. As an example, we study the impact of the plague, which hit Venice and all the surrounding regions in 1630, and we verify that its impact was to reduce prices in a significant way. The same happened in the other art centres as Florence, Rome and Naples, where, however, the plague arrived in 1656.

The Happy End of the EU vs. Microsoft Case with the Choice Screen for the Selection of Browsers

After a decade of contrasts, the EU vs. Microsoft antitrust case finally arrived to a conclusion with an agreement for which Microsoft will now distribute its operating systems with a "Choice Screen" for the selection of the web browser.

Consumers will be able to install immediately their favourite browser as the default between the 12 most widely used browsers (including Internet Explorer, of course, but also Firefox Mozilla, Google Chrome, Safari, Opera and others), rather than downloading it from the Internet through the pre-installed browser Internet Explorer as until now. The 12 browsers will be presented in a random order in a neutral initial page. This outcome follows a market test opened by the Commission between October and November and is a positive conclusion of a longlasting case, which opens a new era of collaboration between the market leader of the software industry and the European antitrust authorities.

Since we want to evaluate the economic consequences of this important step, we need to have a look at its background. In the last twelve years, Microsoft has distributed its operating system bundled with IE – and for eight of those twelve years, this has been done under a Consent Decree issued by the U.S. antitrust authorities. Even without the “choice screen” offering an opportunity to download rivals' browsers, alternative browsers can be easily installed on every PC. Competition in the field is on the basis of quality and functionality, at least since the introduction of IE in the mid-90s resulted in browsers’ prices dropping to zero. Recently Mozilla's Firefox has seen considerable success, with the gap between IE and Firefox's respective market shares narrowing with every passing month; Opera and Safari have consolidated their market positions, while Google's new Chrome quickly picked up a few percent of the global market following its launch in the fall of 2008. This tendency is even stronger in Europe, where the most recent data (from W3 Counter) show a large drop of the market share of IE (in all its different versions), from more than 80% a few years ago to 60.6% in July 2008 and 52.9% in July 2009, while Firefox grew from 29.7% to 31.4% in the last year, Safari moved from 1.9% to 3.1% and Opera from 1.1% to 1.2%, with the new Chrome reaching a market share of 3.1% in July 2009. In spite of this dynamic competitive scenario, following a formal complaint by Opera, in January 2009 the European Commission sent a Statement of Objections to Microsoft concerning the possible anti-competitive consequences of tying Windows with IE. The Commission was applying the judgment rendered by the Court of First Instance in the earlier European case. In that case, Microsoft was accused of excluding competition in the market for media players and was forced to commercialise a new operating system without its Windows MediaPlayer, which, by the way, no one purchased. In the Internet Explorer case, the focus was on the market for browsers, which is characterised by lively competition and increasing market shares for rival products.

To a large extent, the browser industry seems extremely competitive, with a firm that is the leader in a primary market (operative systems) pressured by entry and innovation in a secondary market (browsers). The latter is characterised by an increasing degree of product differentiation (in terms of performance and visual experience) and by demand that overlaps with the primary good (almost any PC has access to the Internet) and typically covers multiple browsers at the same time (Internet users often try and sometimes use different browsers on their devices). Under these conditions, tying becomes a normal aggressive strategy of the leader without exclusionary purposes, but aimed at strengthening competition and reducing prices in the secondary market to gain scale economies in the secondary market (against a modest sacrifice of profits in the primary market). As shown in "Endogenous Market Structures and Antitrust Policy" (International Review of Economics) , this is the classic situation in which the entry pressure in the browser market reinforces innovation by leaders and followers, producing important consumer benefits in terms of price, quality, and product variety. In such a scenario, it is hard to see other pervasive anti-competitive consequences of the Microsoft strategy. It seems unlikely that it could have a predatory purpose because any future increase in the price of IE is now unrealistic. Moreover, Microsoft mostly gains from the introduction and the diffusion of other browsers because this increases the quality of PCs and therefore the demand for Windows and Office applications, its main products. Finally, there are technological efficiencies from the design of an operating system including a browser. In conclusion, tying Windows with IE could have represented a constraint for competing browsers in theory but not practice; after all, IE could be substituted with another browser in a few seconds and freely even before the introduction of the choice screen.

With the new mechanism launched by Microsoft, minor browsers and even new entrants will get a boost, strengthening the competition against Microsoft. As a matter of fact, the choice screen will show up if IE has been installed, but if the computer manufacturers install an alternative browser, no choice screen will appear for the final consumers – this may represent a substantial advantage for Firefox, Opera, and other competing browsers. What is sure is that, given the choice screen prepared in the agreement between the European Commission and Microsoft, all the possible constraints to entry and competition in the browsers’ market will be eliminated. It will be interesting to verify the impact of this policy shift on the browser market.

The Future of IT

Intertic has recently proposed one of the first investigations of the economic impact on business creation in Europe of a new technology emerging in the software sector, cloud computing, through which information will be stored in servers and provided on line as a service to clients in a pay-as-you-go manner by leading companies of the software market as Google, Microsoft, Amazon and others. Firms will be able to adopt this service on demand, so as to avoid large up-front costs (that are currently necessary for hardware and software equipment) and spend in IT according to their production necessities. This will have a large impact on the cost structure and lower barriers to entry  for all firms, especially SMEs. The study projected over a five years horizon (by 2013) an increase in GDP growth of about 0.1-0.3 % in Europe if the cloud model was aggressively adopted around the region associated with a decrease in unemployment of 0,3-0.5 % due to the creation of around a million new jobs. According to the study, which is based on an analysis in the tradition of the endogenous market structures approach, this substantial impact will emerge through the creation of 300-400 thousand new SMEs in all sectors generated by the shift in the cost structure - for a technical treatment see the article on the Review of Business and Economics “The Economic Impact of Cloud Computing on Business Creation, Employment and Output in Europe” (June, 2009).

Today, some of the results of that study find support in an interesting new report issued by IDC, a company specialized in economic research on the software and hardware sectors. The new study about the economic impact of the global IT economy, “Aid to Recovery:  The Economic Impact of IT, Software, and the Microsoft Ecosystem on the Global Economy” (sponsored by Microsoft) focuses on fifty-two countries and emphasizes that IT is crucial in driving economic growth and creating new jobs (globally, IT spending and employment growth will outpace GDP and overall employment growth by a factor of three by 2013, creating 5.8 million new jobs and 75,000 new IT companies by the end of 2013), that software is the engine behind this growth and that the role of the leader of this market will generate a strong multiplier (the global Microsoft ecosystem of nearly 700,000 business partners will generate revenues of $ 537 billion in 2009 and for every dollar of Microsoft revenue in a local market, partners are expected to make $ 8.70).

Moreover, the IDC report emphasizes the novel impact due to the diffusion of cloud computing. According to the report, “the industry is flush with new technology, from new servers and client devices and new storage and networking technologies, to new software architectures and delivery models. Together, these new technologies are ushering in what may be a new paradigm of computing, known variously as cloud computing, cloud services, dynamic IT, and software plus services [which] involves the use of Internet-based services (including storage and applications) and intelligent clients (including handheld devices, PCs, and servers). The promise of this new way of computing is that businesses, governments, and educational institutions will be able to lower the capital costs of IT and increase the amount of their IT budgets that can be devoted to innovation, rather than to maintenance of legacy applications and infrastructure. IDC research indicates that as much as 75% of IT budgets is allocated into such application maintenance and infrastructure support.

This increased ability of organizations to vector IT dollars into innovation will have long-term economic benefits – from more efficient customer self service and faster product development, to lower barriers to entry for first time organizational and consumer users of IT. This new type of computing is in its infancy - while IDC estimates that this year it will account for just over 1% of IT spending, that percentage may triple over the next four years. Despite this small footprint, the economic benefits are significant. If that amount of IT spending is applied to innovation more effectively than it is today, IDC estimates that cloud services could add $ 800 billion in net new business revenues to the economies of our 52 countries between the end of 2009 and the end of 2013”, of which $ 210 billion in Europe.

Of course, this large impact is limited to the software ecosystem, and ignores the wider impact of cloud computing on all the other sectors, that was the interest of the Intertic study. Putting together the two impacts suggests that the contribution to the global recovery of the diffusion of cloud computing in the next years will be crucial.

The Economic Impact of Cloud Computing on Business Creation, Employment and Output in Europe (June 2009)

A new GPT (general purpose technology) can provide a fundamental contribution to promote growth, competition and business creation. This was the case of the Internet in the 90s, but a new interesting example is now given by the introduction of "cloud computing", an Internet-based technology through which information is stored in servers and provided as a service and on-demand to clients. Its impact will be spectacular on both consumers and firms. On one side, consumers will be able to access all of their documents and data from any device (the personal laptop, the mobile phone, an Internet Point..), as they already do for email services. On the other side, firms will be able to rent computing power (both hardware and software) and storage from a service provider, and to pay on demand, as they already do for other inputs as energy and electricity. The former application will affect our lifestyles, but the latter will have a profound impact on the cost structure of all the industries using hardware and software, and therefore it will have an indirect but crucial impact on business creation and on the macroeconomy.

The Endogenous Market Structures approach provides the tools to evaluate the economic impact of the introduction of cloud computing. Before showing this, however, we need to describe further the nature of this new GPT. Many hardware and software companies are currently investing to create new platforms able to attract customers "on the clouds". These "cloud platforms" provide services to create applications in competition or in alternative to "on-premises platforms", the traditional platforms based on an operating system as a foundation, on a group of infrastructure services and on a set of packaged and custom applications. The crucial difference between the two platforms is that, while on-premises platforms are designed to support consumer-scale or enterprise-scale applications, cloud platforms can potentially support multiple users at a wider scale, namely at the Internet scale.

Currently we are only in a phase of preparation with a few pioneers offering services that can be regarded as belonging to cloud computing. Many large high-tech companies are building huge data centres loaded with hundreds of thousands servers to be made available for customer needs in the near future. The first mover in the field has been Amazon, that provides access to half a million developers by way of Amazon Web Services. Through this cloud computing service, any small firm can start a web-based business on its computer system, add extra virtual machines when needed and shut them down when there is no demand: for this reason the utility is called Elastic Cloud Computing.

Google is also investing huge funds in data centres. Already nowadays Google Apps provides word processing and spreadsheet applications online, while the software and data are stored on the servers. Even the search engine of Google or its mapping service can offer cloud application services. For instance, when Google Maps was launched, programmers easily found out how to use their maps with other information to provide new services.

Other software and hardware companies have been actively investing in cloud computing. Notice that cloud computing implies outsorcing of both software and hardware, therefore it should not be surprising that hardware producers like Dell, Hewlett-Packard, Cisco and IBM are investing in the field as well (and even producers of consoles for videogames may switch to games in the clouds in the near future). Social networks have moved in the same direction turning into social platforms for consumer based applications, with Facebook in the front road (with its 200 million or more subscribers and an impressive amount of information available). Yahoo! is developing server farms as well. Oracle has introduced a cloud based version of its database program.

The leading software company, Microsoft, has started later but with huge investments in the creation of new data centres. In the fall of 2008, the leading software company has introduced a cloud platform called Windows Azure, currently available only in a preview version. Azure is able to provide a number of new technologies: a Windows-based environment in the cloud to store data and to run applications, an infrastructure for both on-premises and cloud applications, a cloud based database, and an application tool which allows to synchronize and constantly update data across systems joined into a "mesh". Moreover, Windows Azure provides a browser-accessible portal for customers: these can create a hosting account to run applications or a storage account to store data in the cloud, and they can be charged through subscriptions, per-use fees or other methods.

In front of this rapid evolution, it is crucial to understand the economic impact of the introduction of this GPT. Its main economic benefit is associated with a generalized reduction of the fixed costs of entry and production, in terms of shifting fixed capital expenditure in ICT into operative costs that depend on the size of demand. This contributes to reduce the barriers to entry especially for SMEs and intensifies the business creation process. The consequences on the endogenous structure of markets with large needs of hardware and software is going to be substantial, with entry of new firms, strengthening of competition, reduction of the mark ups, and with an increase in average and total production.

We have employed an adapted version of the model of Etro and Colciago (2007) with accumulation of ICT capital (hardware and software) and fixed costs of entry in terms of the final good, to estimate the impact of a gradual diffusion of cloud computing. This is translated into a slow reduction of the fixed cost of entry, which endogenously generates further investments in business creation. The calculations based on a model calibrated on E.U. countries show a significative impact. Starting from conservative assumptions on the gradual reduction of the fixed entry costs due to the adoption of cloud computing, the exercise suggests that the diffusion of this innovation may induce the creation of 100-400 thousand new SMEs in the whole Euroarea, adding a few decimal points to the growth rate and about a million new jobs in the medium run.

Part of the positive effects of cloud computing are going to be positively related to the speed of adoption of the new technology. For this reason, our investigation suggests that policymakers should promote as much as possible a rapid adoption of cloud computing. Concrete possibilities include fiscal incentives and a specific promotion of cloud computing in particular dynamic sectors. For instance, governments could finance, up to a limit, the variable costs of computing for all the (domestic and foreign) firms that decide to adopt a cloud computing solution. Moreover, they could introduce business-friendly rules for the treatment and movement of data between their country and foreign countries. These policies may be studied in such a way to optimize the process of adoption of the new technology and to strengthen the propagation of its benefits within the country. Moreover, in a context as the European one, smaller countries would be able to obtain larger gains from similar policies at least in the initial phase, because they would easily attract foreign investments from larger countries. In a period of increasing limits to other forms of fiscal competition, a policy of subsidization of cloud computing (without discrimination across firms of different member countries) could generate substantial capital flows toward countries with good general infrastructures. For instance, early adoption of these policies by small E.U. countries as Luxembourg or Malta could attract large investments and create wide effects in terms of output growth and job creation in these countries.

More generally, international policy competition for the subsidization of cloud computing solutions would generate positive spillovers across countries, and some coordination at the E.U. level would be welcome.

Competition and Antitrust Issues in the Browsers' Market (May 2009)

In the last twelve years Microsoft has distributed its operating system with the browser Internet Explorer and for eight of those twelve years, this has been done under a Consent Decree issued by the U.S. antitrust authorities. Nowadays, alternative browsers can be easily installed on every PC and competition in the field is on the basis of quality and functionality, at least since the introduction of IE in the mid 90s led to a drop of the price to zero. In the recent years Mozilla's Firefox has seen considerable success, with the gap between IE and Firefox's respective market shares narrowing with every passing month (see the figure below for world market shares). Opera and Safari have consolidated their market positions, while Google's new Chrome quickly picked up a few percent of the global market following its launch in autumn of 2008.

This tendency is even stronger in Europe, where the most recent data (from AT Internet Institute) show a large drop of IE's market share, from about 85 % a few years ago to 66 % in January 2008 and 55 % in March 2009, while Firefox has been growing up to 28 % in January 2008 and 35% in March 2009, Opera reached respectively 3.2 % and 4.1 % and Safari 2.1 % and 3 % (with Chrome at 1.5 %). Notice that browsers are now an integral part of computer experience and they have promoted the rapid development of all the Internet markets, starting with online sales and online advertising. These kinds of markets represent the main engine of innovation, and in times of crisis they contract as well, though they remain crucial drivers of the economic recovery.

It is odd, to say the least, that the European Commission has decided at this moment to pursue a preliminary investigation on Microsoft for abuse of dominance in connection with the integration of IE into Windows - the original complaint was by the competitor Opera, later backed by Firefox and Google. It is an issue already raised and solved in the U.S. Clearly, the Commission is applying the judgment rendered by the Court of First Instance in the earlier European case. In that case, Microsoft was accused of excluding competition in the market for media players and was forced to commercialize a new operating system without its media player - which, by the way, was not bought by anybody, except for a few hundred collectors. Today, the issue emerges with IE. As with media functionality, a domain that has seen a flourishing of competitors' products such as Apple's iTunes, despite the alleged anticompetitive conduct, the market for web browsers is marked by lively competition and a wide and easy diffusion (rather than foreclosure) of rival products. The market can be read as extremely competitive, with a leader in a primary market (Microsoft for operative systems) pressured by entry and innovation in a secondary market (browsers) to adopt aggressive strategies. These include tying of the two products to be sold at a very low price and heavy investments in R&D to preserve the leadership. The consequence has been a strong competitive and innovative pressure from other browser producers, with Firefox as the main alternative to IE, and important benefits accruing to consumers in terms of price, quality and product variety.

Beyond this, there do not seem to be solid economic motivations in support of the Commission's thesis. It seems unlikely that Microsoft's strategy can have a predatory purpose because any increase in the price of IE is now unrealistic (meaning recoupment is impossible). Moreover, Microsoft mostly gains from the introduction and the diffusion of other browsers because this increases the quality of PCs and therefore the demand for Windows, its main product. Many users try different browsers before choosing their favorite one, and it is hard to imagine a more competitive scenario than this - notice that the new version of Windows allows users to turn off applications such as Media Player and IE, avoiding any limit to the exclusive use of competing applications.

Finally, there are clear (technological) efficiencies from the design of an operating system including a browser, which, as a matter of fact, can be substituted with another one in a few seconds and freely. In conclusion, there are no reasons for which the tying of Windows and IE could harm consumers, whose interest (not the interest of the competitors) should drive antitrust policy.

If the Commission is going to pursue this direction, most likely it will fine Microsoft and force it to commercialize a new operating system without IE (which, as it happened for the one without media player, will not be bought by anybody) or with the option to install other browsers (saving few seconds of free download). Apparently, such an outcome would not have any impact on consumers, but the uncertainty on the freedom of innovation and efficient product integration could reduce the incentives to invest in R&D for Microsoft, for all the software companies producing applications for Windows and IE, and for many other firms in similar situations, with harmful consequences for the future consumers.

Moreover, a "must-carry" remedy would strengthen the dominance of Google as a search engine, since Mozilla and Opera are currently paid to pre-set Google as the default search engine, and original equipment manufacturers would be paid to do the same in the future, so as to limit competition in the market for online advertising even more - not by chance, Google is heavily supporting the investigation on Microsoft, while advertisers and content providers fear such a bonanza for Google. These results are not what we expect from policymaking aimed at promoting consumer welfare and growth, especially during a crisis that should suggest other priorities for policymaking.

The Role of Market Leaders and IPRs Protection in R&D Investment

In a recent paper on "The Effect of Entry on R&D Investment of Leaders: Theory and Empirical Evidence" Dirk Czarnitzki, Federico Etro and Kornelius Kraft have provided new empirical evidence on the determinants of R&D investment and on the role of market leaders and of the protection of intellectual property rights. There is a long debate on the role of market leaders in investing in R&D. Following Arrow (1962), a popular view regards competitive pressure as being supportive for innovative activity and claims that incumbents tend to be less innovative than the outsiders. This article reconsiders this view both from a theoretical and an empirical perspective. Following the endogenous market structures approach, a theoretical model provides hypotheses on the incentives to invest in R&D for incumbent leaders and outsiders. It establishes the crucial role of entry pressure on the behavior of leaders and followers. In markets with endogenous entry each firm tends to invest less, but when the incumbents have a leadership position in the competition for the market, they tend to invest more than the average firm. Hence, the endogenous market structures approach obtains the exact opposite of the commonly held view associated with Arrow.

These predictions are tested through a statistical (Tobit) model for R&D intensity (RDINT). The empirical investigation is based on a unique dataset on the German manufacturing sector, the Mannheim Innovation Panel from 2005, which includes a wide number of firm level data and answers to a survey conducted by the Centre for European Economic Research (ZEW) with a special focus on innovation. Besides we summarize the number of firms per industry, the percentage of leaders (defined below) and the average R&D intensity. The Information and Communication Technology sector and the Instruments/Optics industry exibit the higher rate of investment in R&D. A novel aspect of this empirical approach is given by the fact that the same firms provide a subjective view on the key determinants of R&D intensity, the entry pressure and the leadership. Rather than determining arbitrarily the size and composition of a market, assigning a degree of entry intensity in a discretionary way, and assigning a status of leadership on the basis of predetermined variables, using the questionnaire of the Mannheim Innovation Panel allows the firms to identify the size of their main market, the existence of an endogenous threat of entry in the market and the identity of the leader in the market. The key variables identify the existence of endogenous entry pressure (ENTRY) and the status of market leaders (LEADER). Control variables include employment (EMP), capital intensity (KAPINT), a measure of the firms’ patent stock (PSTOCK), the Herfindahl index of concentration (HHI) and sector dummies.

The independence of the entry variable from the dependent variable, R&D intensity, is supported through an instrumental variable analysis and a number of exogeneity tests - instruments for entry are a default index, the minimum efficient scale (MES) and dummy variables on the importance of substitutability between products and advertising. Descriptive statistics tell us that the average firm invests almost 2.3 % of its sales in R&D, employs 300 workers with a capital endowment of 78 thousand Marks each, and 8% of the firms are leaders in their main market.

The main regressions for R&D intensity adopt different technical assumptions on the statistical properties of the relations under investigation. In a first work they propose the homoscedastic Tobit model and find that R&D investement decreases as the threat of entry increases. The leaders' investment does not differ from that of the outsiders. When we add the interaction term of leadership and entry threat, however, interesting differences occur. While the leader dummy is still insignificant, we now find that leaders who are faced by potential entry invest more than the outsiders. The results remain robust when we control for prior R&D using the patent stock. The patent stock is highly significant and positive, confirming that firms receiving stronger protection of IPRs through patents tend to invest more - alternatively, firms that (successfully) conducted R&D in the past will also invest more in the current period.

With respect to the other covariates, we find a positive and concave relation with employment, while capital intensity is positively significant in all models, and the Herfindahl index is always insignificant. Furthermore there are differences in R&D investment across industries. The industry dummies are always jointly different from zero in the regressions, and our results emphasize a high correlation of R&D spending with firms of the Information & Communication Technology.

The assumption of homoscedasticity is rejected for all models, therefore we move to the heteroscedastic Tobit model. The industry and firm size dummies are always jointly significant. The main results are robust to the model modification. Leaders, in general, are still not differently investing in R&D than the outsiders, and R&D investment is negatively affected by the entry variable. Leaders that suffer from entry threat also invest more than outsiders in the heteroscedastic version. There are no dramatic changes in the estimates of the other covariates. The patent stock is still highly positively significant, confirming the positive relation between IPRs protection and investment in R&D. The estimated employment effect remains stable, however, the positive relationship between R&D and capital investment becomes statistically insignificant, once we correct for heteroscedasticity. To sum up, our findings on entry are in line with the hypothesis that investment decreases with the strength of endogenous entry threats. Furthermore, incumbent leaders do not differ in their investment from other firms (LEADER is insignificant), unless they are threatened by endogenous entry. Then the negative investment effect is offset (see the positive sign of the interaction term LEADER×ENTRY). Thus, incumbents invest more than the outsiders under endogenous entry threat.

In line with the theoretical prediction of the endogenous market structures approach, the competitive pressure of the potential entry of other firms induces the market leaders to invest in R&D more than any other firm. This implies that we may have to change our way of looking at persistent market dominance: this may be the result of strong competitive pressure rather than of market power. Finally, the size of the firms and their patent stocks, proxy for the protection of IPRs, are positively related to R&D intensity. Therefore, markets with large incumbent leaders pressured by endogenous entry (not in the production process but in the innovative process) and whose IPRs are well protected may be more innovative than other markets.

The Economics of Online Advertising

The merger between Microsoft and Yahoo!, proposed by the former and provisionally rejected by the latter in February 2008, and the merger between Google and DoubleClick, announced in April 2007 and currently under the scrutiny of the European Commission, will be a turning point in the fight to dominate the Internet. The first merger would produce substantial synergies between two companies active in complementary markets and, most of all, could create a strong competitor against Google for search engines and related on line advertising. The second merger would combine Google's dominance in pay-per-click Internet advertising with DoubleClick's dominance in ad serving services. Consumer groups have aggressively pushed regulators to reject the Google merger on the grounds that it would spawn a privacy nightmare, but after the strategic offer of Microsoft for Yahoo!, it can be useful to examine the issue from a purely economic point of view. When does a merger involving a market leader hurt consumers? A pre-condition for this is that the merger relaxes competition between two firms and leads them to increase prices. Two further requirements are needed: first, the merger doesn’t create efficiency gains; second, it doesn’t attract entry of new firms. Of course, the extent to which a merger leads to price increases depends on multiple factors. First, high substitutability between the products of the merging firms brings higher incentives to increase post-merger prices (after all, firms producing unrelated goods would have no reason to increase their prices). Second, when price-cost margins are high, it is more profitable to increase prices. Third, when the firms operate in a multi-sided market (as a software platform which charges both publishers and advertisers), a price change can optimize network effects between sides leading to higher profitability.

A merger between Microsoft and Yahoo! would mainly create synergies in R&D efforts without consequences on the prices of the main products of Microsoft (its operating system and Office) and Yahoo! (Internet services), which are complements and not substitutes. Antitrust authorities would hardly contrast such a merger. Moreover, it would allow Microsoft and Yahoo! to join their forces and develop search engine capabilities and online advertising services able to represent an alternative to Google, so as to strengthen competition in the Internet. What about the merger between Google and DoubleClick? As well known, Google dominates the lucrative business of placing text ads next to search engine results. DoubleClick leads the business of placing banner ads on publishers, dominating the direct advertising channel, that is the valuable ad inventory that large web publishers directly negotiate with the advertisers. But this is not the end of the story, because most of the advertising space available on websites cannot be sold directly: most of it is sold through intermediaries that buy the so-called “remnant” ad inventory from web publishers and sell it to advertisers. In this huge “indirect” market Google and DoubleClick have been strongly competing, with Microsoft and Yahoo! playing a marginal role until today.

Google provides a vertically integrated intermediation platform between online publishers and advertisers: its AdSense reaches more than 80 % of the revenue in the indirect channel with integrated ad networks, again with Microsoft and Yahoo! trying to catch up. This platform targets advertising to the relevant websites and pays web publishers a percentage of its revenues. Meanwhile, advertisers buy inventories from the platform through bids on the keywords that match the content of the webpages. DoubleClick offers a substitute product, DART for both publishers (DFP) and advertisers (DFA). The publisher tool, in particular, manages the inventory of a website, receives the ads from ad networks and delivers them in the relevant inventory for a percentage of the advertising price. The market share of DFP is around 75 %. Since almost 60% of online advertising taking place through the indirect channel adopts integrated intermediation, Google controls about half of this global market and DoubleClick about a third of it. After the merger, they will control at least 80 % of the worldwide market for online advertising, with Microsoft and Yahoo! left behind.

The two services offered by Google and DoubleClick are highly substitutable (many web publishers use both for different inventories in the same website) and alternatives are hardly available. Switching to a different publisher tool involves high sunk costs in terms of investment in software, training of the staff, coding all of the publisher’s web pages, transferring ad campaigns to the system…These high costs, together with the difficulty for other companies, even Microsoft and Yahoo! until now, to build alternatives have represented a substantial limit to entry of competitors.  Consequently, after the merger (which would not affect the marginal cost of production, already close to zero), Google will be able to increase the price of DFP services, and be sure that most of the lost customers will switch to AdSense. The profitability of this strategy would be enhanced further because of the high margins and of the network effects that Google could enjoy by increasing its market share (more publishers, more advertisers, more searches and so on). Moreover, higher prices of DoubleClick may jeopardize competition and innovation of other firms competing with Google’s integrated channel, and the dominance of Google after the merger would be strengthened once again. But all of this doesn’t take the Microsoft move into account.

The reply of Microsoft to the Google expansion is crucial: a merger with Yahoo! could create the conditions to compete effectively with the dominant force of Google in online advertising. As always in these cases, aggressive competition will reward consumers with better products and lower prices.

Trade, Growth, Business Cycle and Entry

At the Bi-annual TEM Lecture of the Catholic University of Leuven held on December 12, 2007, Prof. Etro, President of Intertic presented the basic insights of the Theory of Endogenous Market Structures and its applications. A technical version of the Lecture focusing on the macroeconomic applications of this approach can be found in Endogenous Market Structures and Macroeconomic Theory (2007, Tijdschrift voor Economie en Management, Vol. 52, 4, pp. 517-40). This work introduces the most recent theories of growth, international trade and business cycles taking into account market structures which depart from the perfectly competitive paradigm and endogenize strategic interactions and entry. In this sense, it goes beyond both the neoclassical theory and the more recent applications of the theory of monopolistic competition to macroeconomics. Our approach, that we define as the EMS ("endogenous market structure") approach, introduces standard theories of imperfect competition, as Cournot, Bertrand and Stackelberg competition in a macroeconomic framework where entry in the markets is free but constrained by costs of entry. The work builds on the microfoundations developed in recent industrial organization research, and applies it to revisit the theory of endogenous growth, the theory of international trade and the theory of real business cycles and to derive a number of policy results.

The foundation of the modern economic theory is based on neoclassical models developed within the constant returns to scale / perfect competition framework. In this framework, entry of firms is endogenous in the sense that all firms expect zero profits at each point in time, but the market structure is indeterminate: whether one or infinite firms produce each good is irrelevant as long as there are constant returns to scale, and strategic interactions do not play any role. This happens in the standard theory of real business cycles and in the neoclassical theory of trade (which are both based on perfect competition in the goods markets), and even in the standard theory of Schumpeterian growth (based on constant returns to scale and no arbitrage condition determining the aggregate investment in R&D). In the last three decades, economists have emphasized the importance of increasing returns to scale and market power, and these factors have been introduced and widely used in the modern theories of international trade (starting with Krugman, 1980), of the business cycle (starting with Blanchard and Kiyotaki, 1987), and of endogenous growth (starting with Romer, 1990). Nevertheless, most of the literature has adopted the monopolistic competition framework of Dixit and Stiglitz (1977) in which strategic interactions do not play any role given the high number of players, and the number of firms has been often kept exogenous (typically in the theory of business cycles). Therefore, the macroeconomic literature has systematically neglected either the strategic interactions between firms or the endogeneity of entry. We believe that the lack of consideration for the rationality of the entry decisions and of the interaction between these and the strategic decisions of the firms are a crucial limit of the modern economic literature, especially because the rest of it is largely relying on the rationality of all the agents and of their expectations.

Recent microeconomic investigations on market structures where entry is endogenous have provided a number of applications for the theory of industrial organization, especially for the understanding of investments in R&D and in advertising, of the determinants of the financial structure, and of the behavior of market leaders (with particular reference to predatory strategies, price discrimination, bundling and vertical restraints), of the effects of mergers and of the effectiveness of price fixing agreements (which of course have crucial consequences for antitrust policy). The endogenous entry approach, however, can be relevant also for the analysis of macroeconomic issues.

The main role the EMS approach for macroeconomic analysis is to clarify a new channel through which competition in markets affects the aggregate economy. We may describe it in a simple way taking in consideration the theory of business cycles. Most of the modern theory of the business cycle, starting with Kydland and Prescott (1982), is based on the constant returns to scale/ perfect competition/ flexible price framework of the so-called Real Business Cycle literature. Since a wide macroeconomic evidence suggests the relevance of departures from the perfectly competitive model, economists have introduced increasing returns to scale and monopolistic competition and have widely used them in the modern general equilibrium new Keynesian literature (together with price rigidities for monetary analysis). Nevertheless, strategic interactions have been neglected because they are absent in the standard monopolistic competition model, and because competition in quantities has never been taken in consideration in a literature that was mainly interested in introducing price rigidities to study the real effects of monetary shocks (and therefore always focused on price choices), while entry has been almost always considered exogenous because the crucial consequences of price rigidities (due to small menu costs or imperfect price adjustments) depended on the existence of market power and positive profits of the firms. As a consequence, macroeconomics has been virtually silent on the fluctuations of the number of firms, on the degree of competition in the markets, on the endogenous mark ups, and on the interaction between these fluctuations and those of the aggregate variables as output, consumption, and employment. To see how the endogenity of the market structures can play a crucial role in propagating the business cycle beyond what happens in standard neoclassical models, we will consider the impact of a standard productivity shock. Suppose that the marginal cost of production exhibits a temporary reduction in all the sectors (for instance because of a temporary reduction in the oil price). In a perfectly competitive sector, all prices equate the marginal costs of production and the shock is instantaneously transferred to the prices: since the price reduction follows the reduction in the marginal cost and is temporary, consumption has a temporary boom which in turn pushes the economy. Now consider sectors characterized by few firms competing in quantities and entering endogenously in the markets. Since firms price at a mark up on the marginal cost, the shock has an initial positive impact on the individual profits, which attracts entry of new firms. Entry strengthens competition which reduces the equilibrium mark ups. This in turn implies that the prices are reduced by more than the reduction in the marginal cost, and the boom in consumer demand is therefore magnified by the competition effect (compared to a perfectly competitive economy). Of course over time the strengthening of competition reduces the individual profits and brings back entry to the initial level. This set up allows to study a number of policy issues including the effects of fiscal and monetary policy. For more on this see Endogenous Market Structures and the Business Cycle.

The same mechanism works in an international context as well. Here, the EMSs approach emphasizes a new form of gains from trade, beyond the traditional one identified by Krugman and associated with the increase in varieties enjoyed by consumers after a country opens up to trade. When strategic interactions are relevant because the number of producers in each sector is limited, opening up to trade enlarges the set of competitors and strengthens competition, which reduces mark ups and prices in turn. This competition effect limits entry, therefore the gains from trade due to more varieties decrease and the gains from trade due to lower prices increase. Moreover, one can study the impact of shocks in an open economy context as well. For instance, a supply shock in one country may induce further entry of its firms in the local sectors for non tradable goods or in the global sectors for tradable goods, reducing the respective mark ups and magnifying the impact of the shock in the domestic market or in the global market as well. Finally, the EMS approach allows to address in a new way a number of aspects of trade policy. One of the most important results is the proof of the general optimality of export subsidies for firms competing in global markets with endogenous entry (against the traditional ambiguous results). For more on this see Endogenous Market Structures and Strategic Trade Policy.

Finally, entry driven by profitable opportunities is what drives investments in R&D and therefore technological progress, and is at the basis of the theory of Schumpeterian growth. Applying the EMS approach to competition for the market in the presence of sequential innovations, allows to open the black box of the engine of growth and study a number of new issues. For instance, our approach allows to identify how many firms and which one invest in R&D, determine the incentives of the technological leaders to invest, derive the general optimality of R&D subsidies and characterize the optimal international organization of R&D policy. For more on this see Growth Leaders.

Microsoft and EU Competition Policy

In March 2004, the European Commission (EC) announced its ruling against Microsoft and imposed an unprecedented fine of 497 million EUR. The EC 1) mandated the licensing of certain software source code for server applications, and 2) ordered the company to sell a version of Windows in Europe without Microsoft’s Windows Media Player. In July 2006, the EC fined Microsoft 280.5 million EUR for failing to fully comply with the 2004 ruling. Microsoft appealed to this decision to the European Court of First Instance (CFI).

With the verdict of the CFI  approaching, it seems an appropriate time to remind the public of the famous Microsoft versus EU case by briefly exploring the potential economic consequences of the verdict. So what does economic science in general, and industrial economics in particular, tell us about the possible results of EU decisions on these matters?  

Firstly, let us look at the nature and characteristics of the dynamic markets of the New Economy, such as the market for software and particularly for operating system software. The supply side of these markets are characterized by high overall costs of production with constant (and close to zero) costs to produce additional units of the product. There is substantially open access by competitors able to create new software and the relevant market is the whole world. Protection of intellectual property rights (IPR) is essential due to intense innovation activity and resulting patents, copyrights and trade secrets. As for the demand side, the market for operating systems is characterized by strong network effects; as more people use a particular operating system, its value increases for both consumers and software developers. Thus it follows that the issue here is primarily focused on competition for-the-market rather than in-the-market. In such circumstances, the relevant economic theory predicts that the market will be rather concentrated, usually dominated by the market leader who would produce for the whole or largest part of the market, adopt aggressive pricing structures and direct a significant amount of money into innovation. Hence, it should not be surprising that, say, in the market for operating systems there is a very strong player, Microsoft, with a large market share. Since the entry into this market is free, the leader has to keep prices low to control for the entry of competitors and to keep upgrading the quality and functionality of its products. Thus in such an environment, there is a clear social value of market (and technology) leadership – low prices and enhanced investment in innovation and product quality! (To be sure, market leaders may also abuse their market position. For instance, in US Microsoft used certain licensing practice with PC original equipment manufacturers and contracts with internet service providers that were anticompetitive violating US competition regulations.)

So let us now look at the first EC verdict and its likely consequences. The EC requested compulsory licensing of the Microsoft software code to its direct competitors. The first and most obvious consequence of this will be a general disincentive to invest in innovation and a dangerous signal to other innovative firms in the EU that the EC has ultimate right to decide when to force a company to reveal the fruits of its long and hard research and development (R&D) efforts and related heavy investments. Given that investment in R&D and innovations is a key vehicle of the economic progress, and that this fact was explicitly acknowledged in the famous Lisbon strategy, such an EC verdict looks even more puzzling and contradictory.

Moreover, by requiring compulsory licensing, the EC not only shakes the foundations of sound IPR but revokes one of the basic property rights – freedom to contract. Such a decision also ignores international treaty obligations designed explicitly to prevent this type of broad-based compulsory licensing of intellectual property rights (see Article 13 of the WTO’s Agreement on Trade-Related Aspects of Intellectual Property Rights).

Secondly, and at a more subtle level, revealing the source code through compulsory licensing to competitors would remove or weaken the market leader and that would in turn enable more firms to stay in the market or/and enable the existing firms to raise the price and enjoy quieter lives. Thus it will lead to the change in what industrial economists refer to as toughness of price competition making it softer. Moreover, as innovation intensity in an industry is positively linked with the toughness of price competition, the industry level of R&D spending and innovations will almost certainly decline. The effect will be the exact opposite of alleged EU intentions to enhance  industry innovation. The consumers will be the biggest losers in the end.  

As for the second verdict, much like in the first one, the EC decision ignores the very nature of the competition on the dynamic software markets relying on the standard tying argument that considers tying illegal practice per se. The verdict requests Microsoft to offer a version of Windows in Europe without the media playback functionality that was designed as part of the operating system, even though this will harm consumers giving them a less capable product and hamper the interaction between Windows and applications that are built to run on it. Thus, like in the case of the EC’s first decision, requiring Microsoft to develop and market a version of Windows without an integrated media player, steps on Microsoft’s IPR to control its own trademark, effectively creating a compulsory licensing regime with all the consequences described above - In fact, Microsoft did prepare and commercialize a version of Windows without an integrated media player in Europe. However, demand for this reduced version of Windows (without the integrated media player) has been virtually zero in Europe!.

The victims in a standard tying case are the consumers who are forced to pay for what they do not want, and the excluded competitors who cannot do business with the tied consumers. None of this is present here. Firstly, there are many other high-quality media players around (Quick Time, Real Player, Winamp, VLC, BSPlayer, etc.) and some of their producers do the same kind of tying. In short, there is no foreclosure of competition going on here. Secondly, there are substantial benefits that the software developers, consumers and others in the PC industry derive from integration of media playback functionality in Windows since this integration has made PCs more attractive and easier for consumers to use and it has made Windows a better platform for software developers and web-based content providers. Therefore this is not a classical case of tying but it rather promotes the idea that product integration increases consumer welfare by adding functionality; this is often the result of market competition, not the lack of competition.

Given that nowadays more and more innovations occur via feature integration, policymakers must not presume that product integration amounts to tying that is per se illegal. Rather, policymakers should embrace an approach that considers the pro-consumer and pro-competitive effects of product integration.

As for the economic consequences of this second EC verdict, such an approach by the EC could easily undermine commercial practices in a wide variety of industries and generate uncertainty whether any market leader can be confident when integrating a new component or features in the future.

The lessons from the above discussion for EU competition policy are clear. It should promote and not upset the natural process of competition in the dynamic markets.  Indeed Antitrust law sometimes does more harm than good, prompting one commentator to say that “in their static way, [competition policy] ban activities for which officials and scholars have not yet discovered the rationale; markets are more dynamic than that“. The 2005 revised Lisbon Strategy aims to make Europe a more attractive place to invest and work; promote knowledge and innovation; and create more and better jobs. However, the EC needs not only to generate more innovation in its productive sector but also be more innovative in its regulatory legislation. One of the key regulatory prerequisites in this respect is sound competition policy. Much like US antitrust legislation, it should focus on consumers’ welfare, protections of consumers and the very competition rather than on protection of competitors and their market shares. It also must ensure that there are proper incentives for creating intellectual property that enables the monetization of intellectual property through competition rules that allow businesses to combine and distribute innovations in new ways.

Empirical Predictions of the Theory of the Endogenous Market Structures

The new book Competition, Innovation, and Antitrust by Federico Etro, President of Intertic is finally available. In many occasions our website has described and commented the theory of market leaders and the endogenous entry approach to antitrust. A lot of empirical research to test that theory is needed, and here we provide a short guide to the empirical analysis of these issues.

The primary empirical implications of the theory of market leaders concern the discrimination between alternative strategies adopted by market leaders facing an exogenous or an endogenous number of competitors. Therefore any empirical investigation of its results should be based on a non-trivial analysis of the entry conditions. Most of the empirical work on the reaction of incumbents to entry takes entry as given; the problem of endogeneity of entry is briefly discussed in Thomas (1999), who examines the reactions of incumbents in the US ready-to-eat cereal industry. He finds that incumbents are accommodating between themselves, but they adopt aggressive pricing to face new entrants. This result may be due to the typical behavior of market leaders facing endogenous entry: while price competition would lead leaders to be accommodating when facing an exogenous number of firms, an aggressive pricing strategy is forced by endogenous entry.

Some markets are clearly characterized by exogenous constraints on the number of firms: for instance, when there are legal barriers to entry, when only a restricted number of firms have licenses, patents or other essential inputs needed to produce a certain good or service, or when a certain activity is confined to a predetermined number of subjects with special permission, we are in front of a market where the number of competitors is exogenous. Some other markets are clearly characterized by entry open to domestic and international firms that changes over time, reacts rapidly to variations in demand and supply conditions, and reduces to zero the supra-normal profits of the marginal entrants: when this is the case, we are in front of a market where the number of competitors can be regarded as endogenous. In other markets the situation is not so clear, therefore we need to add a few remarks to clarify how one could approach the concept of entry in an empirical investigation aimed at testing the theory of market leaders.

First, there are markets in which processes of liberalization or deregulation have radically changed the entry conditions, from a situation with a fixed number of competitors to one with endogenous entry: these shocks may represent interesting natural experiments for a test of our theory. Spiller and Favaro (1984) have studied the behavior of market leaders in the process of deregulation of the commercial banking sector (with data on the Uruguay experience in the late 70s). Their "results are consistent with a von Stackelberg type of industry where the degree of oligopolistic interaction among the leading firms is reduced as a consequence of the relaxation of the legal entry barriers." In recent times, it would be interesting to verify the impact of online banking, which has dramatically increased entry (also of international banks) and competition in the banking sector of many countries: in such a case, the theory of market leaders would imply the emergence of leaders offering better conditions on savings accounts (think of the Orange Savings Account by ING Direct).

Other exogenous shocks leading to entry of new firms may create interesting natural experiments. Goolsbee and Syverson (2006) have examined how incumbents respond to the threat of entry of competitors. They use a case study from the American passenger airline industry, namely the evolution of Southwest Airlines' route network between 1993 and 2004, to identify routes where the probability of future entry rises suddenly for major US carriers as American, Continental, Delta, Northwest, TWA, United and US Airways. Notice that this is a market characterized by a limited degree of product differentiation (mostly driven by frequent flyer miles programs), by U-shaped cost functions, and by competition in prices between airlines active on each route. When Southwest begins operating in airports on both sides of a route but not the route itself, the probability that it will start flying that route in the near future increases. Examining the pricing of the incumbents on threatened routes in the period surrounding these events, and controlling for a number of airport-specific operating costs, it emerges that incumbents cut fares significantly when they have faced an exogenous number of competitors in the past, but expect endogenous entry in the future. More exactly, 3 to 4 quarters before Southwest starts its operations on a new route, the fares of the market leader on that route have fallen about 7 %, and by 1 to 2 quarters prior, they have fallen 10 %, while when Southwest actually starts operating, prices are almost 12 % lower, and after entry the total drop in fares is about 26%. However, price cuts (in the run up to Southwest starting operations) are absent in low-concentration routes, that is in the routes where, most likely, entry was already free. Furthermore, the empirical analysis of Goolsbee and Syverson (2006) reveals a switch toward the aggressive behavior of market leaders facing endogenous entry and without exclusionary purposes. They test whether there are differences between the reactions of incumbents when pre-emptive deterrence is possible (Southwest's entry is likely after starting operations on both sides of a route, but could be avoided through price cuts) and when it is not (Southwest's entry in the route is announced simultaneously with its start of operations in the airport). The pricing strategies of the incumbent are quite similar in the two samples, and the conclusion is that "even on routes where deterrence is impossible, the incumbents engage in the same pre-emptive price cutting behavior. Thus the behavior cannot be motivated as seeking to deter entry." Following the traditional theory of price leadership which generates an accommodating behavior of the leaders, Goolsbee and Syverson (2006) are forced to conclude that "the firms are instead accommodating entry", which can be quite misleading since these leaders are radically reducing their prices rather than increasing them. The paradox disappears once we realize that we are in front of price leaders facing endogenous entry, and that our theory tells us that these leaders should be aggressive and also reduce their prices when they are not trying to deter entry.

A related situation emerges in markets with IPRs: when a patent or a copyright expire, endogenous entry suddenly takes place, and the effect on the behavior of the incumbents could be used to test our results. A similar experiment, which could be re-interpreted in the terms of our theory, is in Ellison and Ellison (2007). They examine the behavior of market leaders in the pharmaceutical industry in the periods around the expiration of patent protection for their patented drugs. Advertising by incumbents declines before entry occurs. Drug prices always decline when entry occurs, and also before the expiration of the patent, but only if the probability of entry is high. Again, these preliminary results are consistent with an aggressive strategy by the leaders, which is induced by endogenous entry. Bergman and Rudholm (2003) examine the Swedish pharmaceutical market where the commitment to a low price is enforced by a particular regulation (for which, if a price is reduced, it is impossible to increase it again). They show that the prices of the incumbent leaders fall at the time of the patent expiration (even before actual entry occurs) by 5-8% for products with small sales volumes.

Another interesting situation that could be used for empirical purposes emerges in markets that, after a period of protection from international competition, are opened to entry of foreign firms: this represents another experiment in which endogenous entry suddenly takes place.
In all of these examples, one can compare the behavior of market leaders relative to the behavior of the followers before and after endogenous entry takes place. Ideally, any empirical methodology should control for the differences between the leader and all of the other firms (our basic testable predictions refer to the behavior of leaders facing competition from equally efficient firms). Thomas (1999) has studied the behavior of incumbents in the ready-to-eat cereal industry, which is characterized by competition in prices, product differentiation and large advertising. The main result is that "incumbent firms accommodate one another on price but respond aggressively using advertising. Entrants on the other hand are more likely to be met with an aggressive price response." The difference in the behavior of market leaders may indicate a switch in strategy from a situation with an exogenous number of competitors (the incumbents) and a situation where entry (of new firms) is endogenous.

Second, there are intermediate situations in which entry can be regarded as exogenous in the short run, but endogenous only in the medium-long run simply because entry takes time. This time can be different in different sectors: rather than being a limit to the testability of the theory of market leaders, this variability in the degree of reactivity of entry to profit opportunities could be exploited as a useful control variable, especially if one has good instruments available to identify the entry conditions.

Third, one has to take into consideration entry in the competition in the market but also entry in the competition for the market: the former is visible and active in the same market, while the latter is often not visible because firms may be effectively competing for a market and investing in R&D, but they will not enter in the market until they actually develop a successful product.

Fourth, one has to distinguish between effective entry and potential entry: while the former is visible and the latter is not, the existence of potential entry is the essential element of a market in which entry is endogenous compared to a market in which the number of competitors is exogenous.

Another important preliminary issue concerns the form of competition in the market. It is well known that the difference between competition in prices and in quantities is more a theoretical abstraction than a clear-cut element of differentiation between sectors. However, there are some markets in which price choices are an essential component of competition, and others where production decisions determine, to a large extent, the equilibrium price: markets for highly differentiated goods typically belong to the first group, while markets for homogenous goods belong more often to the second group. These broad differences should be kept in mind when comparing results from different markets. This is particularly important because entry conditions can fundamentally change the behavior of market leaders under competition in prices. Furthermore, when firms compete in multiple strategies, it is important to understand which preliminary investments or commitments can substantially affect competition: the different behavior of market leaders in undertaking strategic investments compared to other firms is a crucial element of the theory of market leaders. Röller and Sickles (2000) have performed the first empirical study of a two-stage competition with preliminary investment in cost reducing capacity. They considered the European airline industry in the period 1976-1990, before the recent liberalization efforts. On the basis of a panel of the largest carriers (Air France, Alitalia, British Airways, Iberia, KLM, Lufthansa, SABENA and SAS) and a large dataset on cost, network and demand data, they have shown that airline companies behaved as puppy dogs: underinvesting in capacity to keep high prices. It would be interesting to compare that situation with the current situation in which EU liberalization is promoting the entry and competition: according to the theory of market leaders, we would expect leading carriers to turn into top dogs and overinvest in capacity to reduce their relative marginal costs.

Finally, our predictions refer to the behavior of market leaders versus the behavior of their followers, and the definition of leaders and followers requires some additional specifications. In this case, market shares can be useful because it is normal to associate first mover advantages to the leading firm in terms of market share. One may consider more than one firm as a leader according to the sector under consideration: theoretical analysis has shown that multiple leaders would tend to replicate the behavior of a single leader. Of course, there can be differences between firms that are beyond the strategic advantages: for instance costs differences, differences in product quality or locational differences. Since the basic results of the theory of market leaders refer to symmetric firms from a technological point of view, these exogenous differences should be used as control variables in the analysis.

Given these short but crucial methodological premises, in what follows we will list some of the empirical predictions of the theory of market leaders that distinguish between markets with an exogenous number of firms and markets with endogenous entry.

Endogenous entry turns market leaders into more aggressive players compared to a situation in which all firms (leaders and followers) do not face entry threats. In particular, our analysis allows one to discriminate a radical change of strategy under competition in prices: when the number of firms is exogenous, market leaders should choose higher prices than the followers, when entry is endogenous they should choose lower prices. This strong implication does not necessarily hold when firms compete in quantities, but in all cases we would expect that the price of the leaders decreases compared to the price of the followers when endogenous entry occurs. Therefore, our first testable implication is a weak one and can be expressed as follows:

P.1a : The gap between the price of the leaders and the average price of the followers decreases with entry.

When this prediction is satisfied in the data, one can look at the stronger result, which is supposed to hold for markets with competition in prices, and test the following implication:

P.1b: Market leaders facing exogenous entry choose higher prices than the followers; market leaders facing endogenous entry choose lower prices than the followers.

Of course, the stronger hypothesis P.1b implies the weaker hypothesis P.1a, while the opposite is not true. Eventually, one could test further predictions of the basic model of Stackelberg competition with endogenous entry. For instance, in the presence of homogenous goods, increasing marginal costs, and competition in quantities we would expect that the equilibrium price corresponds to the marginal cost of the leader but it is higher than its average cost, while the same price is above the marginal cost of the marginal entrant but just enough to match its average cost. This is consistent with positive profits for the leader and endogenous entry. When one introduces product differentiation, also the equilibrium price for the leader is above its marginal cost according to a mark up which increases in the degree of product differentiation, but the equilibrium price of the followers is still equal to their average cost. These predictions could be tested against other hypotheses using the tools of the new empirical industrial organization (see Berry et al. (2004) on the US automobile market, and Kadiyali (1996) with particular reference to entry deterrence and accommodation in the US consumer market for photographic film in the period 1970-1990, when Kodak was the leader and Fuji the follower) and are summarized as follows:

P.2: In a sector with homogenous goods and increasing marginal costs, the equilibrium price of a market leader facing endogenous entry is equal to its marginal cost and above its average cost, and the equilibrium price for the marginal entrant is above its marginal cost and equal to its average cost; an increase in product differentiation increases the equilibrium price above the marginal cost of the leader.

Let us move to the case of strategic investments by market leaders. With competition in the market entry conditions affect the way leaders undertake preliminary investments. In particular, using the classic taxonomy of business strategies, leaders facing endogenous entry always act as top dogs or with a lean and hungry look, and never as puppy dogs or fat cats: ultimately, they are always aggressive compared to the entrants in the competition in the market, which is in line with the previous results. Between the many commitments one can analyze, some can be particularly interesting for empirical investigations. For instance, we analyzed cost reducing and demand enhancing investments. From the first category one can obtain neat predictions (leaders invest more in cost reducing activities when facing endogenous entry), and later we will revisit them again when dealing with more general forms of investments in R&D. From the second category one obtains results that depend crucially on the kind of demand enhancing investments under consideration.

Consider product quality. Here, our focus will be on the implications of the theory of market leaders in the presence of a double choice on both the quality and the price of the products. Summarizing the strategies with the quality-price ratio, a strong prediction deriving from our characterization would be the following:

P.3: Market leaders facing an exogenous number of firms choose a lower quality-price ratio than the followers; market leaders facing endogenous entry choose a higher quality-price ratio than the followers.

Given the complex strategic interactions emerging in a situation where firms choose multiple variables, it could be reasonable to limit the analysis to a weaker implication like the following: the quality-price ratio of the leaders increases with entry compared to the quality-price ratio of the followers. Another form of demand enhancing investment is the expenditure on nonprice advertising aimed at increasing demand. If we focus on markets with product differentiation and competition in prices, the theory implies the following strong testable prediction:

P.4: Market leaders spend more than the followers in nonprice advertising (as a percentage of turnover) when the number of firms is exogenous, and less when entry is endogenous.

Finally, after pointing out empirical implications for the policies concerning price, product and promotion, we emphasize an implication for the last strategic investment that characterizes the marketing mix of a firm (the fourth P), place which stands for distribution. From our analysis on the choice of wholesale prices to retailers in the presence of downstream distribution channels, we have the following prediction:

P.5: Market leaders set higher wholesale prices for their retailers than their competitors when the number of firms is exogenous, while they set lower prices when entry is endogenous.

Concerning financial issues, we need to take care of a more subtle differentiation on the source of uncertainty in the market, which can be used as an additional control variable (an interesting related analysis on the effect of debt on prices is in Chevalier (1995), but that treatment does not take into account the source of uncertainty and the endogeneity of entry). Then, we have the following prediction based on the hypothesis of competition in prices:

P.6: The financial structure of market leaders is biased toward debt financing compared to the financial structure of the followers when the number of firms is exogenous, while it is biased toward equity financing when entry is endogenous, as long as uncertainty is mainly on the demand side (while uncertainty on costs pushes the predictions in the opposite direction).

Notice that under competition in quantities the model always implies a bias toward debt financing for the leader, therefore, once again, we can distinguish a weaker hypothesis from the strong one stated above: the debt-equity ratio of the market leaders should increase with entry.

Investments in cost reductions aimed at reducing the price of a good give rise to neat predictions under competition in prices: in particular, market leaders should spend less than the other firms in R&D investments in cost reductions when the number of firms is exogenous, and they should spend more when entry is endogenous. One should always keep in mind that this hypothesis holds under competition in prices, while under competition in quantities the leader would generally spend more than the followers in cost reductions under both entry conditions. However, we can generalize our result under general forms of competition for the market. The theory of market leaders provides radical predictions concerning the incentives to invest in R&D by the firms already present in a market with the leading products. We can express the main implications in different ways. We start from the weakest possible prediction, which is already in contrast with the traditional result of the theory of innovation (see Malerba and Orsenigo (1999), Blundell et al. (1999), Czarnitzki and Kraft (2007a) and Hughes (2007) on evidence on the high investment in R&D by market leaders):

P.7: Incumbent market leaders facing endogenous entry in the competition for the market invest in R&D.

Of course the theory of market leaders suggests more than this. First of all, leaders invest more than the followers when entry is endogenous. This is true in all models of competition for the market, independently from the kind of strategic interaction between firms. Therefore, we state this as an intermediate hypothesis:

P.8: The investment rate in R&D of market leaders is higher than the average investment rate in R&D of the followers when entry in the competition for the market is endogenous.

We also have a radically strong hypothesis that derives from a model in which the investments of the firms are strategic complements:

P.9: Market leaders invest less in R&D (as a percentage of turnover) than the followers when the competition for the market is between an exogenous number of firms, they invest more when entry is endogenous.

Finally, the theory of sequential innovation by leaders suggests a way to discriminate between different degrees of persistence of leadership in innovative sectors. When entry of firms in the competition for the market is endogenous we should expect that technological leaders invest a lot and their persistence is more likely. Of course, when there is no competition for the market we should expect that the monopolistic leadership is also persistent. However, when the degree of competition for the market is intermediate (entry is not free but more than one firm invests), we should expect that the incumbent does not invest much in R&D and that its leadership is more likely to be replaced. This suggests our last prediction:

P.10: The degree of persistence of leadership should follow and inverted U relation with the degree of entry in the competition for the market.

These testable implications could be brought to the data in future research. Many other issues could be studied through the market leaders approach and, accordingly, other empirical implications could be derived and eventually tested.

The Political Economy of Antitrust

Microsoft's leading position in the software market has induced large opposition in the industry and the emergence of multiple antitrust cases with importance at the global level. From the history of these cases and from the positions of major players and observers (in particular many important economists who have followed these cases) we can learn a lot about the current European case, which is about to arrive at a conclusion with the result of the Appeal expected for this summer.

Microsoft has been under investigations in the US by the Federal Trade Commission and the Department of Justice since 1990, primarily for its contracts with computer manufacturers and for bundling secondary products with its OSs. Already in the mid 90s we could see important economists in action in these early cases. In 1995 the Nobel prize Kenneth Arrow intervened saying that "Microsoft appears to have achieved its dominant position in its market as a consequence of good fortune and possibly superior products and business acumen" and that Microsoft's licensing practices toward original equipment manufacturers "made only a minor contribution to the growth of Microsoft's installed base. Even this minor contribution overstates the impact of Microsoft's licensing practices on its installed base barrier to the entry and growth of competing operating systems" (Declaration of Kenneth Arrow, U.S.. v. Microsoft Corp., Civil Action No. 94-1564 (SS), January 17, p. 11-12). However, it was only in the late 90s, under the Democratic Clinton Administration, that the most important US case began, followed after a few years by the EU case.

In the main Microsoft vs. US case, started in 1998, the software company was accused of protecting its monopoly in the OS market from the joint threat of the Internet browser Netscape Navigator and the Java programming language, which could have developed a potential substitute for OSs allowing software applications to run on hardware independently from the desktop OS. Basically, the hypothetical threat for Microsoft was the development of an alternative to the software platform based on the OS, a sort of middleware platform or a web-based platform leading to the "commoditization" of the OS (as ten years before the software platform led to the commoditization of hardware), and hence to the loss of leadership of Microsoft. Microsoft reacted by improving its Internet Explorer (IE) browser, engaging in contractual agreements with computer manufacturers and Internet service providers to promote preferential treatment for IE (notably AOL, whose "You've got mail" sound track was attracting more than 20 millions Americans at the time), and finally tying Windows with IE.

As Benjamin Klein (2001) pointed out in an academic survey on the Journal of Economic Perspectives (Symposium on the Microsoft case), "Microsoft spent hundreds of millions of dollars developing an improved version of its browser software and then marketed it aggressively, most importantly by integrating it into Windows, pricing it at zero and paying online service providers and personal computer manufacturers for distribution. All of this was aimed at increasing use of Microsoft's Internet Explorer browser technology, both by end users and software developers, to blunt Netscape's threat to the dominance by Windows of the market for personal computer operating systems." Microsoft's investments in browser technology, which largely improved IE until it became a superior product compared to Netscape Navigator (see the empirical analysis in Stan Liebowitz and Stephen Margolis, 1999), and Microsoft's pricing of IE at zero (as always since then) appear to us as examples of aggressive strategic investment and aggressive pricing by a market leader facing competition, and not as anti-competitive strategies. According to Klein, "a crucial condition for anticompetitive behavior in such cases is that the competitive process is not open. In particular, we should be concerned only if a dominant firm abuses its market power in a way that places rivals at a significant competitive disadvantage without any reasonable business justification. Only under these circumstances can more efficient rivals be driven out of the market and consumers not receive the full benefits of competition for dominance. The only Microsoft conduct ... that may fit this criteria for anticompetitive behavior are the actions Microsoft took in obtaining browser distribution through personal computer manufacturers".

After a failed attempt by Judge Richad Posner (one of the fathers of the Chicago school) to mediate in settlement negotiations, Judge Thomas Penfield Jackson decided to impose heavy behavioral and structural remedies on Microsoft, including the break up in an operating system and an application company (the so-called "Baby Bills", as Baby Bells were the companies derived from the 1984 break up of AT&T). At the time, this draconian remedy was criticized by many economists as Richard Schmalensee, consultant for Microsoft in the case, but also other economists with different perspectives on the case, for excessively penalizing the company without a clear relation between the punishment and the alleged crime, and for inducing perverse consequences for consumers. For instance, on the pages of The New York Times, Paul Krugman pointed out the risk of creating two monopolists engaging in double marginalization: "The now `naked' operating-system company would abandon its traditional pricing restraints and use its still formidable monopoly power to charge much more. And at the same time applications software that now comes free would also start to carry heftly price tags." Nevertheless, the government proposal of splitting Microsoft into two companies, which was adopted by the Judge without substantive changes, had been supported by declarations of important economists, including Paul Romer and Carl Shapiro. For instance, Shapiro declared that, while "network monopolies can be very strong, they are most vulnerable to attack by firms with a strong position in the provision of a widely-used complementary product", hence "the proposed reorganization of Microsoft into separate applications and operating systems businesses will lower entry barriers, encourage competition and promote innovation" (Declaration of Carl Shapiro, U.S. v. Microsoft Corp., Civil Action N0. 98-1232 (TPJ), p. 7 and p 29).

After the appeal phase and the return of the Republican Administration with George W. Bush, the DOJ changed attitude looking for a settlement. The November 2002 ruling of the District of Court decided on behavioral remedies aimed at preventing Microsoft from adopting exclusionary strategies against firms challenging its market power in the market for OSs. Moreover, the Court adopted forward looking remedies that required limited disclosure of APIs, communication protocols, and related technical information in order to facilitate interoperability, and created a system of monitoring of Microsoft's compliance which has been working quite well in the last years. Since other derivative private actions have also been dismissed or settled, it seems that this long-standing conflict has arrived to its end in the US.

The Microsoft vs. EU case was subsequently developed on somewhat similar issues. In particular, Microsoft has been accused of abuse of dominance in the market for OSs through technological leveraging and in particular in two ways: first, by bundling Windows with Media Player, a software for downloading audio/video content, and, second, by refusing to supply competitors with the interface information needed to achieve interoperability between work group server OSs and Windows [a work group server OS is a software providing services to share files and printers and other administration services to a group of users connected in a network, typically in office environments]. Contrary to the US case, the bundling part of the EU case is a traditional case of bundling, since the competitors in the secondary market, notably RealNetworks, do not represent a threat for Windows, the primary product of Microsoft.

In the famous antitrust decision of March 24, 2004, Competition Commissioner Mario Monti imposed on Microsoft the largest fine in the history of antitrust (€ 497 million), required Microsoft to issue a version of its Windows operating system without Media Player, and mandated the licensing of intellectual property to enable interoperability between Windows PCs and work group servers on one side, and competitor products on the other side. After this decision, Microsoft paid the fine, developed and released a version of Windows without Media Player, and entered into extensive discussions with the Commission about the implementation of the remedies concerning interoperability. In the original decision this required to prepare a complete and accurate interface documentation describing portions of Microsoft server operating system software and to license innovations created by Microsoft under "reasonable and non discriminatory" (so-called RAND) terms to competitors. These imply that the royalties should be set at levels that enable use by other developers in a commercially practicable way with reference to standard valuation techniques, to an assessment of whether the protocols are innovative, and with reference to market rates for comparable technologies.

Over time, the new Competition Commissioner Neelie Kroes has continued to extend the scope of the information required, from information that would enable interoperability with Windows PCs and servers for the purpose of creating new products for which there is unmet consumer demand, to information that would allow a competitor to produce clones or "drop-in replacements" of the Windows server OS. Even more controversially, the Commission's Competition Directorate-General has sought to loosen the terms under which Microsoft would be able to licence its information, so as to allow products implementing its technical specifications to be released under so-called Open Source licences (DG Competition was prepared to make an exception for technologies that involved an inventive step and were considered novel by comparison with the prior art, thus meeting the criteria for patentability). Such release, by revealing to the world Microsoft's own implementations of its technical specifications, would irreparably undermine the trade secret protection to which these technologies, some of which are not patented, are subject. In a further shift, the Commission made clear in Spring of 2007 that it expected Microsoft to forego royalty payments on any technologies that were not covered by patents. With the compliance process made more difficult on both sides by the technical complexity of the material and key policy differences (e.g. over the intellectual property issues), DG Competition challenged Microsoft to comply with the interoperability remedy by 15 December 2005, on pain of massive penalty payments for non-compliance. In early 2006, Microsoft provided further information needed for interoperability purposes, and even made available to its competitors selective access to the source code of Windows. Nevertheless, in July 2006 the Commission levied fines of  € 1.5 million a day from the December hearing onwards (for a total of other € 280.5 million), and threatened to double the fine if the company did not comply. The case is still unresolved: Microsoft's Appeal of the Commission's 2004 landmark decision was heard by the European Court of First Instance in April 2006. By the way, also in this case important economists played a crucial role: for instance with Joseph Stiglitz, on the European Commission side and David Evans on the Microsoft side. A decision is expected by mid 2007, and the hope is that it will put an end to a situation that in the last years has largely jeopardized R&D investment in the European markets of the New Economy.

A common element in both the US and EU cases has been the substantial involvement of competitors of Microsoft on the side of the antitrust authorities. In a neat article about the US vs. Microsoft case on Business Week, Robert Barro (1998) noticed that: "a sad sidelight in the Microsoft case is the cooperation of its competitors, Netscape, Sun and Oracle Corp., with the government. One might have expected these robust innovators to rise above the category of whiner corporations [...] The real problem is that whining can sometimes be profitable, because the political process makes it so. The remedy requires a shift in public policies to provide less reward for whining. The bottom line is that the best policy for the government in the computer industry is to stay out of it." Nevertheless, IBM, Sun, Oracle, Novell, Sun Microsystems and the wide open source movement have been quite active against Microsoft in the EU case, and most likely, they will continue to be after the end of this case.

Wikipedia and Traditional Encyclopedias

While intellectual property rights are fundamental drivers of innovations in all sectors, software development has recently been characterized by a large amount of innovations obtained in a decentralized, voluntary and uncompensated way by programmers within the so-called open source movement.

Technically, open source software is made available for direct use and modification (through direct access to the source code) under limited protection. For instance, the GPL (General Public License, first used in 1981 by Richard Stallman, the leader of the Free Software Movement) grants unlimited right to use, modify and distribute software as long as its redistribution makes available the modified source code and does not impose further restrictions on the rights granted by the GPL. These enforcement mechanisms make cooperative innovation quite effective and immune from free riding, but can create problems when an innovation includes both open source software and licensed proprietary software.

Major results of the open source movement are Linux, an Operating System based on Unix (an old Operating System first created at Bell Labs) and developed in 1991 by Linus Torvalds, Apache, a world wide web (HTTP) server, and Mozilla Firefox, a web browser. Besides software that is freely distributed, there is an increasing number of companies, like Red Hat and Novell, that profit from collateral services supplied jointly with free software. In theory, any rival could resell Red Hat software at a lower price because it is under GPL (and some firms actually do it), but Red Hat managed to sidestep this problem protecting its products with trademark law. In this sense, the difference between proprietary software and open source software appears much less relevant: the former earns from licenses to end-users, the latter mainly licenses software free of charge and earns from selling support description needed by end-users to install and run the software.

While many private corporations support open source software because they supply products that are complementary to open source software (IBM first of all, but also HP, Intel, Sun, Oracle,...), it remains surprising that such a large innovative process can take place, at least in part, through directly unrewarded efforts. Some economists, as Lerner and Tirole, have provided a few explanations for the incentives of these individual programmers: career concern, ego gratification and signalling activity are quite powerful and effective in this field. Unfortunately, the same nature of these incentives shows the possible limits of the innovative activity in the open source community: it is limited by the usual free riding problems emerging in the private provision of public goods (it is interesting that an information good as software is substantially a public good: it can be provided to new agents at no substantial cost and without reducing the utility of the other agents), it requires a complementary activity in the for-profit sector (to motivate the career concern and the signalling activity), it may be biased by research efforts that are different from general consumer needs and by adverse selection of the contributors, and it may be effective to solve a number of small and short term problems, but less effective to solve multi-sided challenges and approach long term projects. Notice that it is often claimed that open source software is more effective than proprietary software in debugging activity (since many programmers find and solve many defects within a software and make the solutions freely available), but may have big problems confronting issues as synchronization of upgrades and efficient levels of backward compatibility.

While the development of this new form of innovative activity is a symptom of high competitive pressure in the sector, it does not provide any evidence against the fundamental role of the protection of IPRs in driving core innovations. Actually, we believe that the current coexistence of open source software and proprietary software exerts a positive impact on innovation on both sides. To see why, think of a different sort of open source activity: Wikipedia is a famous and successful on line encyclopedia where anybody can post a new voice or edit an old one. While it contains a lot of useful and constantly updated information (especially in certain fields, as those related to the on line community), it often includes unmotivated and misleading references or mistakes that are the normal consequences of overlapping additions by heterogeneous contributors whose preparation is not properly controlled and whose effort is not rewarded. Traditional encyclopedias based on rewarded contributions by selected experts are not constantly updated as Wikipedia, but they provide a standard of quality and a balanced unifying structure that Wikipedia lacks. The trade-off for the end users is clear, and coexistence appears natural.

In a recent interesting book by Michele Boldrin and David Levine (see the version in Boldrin and Levine, 2005, Against Intellectual Monopoly) have adopted open source software as a main example of innovation created without IPRs, and have collected a large amount of anecdotic evidence suggesting that innovations can perfectly take place in absence of what they call "intellectual monopoly". Their idea behind this possibility is that the first mover advantage in the market of an innovator preserves a certain amount of profits even when entry of imitators is free, and this Stackelberg advantage can be sufficient to promote innovation. We already know from the theory of market leaders that leaders with a first mover advantage can obtain positive profits even in markets where entry is free by adopting aggressive strategies, and the standard Schumpeterian theory of growth is perfectly compatible with incentives deriving from the profits of a market leader facing free entry, rather than deriving from a monopolistic position. Therefore, the idea of Boldrin and Levine can have reasonable implications. However, the problematic point for the relevance of their provocative idea is another one: how much innovation can be promoted by the simple first mover advantage?

Without a deeper analysis of the industrial organization of the competition for the market it is quite hard to answer this question, and the general equilibrium analysis of Boldrin and Levine concluding that that the first mover advantage induces the first best amount of innovation neglects to a large extent the industrial organization of the market for innovations. Unfortunately, whether the incentives to invest are efficient or not is more an empirical question than a theoretical one, and we still don't see a consistent piece of evidence showing that current patent systems provide excessive incentives in a systematic way, or that we should totally eliminate IPRs, as Boldrin and Levine actually suggest.

As a matter of fact, the opposite may be true. Recently, Denicolò has analyzed a general model of the organization of innovations and has obtained a simple rule for the optimal level of patent protection: his empirical estimates suggest that current patent systems do not over-compensates innovators, while they may actually induce too limited incentives to invest in R&D.

This leads us back to the rational for the protection of intellectual property rights on software. We believe that the rationale for these patents is strong: while their main social gain is to promote innovation in the most dynamic sectors, the social cost is smaller than for other patents since in these sectors competition mainly works through frequent price-reducing and quality-improving innovations, therefore price distortions are less relevant and do not last long anyway. Neglecting these traditional economic insights, opponents of the patent system as Boldrin and Levine, have tried to claim that patents stifle innovation, but there is not clear empirical evidence behind these claims. In US, the extension of patent protection to CIIs started in 1980 (the first patent of this kind was granted by the US Patent and Trademark Office in 1981), and it was associated with a clear increase in R&D investment during the eighties. The R&D/sales ratio for US firms innovating on computer, telecommunications and electronic components (the relevant field here) increased from 5.5% to above 8% in 1989.

In a careful empirical study Mann (2005) has shown that patents bestow significant benefits, especially for start up companies, in terms of traditional appropriability, information signalling and cross-licensing revenue, while Merges (2006) looking at patent data in the US software market found that "new firms entry remains robust, despite the presence of patents (and, in some cases, perhaps because of them). Successful incumbent firms have adjusted to the advent of patents by learning to put a reasonable amount of effort into the acquisition of patents and the building of patent portfolios. Patent data on incumbent firms shows that several well-accepted measures of `patent effort' correlate closely with indicators of market success such as revenue and employee growth." In conclusion, we have no reason to doubt that standard incentive mechanisms to promote innovations based on the protection of intellectual property rights are effective in the software field as they are in many other fields.

Software Platforms in the Third Industrial Revolution

In a recent important book, Evans, Hagiu and Schmalensee (2006, Invisible Engines, MIT Press) have emphasized the crucial role that software platforms are playing in shaping our economies, the functioning and the development of many sectors, and ultimately our way of living. These "invisible engines", as they call them, power not only the PC industry but also other industries as those associated with mobile phones and other handheld devices, video games, digital music, and (with strong externalities for the rest of the economy) on-line auctions, online searches and web-based advertising. Their convincing claim is that, as the steam engine was at the basis of the first industrial revolution (1760-1830) and electric power at the basis of the second industrial revolution (1850-1930), microprocessors and software platforms are at the basis of the third industrial revolution (since 1980), which started with the introduction of commercial PCs and had a second phase starting in 1995 with the Internet.

A software platform is a software program that makes services available to other software programs through Application Programming Interfaces (APIs). Examples are the operating systems running on PCs as Windows, Mac OS or Linux, those employed by videogame consoles as the Sony one for PlayStation or Windows 2000 for the Xbox, Palm OS for personal digital assistants (PDAs), RIM for the BlackBerry, iPod OS for the Apple iPod, the Symbian operating system for cellular phones - Symbian is a joint venture founded by Nokia, Ericsson and Motorola, which left it in 2003; it is currently owned by Ericsson (15.6%), Nokia (47.9%), Panasonic (10.5%), Samsung (4.5%), Siemens AG (8.4%), and Sony Ericsson (13.1%).

To understand the peculiarities of software platforms in general it is convenient to focus briefly on the main functions of PC operating systems. The main one is to serve as a platform on which applications (such as spreadsheets or word processors) can be created by software developers. Operating systems supply different types of functionality, referred to as system services, that software developers can call upon in creating their applications. These system services are made available through APIs. When an application calls a particular API, the operating system supplies the system service associated with that API by causing the microprocessor to execute a specified set of instructions. Software developers need well-defined platforms that remain stable over time. They need to know whether the system services on which their applications rely will be present on any given PC. If they did not, then software developers would have to write the software code to provide equivalent functionality in their own applications, generating redundancy, inefficiency and a lack of interoperability. Moreover, modern OSs provide a user interface, the means by which a user interacts with his computer. User interfaces for computers have evolved dramatically over the last decades, from punch card readers, to teletype terminals, to character-based user interfaces, to graphical user interfaces, first introduced by Apple with Macintosh. Finally, operating systems enable users to find and use information contained in various storage devices: local ones, such as a floppy diskette, a CD-ROM drive or the hard drive built into a PC, or remote ones, such as local area networks that connect computers in a particular office, wide area networks that connect computers in geographically separated offices, and the Internet.

Over time, the OS of Microsoft became the most popular because Microsoft continually added new functionality to the OS and licensed it to a wide range of computer manufacturers with extremely aggressive pricing strategies. Microsoft recognised early on that an OS that served as a common platform for developing applications and could run on a wide range of PCs would provide substantial benefits to consumers. Among other advantages, development costs would fall and a broader array of products would become available because products could be developed for the common platform rather than for a large number of different platforms. By providing a single OS that ran on multiple brands of PCs, Microsoft enabled software developers to create applications, confident that users could run those applications on PCs from many different computer manufacturers. In addition, applications developed for a single platform are more easily interoperable because they rely on the same functionality supplied by the underlying OS. The winning strategy of Microsoft was the creation of these network effects between hardware producers, software developers and consumers: computer manufacturers benefit because their PCs can run the many applications written for Windows and because users are familiar with the Windows user interface; software developers benefit because their applications can rely on system services exposed by Windows via published APIs and because they can write applications with assurance that they will run on a broad range of PCs; consumers benefit because they can choose from among thousands of PC models and applications that will all work well with one another and because such broad compatibility fosters intense competition among computer manufacturers and software developers to deliver improved products at attractive prices.

Software platforms deal with multiple sides. Microsoft deals with at least three: consumers, software developers and PC manufacturers. Apple produces hardware internally, hence it deals with the remaining two sides: consumers and software developers. Sometimes relationships are even more complex, as in the platform ecosystem for smart mobile phones where, beyond OSs, software developers and handset makers, there are network operators (Vodafone, NTT DoCoMo, T-Mobile, Tim,..) to play a coordinating role and even competition between layers is strong.

In the presence of multiple sides with network effects between them, the choice of which ones should be charged more to use the platform is not simple. Rochet and Tirole (2003) and others have been the first to notice that software platforms, as other similar multi-sided platforms, give rise to market structures that are quite different from traditional ones. For simplicity, here we will refer to two-sided platforms, which connect two sides in such a way that for each side the valuation of the interactions with the other side depends on the number of agents on the others side. These network externalities, and in particular the non neutral impact of the pricing structure on both sides (and hence on these externalities) distinguishes a two-sided market from a traditional one-sided market with different consumers (and possibly price-discrimination between them).

An analogous situation to software platforms emerges in many completely different contexts. A classic example is given by newspapers. They are sold to readers, but they also sell advertising space to advertisers: the reader is not only a "customer" of the newspaper, the reader is also a supplier of "eyeballs" that the newspaper sells to advertisers. Here, network effects emerge because advertisers (the sellers for the platform) value their advertising more in a newspaper when the number of its readers (the buyers of the platform) is higher (the effect in the other direction may exist but is typically less important). This has crucial consequences on the pricing structure since a low price for the readers increases the number of sold copies and hence the value of advertising. Such a phenomenon is even stronger when the newspaper is competing with other newspapers, and a low price reduces the readers of competing newspapers and the value of advertising on these competing newspapers.

Other two-sided platforms include other media networks as television channels, real estate agencies, traditional auction houses, shopping malls, night clubs and dating clubs, payment card systems, telephone networks and many industries of the New Economy as those related with video game consoles, smart phones, digital music, PDAs, i-Mode (this was created by the main Japanese mobile network operator, DoCoMo, to connect mobile phones with Internet content providers and application developers. Both the US and the EU lag behind in the development of a similar platform), search engine-based portals (like Google), on line messaging (like Yahoo!), on line chatting (like Skype), on line social networks (MySpace or asmallworld), on line academic articles (JSTORE or SSRN), on line shopping (Amazon) and on line auctions (eBay). In many of these markets, multi-homing on at least one of the two sides is common: people often buy more than one journal or watch more TV channels (as companies advertise on multiple medias), hold multiple credit cards (as merchants accept multiple cards) and software developers prepare applications for multiple OSs (while individuals typically use only one).

In each one of these examples, network externalities are crucial to the success of a software platform, and the pricing structure toward buyers and sellers is crucial to the creation of these network effects. In particular, a platform typically ends up charging one of the two sides less than the other, taking into account demand elasticities and which side values the other side more: the aim is to get on board as many agents as possible from one side, so as to increase the value of the platform for the other side and earn more revenue from it. For instance, when the price is the strategic variable, it is optimal to charge the side whose demand is more elastic relatively more because this allows one to maximize the total volume of interactions – but this is the exact opposite of what happens normally, when it is optimal to charge less consumers with a less elastic demand! Prices will be constrained downward when there are competing platforms (especially in case of multi-homing), but the general principles on a balanced price structure between the two sides remain unchanged. In extreme cases, one side may even receive its goods or its services for free or even be subsidized so as to maximize earnings from the other side.

The above theoretical implications are surprisingly confirmed by what happens in the above mentioned two-sided markets, whose companies typically settle on pricing structures that are heavily skewed toward one side of the market, or in other words adopt what is sometimes called a "divide and conquer" strategy. Newspapers, television networks and even websites typically earn more from advertisers than from consumers, real estate agencies earn more from sellers (or from landlords) than from buyers (or renters), auction houses from sellers rather than from the buyers, shopping malls from stores rather than from the shoppers, night clubs from men rather than from women, payment card companies from merchants rather than from cardholders, phone operators (often) from call makers rather than from receivers, video game platforms from royalties on game developers rather than from buyers of consoles (that are often sold below cost), while most of the other software platforms, including PC operating systems, earn more from end users rather than from software developers. This happens in different ways however: Microsoft licensees Windows, Palm and Symbian license their OSs to manufacturers of PCs, PDAs and cellular phones, while RealNetworks licenses access to digital content and Apple sells PCs and iPods, but none of these companies charges content owners (Apple and RealNetworks actually pay them) or software developers (which are typically subsidized).

Notice that, in spite of the network effects, most of these two-sided markets are also characterized by a certain degree of fragmentation between platform providers (real estate agencies, dating clubs, traditional auction houses), often associated with a certain degree of differentiation (newspapers, TV channels and other medias, shopping malls). Only when technological innovation is particularly important and fixed costs of investment in R&D are high (while marginal costs of production are particularly low), the number of competing platforms is endogenously reduced, as in the above mentioned markets of the New Economy (but tipping on a single leader rarely happens, especially when product differentiation and multi-homing have a role, as for video games). Nevertheless, even in these cases, competition for the market can be quite effective and induce periods of persistent leadership with occasional replacement of the leader: pathbreaking innovations (or "killer applications") is what competitive firms really look for.

For instance, in the console video game industry, sequential innovations brought to leadership a number of companies as Atari (that reached 80% share of the market in 1980), Nintendo (90% of the market in 1987), Sega (leader in the early 90s), Nintendo again (in the mid 90s) and Sony with the PlayStation in different improved versions (during the last decade): recently Microsoft Xbox started gaining market shares, and Nintendo is still active, but the leadership of Sony (58% market share in 2004) does not appear under threat yet, especially after the recent successful launch of PlayStation 3. Similarly, after a number of unsuccessful attempts by many companies, Palm's PDA gained success and leadership in the market for OSs for organizers thanks to a simple handwriting recognition system (65% market share in 2000) until Microsoft competing platform and other handheld devices, including Blackberry and (in perspective) Apple's iPhone, gained success.

The Industrial Organization of the Software Market

The software market, one of the markets of the so-called New Economy, developed in the very last decades through progress in the Information & Communication Technology. In the 1960s, the computer industry was dominated by IBM, which manufactured expensive mainframe computers that were used by large enterprise customers; at the time, very few consumers had access to computers. Apart from IBM, mainframes were offered by firms such as Bull, Burroughs, Data General, Fujitsu, ICL, Nixdorf and Sperry-Rand. There was little or no interoperability among mainframes from different vendors. For the most part, an enterprise customer was required to choose an all IBM solution or an all Nixdorf solution. In the 1970s, Digital Equipment achieved considerable success with a line of less expensive minicomputers that were well-suited to engineering and scientific tasks. Again, however, there was little or no interoperability between these minicomputers and mainframes offered by IBM and others. The structure of the industry at that time was still largely vertical. By 1980, a number of companies had started offering less expensive microcomputers which were not interoperable with one another: early PCs by Tandy, Apple, Commodore and Atari ran their own operating systems, meaning that applications written for one brand of PC would not run on any other brand: the industry was fragmented. In mid-1980, IBM announced plans to introduce an IBM personal computer. The first one was offered with a choice of three operating systems: CP/M-86 from Digital Research, UCSD-P System and MS-DOS from Microsoft, a company founded by Bill Gates, a young software architect who dropped his studies at Harvard to develop what was going to become a symbol of market leadership.

To understand the peculiarities of the software market in general it is convenient to focus briefly on the main functions of PC operating systems (OSs). The main one is to serve as a platform on which applications (such as spreadsheets or word processors) can be created by software developers. OSs supply different types of functionality, referred to as system services, that software developers can call upon in creating their applications. These systems services are made available through Application Programming Interfaces (APIs). When an application calls a particular API, the OS supplies the system service associated with that API by causing the microprocessor to execute a specified set of instructions. Software developers need well-defined platforms that remain stable over time. They need to know whether the system services on which their applications rely will be present on any given PC. If they did not, then software developers would have to write the software code to provide equivalent functionality in their own applications, generating redundancy, inefficiency and a lack of interoperability.

Moreover, modern OSs provide a user interface, the means by which a user interacts with his computer. User interfaces for computers have evolved dramatically over the last decades, from punch card readers, to teletype terminals, to character-based user interfaces, to Graphical User Interfaces, first introduced by Apple with Macintosh. Finally, operating systems enable users to find and use information contained in various storage devices: local ones, such as a floppy diskette, a CD-ROM drive or the hard drive built into a PC, or remote, such as local area networks that connect computers in a particular office, wide area networks that connect computers in geographically separated offices, and the Internet.

Over time, the OSs of Microsoft became the most popular because Microsoft continually added new functionality to the operating system and licensed it to a wide range of computer manufacturers with extremely aggressive pricing strategies. Microsoft recognised early on that an OS that served as a common platform for developing applications and could run on a wide range of PCs would provide substantial benefits to consumers. Among other advantages, development costs would fall and a broader array of products would become available because products could be developed for the common platform rather than for a large number of different platforms. By providing a single operating system that ran on multiple brands of PCs, Microsoft enabled software developers to create applications, confident that users could run those applications on PCs from many different computer manufacturers. In addition, applications developed for a single platform were more easily interoperable because they were relying on the same functionality supplied by the underlying OS. In other words, network effects were created.

In 1981, Microsoft released its first operating system, MS-DOS, which had a character-based user interface that required users to type specific instructions to perform tasks. In 1985, Microsoft introduced a new product called Windows that included a GUI, enabling users to perform tasks by clicking on icons on the screen using a pointing device called a mouse. Windows 3.0, shipped in 1990, was the first commercially successful version of Windows. In 1995, Microsoft released Windows 95, which integrated the functionality of Windows 3.1 and MS-DOS in a single operating system. In 2000, Microsoft shipped Windows 2000 Professional, a new generation of PC operating system built on a more stable and reliable software code base than earlier versions of Windows. Windows XP and the forthcoming Vista represent furthers evolution of the operating system, with a range of added functionality for both business and home users. Even if official and unanimous data are unavailable, consistent evidence suggests that the market share of Windows on sales of OSs for PCs rapidly increased toward 80% in the first half of the 90s to gradually arrive at 92% in 1996, 94% in 1997, 95% in 1998 and remained basically at this level since then: meanwhile the average consumer price of Windows (calculated as average revenue per licence in OEM channel based on Microsoft sales) was constant (in nominal terms) around 44-45$.

Beyond OSs, Microsoft produces very successful applications. Some essential applications have been freely bundled with the operating system: for instance a basic word processing software, WordPad, a browser to access Internet and media player functionalities have been gradually added for free to subsequent versions of Windows when they became standard components of a modern OS. Other more sophisticated applications are supplied separately. Most notably this is the case of the Office Suite consisting of the advanced word processor Word, the spreasheet Excel, the software for presentations PowerPoint and more. The main two applications, Word and Excel, have been successfully competing against alternative products like WordPerfect, WordStar, AmiPro and others on one side and Lotus, Quattro and others on the other side. Liebowitz and Margolis (1999) have shown convincing evidence for which a better quality/price ratio together with network effects were at the basis of this success (it is important to notice that Microsoft achieved leadership in the Macintosh market, hence without exploiting the presence of its own OS, considerably earlier than in the PC market). In the market for word processing applications, Microsoft's market share was hardly above 10% at the end of the 80s, to gradually increase at 28% in 1990, 40% in 1991, 45% in 1992, 50% in 1993, 65% in 1994, 79% in 1995, 89 in 1996, 94% in 1997 and to arrive at 95% in 1998, meanwhile the average consumer price of Word (calculated as average revenue per license) decreased from 235$ in 1988 to 39$ in 2001. In the market for spreadsheet applications, Microsoft followed a similar progress, with a market share of 18% in 1990, 34% in 1991, 43% in 1992, 46% in 1993, 68% in 1994, 76% in 1995, 84% in 1996, 91% in 1997 and 94% in 1998, with minor progress in the following years, while the average consumer price of Excel was decreasing from 249$ in 1988 to 42$ in 2001.

The leading position of Microsoft induced large opposition in the industry and the emergence of multiple antitrust cases with importance at a global level. In the main Microsoft vs US case, the software company was accused of monopolizing the PC operating systems market for Intel-compatible computers, tying its Windows operating system with the Internet Explorer browser with predatory purposes and to engage in anti-competitive contractual agreeements with computer manufacturers and Internet service providers. After an initial decision which imposed heavy behavioural and structural remedies on Microsoft, including the break up in a operating system and an application company (the socalled "Baby Bills"), the November 2002 ruling of the District of Court decided only to impose behavioural remedies aimed at preventing Microsoft from adopting exclusionary strategies against firms challenging its market power in the market for operating systems.

The Microsoft vs EU case was developed on very similar issues, in particular on the bundling of Windows with mediaplayer functionality and on the level of interoperability with softwares by other companies; at the time of writing, the case is still unresolved. In the March 2004 decision, the European Commission imposed the largest fine in the history of antitrust, required Microsoft to issue a version of its Windows operating system without Media Player, and mandated the licensing of intellectual property to enable interoperability between Windows PCs and work group servers and competitor products. Microsoft's Appeal of the decision was heart by the European Court of First Instance in April 2006 and a decision is expected by the end of the year.

A common element in both cases has been the substantial involvement of competitors of Microsoft on the side of the antitrust authorities, something that usually can create suspicion on the fact that a firm is really behaving as a monopolist rather than as an aggressive competitor. In a neat article on Business Week, Robert Barro (1998, Why the Antitrust Cops should Lay off High-tech) noticed that "[a] sad sidelight in the Microsoft case is the cooperation of its competitors, Netscape, Sun and Oracle Corp., with the government. One might have expected these robust innovators to rise above the category of whiner corporations... The real problem is that whining can sometimes be profitable, because the political process makes it so. The remedy requires a shift in public policies to provide less reward for whining. The bottom line is that the best policy for the government in the computer industry is to stay out of it." Nevertheless in the European case Sun, Oracle, Novell, IBM and the Free Software Movement are active sides against Microsoft.

The technological conditions in the software market are well known. Producing software (whether it is an operating system or a particular application) takes a very high up-front investment and a constant marginal cost which, as well known, is close to zero. The entry conditions in this market are more debated, but there are good reasons to believe that even though entry into the software market may entail large costs, it is substantially open, i.e. endogenous. First of all, there are already many firms producing OSs (as IBM, Red Hat, Oracle, Sun, Apple, HP, Compaq, Data General,...), and even more potential entrants -- think of the giants in adjacent sectors of the New Economy (hardware and telecommunications in particular). Second, it is hard to think of a market which is more "global" than the software market: demand comes from all over the world, transport costs are virtually zero, the knowledge required to build software is easily accessible worldwide and competition is global. Nevertheless, it has been claimed that in the market for PC (or client) operating systems, the high number of applications developed by many different firms for Windows represents a substantial barrier to entry. Unfortunately, such a claim usually leads to misleading conclusions. It is true that competitors need to offer (and some do offer already) a number of standard and technologically mature applications upon entry to match the high quality of the Windows package, but the cost of offering these applications is unlikely to be prohibitive compared to the global size of this market. There are at least two reasons for this. First, notice that the alleged "applications barrier to entry" is often erroneously associated with thousands of applications written for Windows, while it is actually limited to a handful of applications such as word processing, spreadsheet, graphics and communications software, which really satisfy the needs of most active computer users (McKenzie, 2001). Second, the competitors of Microsoft should not (and the existing ones do not) even finance the development of all the needed applications: as Microsoft did in most cases, they should just fund and encourage other firms to write applications for their operating system (or have old applications originally written for other operating systems "ported to" theirs). Finally, it is important to emphasize that if we look at competition in the software market in a dynamic sense, that is competition for the market (as opposed to competition in the market), there is no doubt that the opportunity to invest in innovations for future, better software is widely open not only to large companies in the New Economy, but even to smaller ones.

Summarizing, the software market is characterized by high entry costs, constant marginal costs close to zero and substantially open access by competitors able to create new software. According to the new theory of market leaders these are the ideal conditions under which we should expect a leader to produce for the whole market with very aggressive (low) prices. Hence, it should not be surprising that, at least in the market for operating systems, a single firm, Microsoft, has such a large market share. We can see the same fact from a different perspective: since entry into the software market is endogenous, the leader has to keep prices low enough to expand its market share to almost the whole market. Notice that network externalities require these prices to be even lower because competitors could (and indeed try to) offer their alternative software at even lower prices to build their own network effects. Not by chance low prices in presence of network effects are very common and often extreme: most email services such as Yahoo or search engines as Google are free because this is the best strategy available for their leading suppliers under the constraint of effective competition. All these market leaders gain from collateral services, and, for sure, their leadership has nothing to do with dominance.

The extremely low price of Windows represents a double proof of our arguments above. Assume for simplicity that the marginal cost of producing Windows is zero, and that the price of hardware is constant and independent from the price of Windows. Standard economic theory implies that the monopolistic price for an operating system should be the price of the hardware divided by ε-1, where ε is the elasticity of demand for PCs (including both hardware and software): it means that a 1% increase in the price of PCs reduces demand by ε%. Now, the above relationship tells us that, if the basic price of the hardware is 1000 Euros, which is about the current average price for PCs, the monopolistic price for Windows would be 1000 Euros if ε=2, 500 Euros if ε=3, 333 Euros if ε=4 and so on. It would take really unreasonable values of demand elasticity to even get close to the real price of Windows, which is around 50 Euros. Moreover, this is a very conservative estimate of the monopolistic price. In the real world, we can imagine that the price of hardware is not independent from the price of Windows: if the latter would double tomorrow, hardware producers would be forced to reduce somewhat their prices (eventually switching to lower cost techniques and/or lower quality products). Even if this effect may be limited by the high level of competition in the hardware sector, it goes in the direction of increasing further the monopolistic price of Windows, that is, even beyond the real price of Windows.

What does all this tell us? Simply that Microsoft is not an unconstrained price-setter, while its prices are limited well below the monopolistic price to compete aggressively with the other firms active in the operating system market and with the potential entrants in it. Important economists have supported this position. Economides (2001) concludes in a similar fashion: "Microsoft priced low because of the threat of competition. This means that Microsoft believed that it could not price higher it if were to maintain its market position." McKenzie (2001) supports this view: "some firms with high market shares might act more like competitors than other firms in markets where they have much smaller market shares. The reason is that the threat posed by potential competitors in a highly concentrated market can be more constraining than the competitive threat of actual competitors in less-concentrated markets".

What the post-Chicago approach suggested about leaders in markets with price competition was that they should be accommodating and exploit their market power, setting higher prices than competitors, or otherwise engage in predatory pricing and, after having conquered the whole market, increase prices. But in the last 10-15 years of global leadership, Microsoft has done neither of these things. It has been constantly aggressive, as any firm under the threat of competitive pressure would be. The theory of market leaders has shown that a market leader in these conditions would price above marginal cost in such a way to compensate for the fixed costs of investment and obtain a profit margin (over the average costs of production) thanks to the economies of scale derived from the large (worldwide in the case of Microsoft) scale of production. Its (quality adjusted) price should be slightly below that of its immediate competitors or just low enough to avoid that they can exploit profitable opportunities increasing their prices. Where other theories cannot, the theory of market leaders can make perfect sense of Microsoft's large market share, large profits and relatively low prices in a global and open market.

On the EU approach to Aftermarkets

The Discussion Paper on the Application of Article 82 of the Treaty to Exclusionary Abuses of the European Commission presents a short part on abusive behaviour in aftermarkets, that is markets for “secondary” products, such as spare parts, consumables or servicing, which are bought after the purchase of the primary product, e.g., toner cartridges for printers, replacement parts for household appliances, maintenance for computer equipment, or even software applications for operating systems.

When an after-market is “brand-specific” (i.e. where secondary products for one brand of primary product cannot be used with another brand of primary product), the supplier may have a very large share of that after-market, but this does not necessarily imply that the supplier enjoys market power, as the relationship between the primary market and the aftermarket may be such as to effectively restrain the supplier’s conduct on the aftermarket (e.g., a supplier’s charging high after-market prices may adversely affect its sales on the primary product market). The examination of after-markets accordingly focuses on how the relationship between the primary market and the after-market impacts on whether the supplier holds a dominant position on the aftermarket and the factors that will be taken into account by the Commission in this assessment. 

The Discussion Paper also draws a distinction between those customers that may purchase the primary product in the future and those customers that have already purchased the primary product. Competition on the primary market may protect future customers from potentially harmful conduct by the supplier on the aftermarket, but may not protect existing owners of the primary products from harm if the supplier changes his commercial policy on the after-market (e.g., by raising prices). The key to assessing whether competition on the primary market will protect future customers is the extent to which future customers make “life cycle” pricing decisions, by taking after-market prices into account in their decision to purchase products on the primary market. However, competition on the primary market may not restrain a supplier’s conduct on the after-market, particularly with regard to existing customers of the primary product who are effectively “tied in” to purchasing the after-market product.  The supplier may change its commercial policy on the after-market (e.g., through raising prices) to take advantage of the installed base of existing customers effectively “tied in” to purchasing the after-market product (so-called “installed base opportunism”).

We suggest that the Commission examine the competitive links between products and systems at the stage of market definition. The Commission would thus recognise, in line with economic analysis, that main products  and their spare parts or consumables should, in appropriate cases, be considered as systems which, together with other systems against which they are in competition, constitute a single relevant product market.

As the Discussion Paper notes, it is common for the supplier of such equipment to have “a very strong position” in the sale of “secondary” products and services used with its own brand of equipment (paragraph 253). Indeed, undertakings with smaller positions in the primary equipment market may have even larger shares of their brand’s aftermarket because third-party suppliers and other primary market firms typically focus on the most successful equipment brands since those brands provide the largest aftermarket revenue opportunity.  As a result, there is a risk that undertakings with quite modest positions in the primary market would be viewed as dominant in the aftermarket if the assessment were to be focused only on an aftermarket consisting of products and services for their individual brand of equipment.

We believe that the Discussion Paper is correct in emphasizing that the “secondary markets” should not be viewed in isolation since “the actual degree of market power of the supplier [in the aftermarket] … may be constrained by competition in the primary market.” (paragraph 246).  As the Discussion Paper explains, “competition in the primary market may make price increases in the aftermarket unprofitable due to its impact on sales in the primary market, unless prices in the primary market are lowered to offset the higher aftermarket prices.” (paragraph 246).  This fundamental insight regarding the key relationship between the primary market and any related aftermarkets means that a separate examination of a single brand aftermarket under Article 82 is rarely, if ever, appropriate. 

The Discussion Paper appears to accept this conclusion for “customers who may buy the primary product in the future” since competition in the primary market will protect such customers (paragraphs 254-259). However, the Discussion Paper draws a distinction between “future customers” and “prior purchasers” on the basis that “competition in the primary market does not protect customers who have already bought the primary product.” (paragraph 254).  We believe that the distinction in the Discussion Paper between “future customers” and “prior purchasers” is misguided.  Since every “prior purchaser” was, by definition, a “future customer” before it acquired the primary product, competition in the primary product market also protects this subset of customers. In addition, as noted in the Discussion Paper, the “prior purchasers” are also protected by the supplier’s interest in its reputation with respect to its aftermarket pricing and practices because its reputation will affect its future sales of the primary product as well as its future sales of other equipment that requires aftermarket products and services (paragraph 262).

We believe that the complex, multi-step analysis of aftermarkets set forth in the Discussion Paper is both unnecessary and counterproductive.  The Discussion Paper appears to acknowledge that harm to customers through actions by a supplier of aftermarket products and services is a limited concern.  The only example provided is one in which a supplier adopts a “policy change” with respect to aftermarket products or services (paragraphs 261-262). 
           
However, such a change is likely to take place only in very unusual circumstances – where both a) the entire primary market is declining or the particular supplier has decided to exit or is losing market share and b) the relevant supplier is not engaged in other equipment markets and thus would not be deterred by the impact of the “policy change” on its reputation (paragraph 262).  Even in those very limited situations, there would be no harm to customers if the customers utilized the primary market competition to protect themselves by contract when they purchased the equipment (paragraph 263).  We submit that it is preferable to address this limited concern regarding “installed based opportunism” through private contracts rather than by attempting to apply Article 82 to single-brand aftermarkets and treating a “policy change” as a potential abuse of dominance. Otherwise, there is a risk that suppliers will be deterred from adopting more open and flexible aftermarket policies in the first place if future changes in those policies will subject them to a risk of costly investigations, fines, and private damages actions for violation of Article 82.

There is a risk that the Discussion Paper’s focus (for example, paragraph 247) on customers who have already purchased the primary product will lead to an over-restrictive analysis on the basis of alleged "lock-in". First, the supplier would need to be able to discriminate against the so-called "locked-in" customers so as not to prejudice sales in the primary market. Secondly, the practical possibility of switching to a different "system" would need to be analysed and not just by reference to up-front purchase costs. This latter point is relevant, for example, in markets where the customer already owns and uses different (competing) systems, for example machinery used with consumable products, and can switch between them whenever the price of the consumables for one system is increased without the need to make a further capital investment (which may be significant in comparison with the increase in the price of the consumables) (see paragraph 249).

Moreover, the supplier risks losing sales in the primary market going forward if, having acquired a sufficiently large "installed base" to make discrimination worthwhile, it then increases prices in the secondary market to customers who genuinely are locked-in, for example because switching costs are too high. The supplier may, however, then suffer reputation damage which reduces future demand in the primary market. This point appears to be missing from the discussion in paragraph  254 -- see also paragraph 261 which postulates a change in policy by the supplier -- albeit that it is raised in paragraph 262 in the more limited circumstances of a supplier with declining sales and poor market prospects or of a supplier who has to exit the market. The same reputation point can be made in relation to the possibility of the supplier lowering quality once the customer is locked-in (see paragraph 254), as can the point that the supplier would need the ability to discriminate. In other words, it is appropriate to consider all of the factors which may exercise a constraining influence on the future conduct of the supplier.

On the EU Approach to Refusals to Supply

Vertical foreclosure can be anticompetitive. According to the Discussion Paper, examples include halting supplies to punish buyers for dealing with competitors and refusing to supply buyers that do not agree to exclusive dealing or tying arrangements and mainly refusals to supply, that is “situations where a dominant company denies a buyer access to an input in order to exclude that buyer from participating in an economic activity” (# 209). The Discussion Paper distinguishes three situations: where an existing supply relationship is terminated, where there is a refusal to commence supplying an input, including situations where this input is covered by IPRs, and where the input is information necessary for interoperability.

The Discussion Paper states that four conditions have to be fulfilled in order to find the termination of such a supply relationship to be abusive: (i) the behaviour must be properly characterised as a termination of the supply arrangement; (ii) the refusing undertaking must be dominant; (iii) the refusal must be likely to have a negative effect on competition; and (iv) the refusal must not be justified objectively or by efficiencies. There is no reference to the need to show that the input is “indispensable”. This implies that the termination of an existing supply relationship is more likely to be abusive than a refusal to supply a new customer. Assuming dominance and a termination of a supply arrangement are proven, the Commission would simply have to demonstrate that the termination is likely to have a “negative effect on competition” in order to establish a prima facie case that the conduct is abusive. The dominant supplier could, thereafter, only escape a finding of abuse by showing that the refusal is justified objectively or by efficiencies.

If the dominant supplier has not previously supplied the input to a potential buyer, an additional criterion is added to the four criteria mentioned above: the input must be “indispensable” to carry on normal economic activity in the downstream market. A facility will be an “indispensable” input, or a socalled “essential facility”, only when the duplication of the existing facility is impossible or extremely difficult, either because it is physically or legally impossible to duplicate, or because a second facility is not economically viable. Nevertheless, the Discussion Paper correctly points out that “to maintain incentives to invest and innovate, the dominant firm must not be unduly restricted in the exploitation of valuable results of the investment. For these reasons the dominant firm should normally be free to seek compensation for successful projects that is sufficient to maintain investment incentives, taking the risk of failed projects into account. To achieve such compensation, it may be necessary for the dominant firm to exclude others from access to the input for a certain period of time. The risks facing the parties and the sunk investment that must be committed may thus mean that a dominant firm should be allowed to exclude others for a certain period of time in order to ensure an adequate return on such investment, even when this entails eliminating effective competition during this period” (# 235).

The Section of the Discussion Paper on Refusal to Supply seems to start from the existing case-law, but still raises many controversial policy issues that need further consideration by the European Commission:

• Necessary or sufficient conditions: It is not clear whether the conditions for finding an abuse are necessary or simply sufficient. The Discussion Paper qualifies that “normally” those conditions must be fulfilled; therefore, it seems to leave open the possibility that on a case-by-case basis the Commission could identify other criteria beyond those listed above. This significantly undermines legal certainty and potentially leads to open-ended cases of intervention.
• Different thresholds: The Discussion Paper does not explain the basis for the view that, in general, continuing a supply relationship should be presumed to be pro-competitive. We consider that this should be the result of a case-by-case assessment of the economic circumstances of each case and not the subject of a legal presumption. We submit that the threshold for intervention should be the same as for cases of de novo refusals to supply and, therefore, the requirement that the input is indispensable should also be added for termination of existing supply relationships.
• Indispensable input: The definition of the indispensable input does not address the necessary economic analysis that should be carried out to decide whether duplication of the input is impossible, difficult or expensive for any competitor or for “as efficient” competitors. The Commission should clarify that the focus of the analysis should be on whether a second, substitute product can be created by “as efficient” competitors, rather than whether any competitors will in fact make the investment to create it. This approach would be consistent with the Commission’s objective of protecting competition on the merits.
• Foreclosure effect: The standard for intervention by the Commission is not fully developed. In particular, the Discussion Paper does not give sufficient guidance on the degree of the likely anticompetitive foreclosure effects in the market. It states that the market distorting foreclosure effect should not be understood to mean the complete elimination of all competition, but it does not specify to what extent competition in the downstream market should be affected for an abuse to be found. Furthermore, there is no mention of the economic analysis that should be carried out of the effects of the abuse, in particular to assess the degree of efficiency of excluded competitors. The Commission should clarify that the foreclosure effect should be substantial and at least amount to the creation of dominance in the downstream market (in terms of price increases or output reduction) resulting from the exclusion of “as efficient” competitors.
• Finally, the thresholds to argue efficiencies and objective justifications seem to be too high to be realistically successful in practice. Furthermore, the Discussion Paper fails to acknowledge that an input may become indispensable simply as a result of a company’s superior business performance. A duty to deal/supply should not be imposed simply because consumers prefer the dominant undertaking products.

Compulsory licensing of intellectual property rights is a very sensitive and controversial area under Article 82 and, therefore, deserves particular attention. It is important to preserve companies’ incentives to engage in research and development and other ventures aimed at generating innovative products and services. We welcome a number of pronouncements in the Discussion Paper that appreciate the benefits of the IPR regime and IPR protection. The Discussion Paper clearly states the priority of IPRs protection saying that “[i]mposing on the holder of the rights the obligation to grant to third parties a licence for the supply of products incorporating the IPR, even in return for a reasonable royalty, would lead to the holder being deprived of the substance of the exclusive right”. Hence, another more restrictive criterion is added in the case of a refusal to license IPRs: the undertaking which requests the licence should intend to produce new goods or services not offered by the owner of the IPRs and for which there is a potential consumer demand. This additional criterion is in line with established case-law, but the Commission introduces an exception to this criterion. It states that a refusal to license IPR-protected technology which is indispensable for follow-on innovation may be abusive even if the license is not sought to directly incorporate the technology in clearly identifiable new goods and services since “[T]he refusal of licensing an IPR protected technology should not impair consumers’ ability to benefit from innovation brought about by the dominant undertaking’s competitors” (# 240). However, this exception is not motivated by economic analysis and inconsistent with its mainstream theories: there are not serious economic arguments supporting the view that weakening IPRs would strengthen innovation in the long run: while this may happen in the short run, the current approach of the Discussion Paper on this matter may have strong negative consequences for EU innovation in the long run.

In setting out the exceptional circumstances where refusal to licence an IPR may constitute an abuse, the Discussion Paper starts from the principles and approach well established in the case-law of the Court of Justice (notably and most recently, IMS Health). However, it then fails to give guidance on some key issues still left open by IMS Health and, in some instances, expands the scope of potential compulsory licensing to cover cases beyond the requirements of exceptional circumstances set out in IMS Health, thus potentially having a chilling effect on incentives to invest and innovate.

The Discussion Paper sets out that the refusal by a dominant company to license access to an IPR could be considered abusive when the five conditions for de novo refusal to start supplying an input are satisfied, and “the refusal to grant a licence prevents the development of the market for which the licence is an indispensable input, to the detriment of consumers”. The threshold for intervention in cases of refusals to license IPRs is therefore higher than in other cases of refusals to supply. In summary, the conditions under the Discussion Paper are as follows: the behaviour can be properly characterised as a refusal (again, including cases of constructive refusals such as delaying tactics in supplying, imposing unfair trading conditions, or charging excessive prices for the input); the company refusing to license must be dominant in the market where input is provided; the input must be indispensable (i.e., it must not be possible to turn to any workable alternative technology or to “invent around” the IPR – the Discussion Paper mentions as examples cases where the technology has become the standard or where interoperability is necessary); the refusal is likely to have a negative effect on competition; there is no objective justification; and the additional condition is that the refusal prevents the development of new goods or services and for which there is a potential consumer demand.

The Discussion Paper does not give guidance on some open issues. The first concern dominance in an upstream market: The dominance requirement as set out in # 227 of the Discussion Paper broadens the scope of potential reach of compulsory licenses for IPRs that have no commercial or independent use (i.e. that are not marketed separately), but are only used as an input in other commercial products or services. Under IMS Health, there must be two identifiable markets as a necessary condition for IPR compulsory licensing. The Discussion Paper states that it is sufficient to identify a “captive”, “potential” or even a “hypothetical” upstream market, and that “such is the case where there is actual demand for the input on the part of the undertakings seeking to carry out the activity for which the input is indispensable” . This broad construction can lead to a greater number of compulsory licensing of IPRs (provided the other conditions are met) by covering IPRs that are only used as an input without the need to identify a distinct product or service that would be sold or licensed separately. Furthermore, there is no reference or explanation in the Discussion Paper of the qualification given by the Court of Justice in IMS Health that the potential market must at least correspond to an identifiable “stage of production”. Finally, there is no economic assessment of the conditions under which holding an IPR could amount to market power, which should be the correct framework of analysis without any presumption that holding an IPR may automatically give rise to market power. Without further qualification, such a potentially broad application of Article 82 could have a negative impact on incentives to invest in developing IPRs and investing in new production processes and research.

Another open issue is about the “New product” requirement. There is no explanation of the requirement that the refusal to license must prevent the appearance of new goods or services. The Discussion Paper says that the company requesting the licence should not limit itself to the duplication of goods/services already offered. However, it does not provide any guidance on the criteria to identify or define a “new” product. The Commission should clearly specify that it must be a new kind of product (rather than just an incremental or minor improvement of an existing product) that must expand the market rather than steal sales. In this respect, it would helpful to clarify, consistently with IMS Health, that the new product should satisfy consumer demand that is not satisfied by existing products.

Despite having some deference for IPRs in a number of welcome pronouncements as explained above, the Discussion Paper does not fully carry them through and goes significantly beyond the exceptional circumstances for compulsory licensing set out in IMS Health. We are concerned about the following sections that may carry the risk of reducing the incentives to invest and innovate in the long term. For follow-on innovations, the additional condition that the refusal prevents the development of new goods or services is not necessary. In # 240 of the Discussion Paper states that “a refusal to licence an IPR protected technology which is indispensable as a basis for follow-on innovation by competitors may be abusive even if the licence is not sought to directly incorporate the technology in clearly identifiable new goods and services. The refusal of licensing an IPR protected technology should not impair consumers’ ability to benefit from innovation brought about by the dominant undertaking’s competitors.” This goes much further than the exceptional circumstances set out in IMS Health and the statements of principle in the Discussion Paper. This would be a worrying departure from the established principles of the European case-law, because it effectively means the introduction of open compulsory licensing to competitors for a myriad of IPRs. Furthermore, the Discussion Paper does not define what could amount to “follow-on innovation” and does not explain why intervention is required in this area to bring benefits to consumers. Finally, inefficient competitors may effectively have the possibility to free-ride on the investments and risks taken by a dominant undertaking. For all these reasons, companies may be deterred from investing and innovating in the first place, with a potential much bigger negative impact on consumers in the medium-long term.

Finally, the Discussion Paper states that leveraging market power from one market to another by refusing to supply interoperability information may be abusive. “Although there is no general obligation even for dominant companies to ensure interoperability, leveraging market power from one market to another by refusing interoperability information may be an abuse of a dominant position” (#241). The Commission will, even if such information is considered a trade secret, not apply the same high threshold as regards IPRs. However, there is no guidance on the lower standards that the Commission will apply and on the definition of “information needed for interoperability” and this statement appears to open doors to a systematic possibility that innovative firms are forced not only to reveal IPRs but even trade secret. The same uncertainty induced by this ambiguous wording is likely to jeopardize the incentives to invest in R&D with dangerous consequences for (future) consumer welfare, exactly the opposite of what the Discussion Paper was aiming to.

A Crucial Month for the Future of European Innovation

In the coming month, two crucial processes are likely to reshape the future of innovation and  competition in Europe: the debate on the reform of EU competition enforcement in the area of  abuse of dominance, and developments in the EU  Microsoft case.

In line with the recent evolution of US antitrust policy, Dutch Commissioner Neelie Kroes is trying to implement an important reform, moving from a formal approach to antitrust toward a more modern welfare-based approach focused on the protection of consumers and of competition (rather than of competitors): the idea is that a particular behavior should not be condemned for being abusive per se, but only when it creates net losses for consumers. While the apparent shift in direction is positive, I have some concern that it is not being fully carried through at the level of specific proposals, beginning with the Commission’s recent Discussion Paper on the Application of Article 82 of the Treaty to Exclusionary Abuses.

For instance, in this Discussion Paper, still in line with old economic views, dominance in a market is associated too closely with a large market share and the efficiency defence - the chance for the dominant firm to prove that its aggressive strategy is not abusive if it enhances consumer welfare or improves the allocation of resources - is virtually excluded in case of market shares over a given threshold. Such an approach to the finding of dominance can be extremely dangerous with respect to the fast-moving markets of high-tech and New Economy industries (computer hardware and software, online businesses, mobile telephony and biotechnology). These industries are often characterised by massive R&D investments, strong reliance on IPRs and other intangible assets, first-mover advantages, high fixed sunk costs and low marginal costs. Competition in these markets is dynamic in the sense that it is often competition for the market in winner-takes-all races. Leading firms in these markets may enjoy high market shares yet be subject to massive competitive pressure to constantly create better products at lower prices, due to the threat from innovative competitors and potential entrants. Companies that hold a significant share of the market at any given point in time may see this share decrease rapidly and significantly following the development and supply of a new and more attractive product by an actual or potential competitor (the launch of the iPod by Apple and its impact on the distribution of so-called “MP3 players” is a good example of such rapid and drastic market developments). Hence, a static definition of dominance based on market share that fails to take account of the entry and technology conditions may be highly misleading.

Parallel to this debate, Microsoft’s appeal of the Commission’s March 2004 antitrust decision will be heart by the European Court of First Instance at the end of April. In this landmark decision, the Commission imposed the largest fine in the history of antitrust, required Microsoft to issue a version of its Windows operating system without Media Player, and mandated the licensing of intellectual property to enable interoperability between Windows PCs and work group servers and competitor products. The last point has turned out to be the most problematic: the picture that is emerging from Bruxelles is of a Commission that has continued to extend the scope of the information required, while deliberately declining to spell out exactly what would constitute compliance with the remedy.

The recent Microsoft's offer of access to Windows source code, including for technologies that are covered by patents and trade secrets, seems to have done nothing to dispel the threat of daily fines of up to € 2 million, fines that would put the company in a difficult position (to stay the least) going into the Court proceedings. One should always keep in mind that in EU antitrust there is not the substantial parity between defense and prosecution before a judge that is taken for granted in the US (something to keep in mind in a reform process). Nevertheless, the Commission is aware that its case is much weaker than two years ago. Microsoft offered Windows without Media Player and nobody bought it, which strongly suggests that the “bundling” strategy was at least not damaging consumers. Microsoft was forced to licence more than a hundred technologies and in Europe not one of its competitors has taken out a license, a sign that the existing level of interoperability was not as low as it was depicted.

The crucial issue for the future of innovation in Europe is whether the Commission will insist on forcing the disclosure of intellectual property rights that are the fruit of years of work and huge investments, something which may seriously jeopardize future investments in R&D not only in the software market, but in all the high-tech sectors. Unfortunately, the Commission’s current proposal on exclusionary abuses deals with refusals to supply intellectual property rights to ensure interoperability in an ambiguous way: in particular, it states that defending patents and trade secrets is fundamental to promote investments, but opens the door to uncertain conditions under which forced disclosure can be required, in a way that seems to go beyond the carefully balanced case law. This could have chilling effects on incentives to invest and innovate and could ultimately end up protecting inefficient competitors that may free ride on the risks and investments of successful companies, in apparent contradiction to the Commission’s important and positive objective of protecting competition on the merits.

Where the Commission comes down in the next weeks on Article 82 reform and the Microsoft case will provide some important guidance about the future of innovation, competition and consumers’ interests in the European Union.

Reforming Article 82 of EU Competition Policy

The main provisions of European Competition Law (what in US terminology would be Antitrust Law) concerning abuse of dominance are contained in the Article 82 of the Treaty of the European Communities which states:

“Any abuse by one or more undertakings of a dominant position within the common market or in a substantial part of it shall be prohibited as incompatible with the common market in so far as it may affect trade between Member States. Such abuse may, in particular, consist in: (a) directly or indirectly imposing unfair purchase or selling prices or other unfair trading conditions; (b) limiting production, markets or technical development to the prejudice of consumers; (c) applying dissimilar conditions to equivalent transactions with other trading  parties, thereby placing them at competitive disadvantage; (d) making the conclusion of contracts subject to acceptance by other parties of supplementary obligations which, by their nature or according to commercial usage, have no connection with the subject of such contracts.”

This article (as Article 81 on horizontal and vertical agreements) is part of the law of each member state and is enforced by the European Commission (in particular the Directorate General for Competition) and by all the National Competition Authorities. In December 2005 the European Commission published a Discussion Paper on exclusionary abuses under Article 82 (hence on, the Discussion Paper) which is the subject of an open debate and gives an important indication as to how the Commission may approach exclusionary abuses in the future. The Discussion Paper states that the purpose of Article 82 is “the protection of competition on the market as a means of enhancing consumer welfare and of ensuring an efficient allocation of resources” (# 4). This implies that antitrust should protect competition and not competitors and be based on an economic approach aiming at the maximization of consumer welfare and allocative efficiency rather than based on a legalistic approach.

In the current proposal of the guidelines for EU antitrust there are some positive aspects, mainly in the central concern to enhance consumer welfare and to protect competition and not competitors, but such a welfare-based approach is not enough supported in the overall design of these guidelines. In what follows, we will review the EU approach to competition law regarding abuse of dominance commenting on the recent proposal and relating the EU competition policy with the principles of the theory of market leaders. We will also provide our own suggestions on how to improve the application of the EU competition policy.

According to the European Competition Law, dominance in a market or its creation cannot be punished, while only its abuse by dominant firms is subject to antitrust screening. Hence, the preliminary phase of any antitrust case applying Article 82 must define the relevant market and verify the existence of a dominant position. The Discussion Paper briefly refers to the definition of a proper market, which can be more complex in Article 82 cases because the market price could be above its competitive level (#11-19). This creates problems with the usual methods of market definition. For instance the SSNIP-test, which defines the relevant separate market as the smallest market where a Small but Significant Non-transitory Increase in (competitive) Prices (say of 5-10%) increases the profits of a hypothetical monopolist, is biased when the market is characterized by higher than competitive prices (which is more likely in cases of abuse of dominance): such a bias usually leads to a too-wide market definition, which in turn may lead to a finding of no dominance, the so-caled “cellophane fallacy” (from the du Pont case). It should be noticed that the cellophane fallacy only applies in presence of a single monopolist in the market and when entry is impossible, while the SSNIP-test at the prevailing prices remains a valid test whenever the market leader is constrained by effective competition and/or potential entry.

Following a traditional definition, the Discussion Paper associates dominance with “a position of economic strength enjoyed by an undertaking which enables it to prevent effective competition being maintained on the relevant market by affording it the power to behave to an appreciable extent independently of its competitors, its customers and ultimately of the consumers” (# 20). Such a definition requires “a leading position on that market” compared to the rivals (# 22) and the lack of “effective competitive constraints” (# 23) in the process in which “the undertaking and the other players act and inter-act on the market”( # 23).

Given the positive stress put on an economic-based approach to competition policy, it is important to notice that this definition of dominance is clearly associated with two situations: the pure monopoly, as an extreme case of dominance, and the market leadership where the dominant firm faces some competitors, which is the subject of the theory of market leaders previously studied. It should be emphasized that, according to this theory, a market leader can really act independently of its rivals (so as to satisfy the above condition for dominance) only when the number of competitors is exogenously set and further entry is impossible, while a market leadership constrained by effective competition and potential entry cannot be associated with dominance: in this case, modern economic theory tells us that leaders tend to be aggressive (pro-competitive) in their pricing and investment strategies, conquering larger market shares in a way that has nothing to do with dominance as defined above, and which is also beneficial to consumers.

As a consequence of the approach of the Discussion Paper, it would be better to eliminate a certain ambiguity in the statement at # 27 saying that “the fact that an undertaking is compelled by the pressure of its competitors’ price reductions to lower its own prices is in general incompatible with […] the existence of substantial market power” and hence with dominance. In particular this should be always true and not just “in general”, since in this case the market leader is constrained by effective competition and cannot act independently from it, as the definition of dominance would require and should be extended to any other form of aggressive competition, that is not only competition in prices, but also competition in quantities or in alternative forms of strategic investments. Hence, the fact that an undertaking is compelled by the pressure of its competitors’ aggressive strategies to adopt aggressive (pricing and investment) strategies should  be always incompatible with dominance.

The stress on market shares in the evaluation of dominance (# 29- 33) appears in clear contrast with the conclusions of the modern theory of market leadership: market leaders have larger market shares exactly when they are constrained by effective and potential competition since in this case they adopt more aggressive (pricing and investment) strategies which expand their market shares. In other words there is not necessarily a positive correlation between the presence of larger market shares and a dominant position and, especially in highly dynamic markets, there is not unambiguous theoretical support for a statement saying that “[m]arket share is only a proxy for market power” (# 32).

As Rey et al. (2005) have correctly pointed out, “the case law tradition of having separate assessments of dominance and of abusiveness of behavior simplifies procedures, but this simplification involves a loss of precision in the implementation of the legal norm. The structural indicators which traditionally serve as proxies for ‘dominance’ provide an appropriate measure of power in some markets, but not in others”, as indeed in high-tech and New Economy industries (as computer hardware and software, online businesses, mobile telephony and biotechnology).

Finally, the part on dominance clearly refers to competition in the market, while it is hardly useful to evaluate cases where competition for the market takes place. In these cases, typical of the New Economy, competition is dynamic and innovators conquer large parts of a market, so that any static analysis of market shares cannot say anything about dominance. In other words, a market can be currently dominated by a single firm, but if many other firms which are not even active in this market are investing in R&D to enter into it, as it happens in many high-tech sectors, this market is substantially competitive in a dynamic sense. Nevertheless, any leader in such a competitive winner-takes-all market would be always characterized as dominant by the static and market-share-based approach of the Discussion Paper.

Moreover, modern economic theory tells us that in these dynamic sectors market leaders, as long as they are constrained by effective competition in the market for innovations, invest more than their competitors and hence are more likely to remain leaders. In this sense, statements saying that “high market shares, which have been held for some time, indicate a dominant position” can be true in some sectors, but not in high-tech sectors with competition for the market. In conclusion, the general impression is that there is an excessive stress on the importance of market shares to evaluate dominance, and that this can be highly misleading especially for dynamic markets.

The part of the Discussion Paper on barriers to expansion and entry (# 34-40) concerns a concept which is far from unambiguous in economic theory. The definition of these barriers as “factors that make entry impossible or unprofitable while permitting established undertakings to charge prices above the competitive level” (# 38) applies well to legal barriers but not to other factors which are sometimes seen as barriers. For instance, high fixed costs of production and R&D or investments needed to develop network externalities or learning by doing advantages, do not make entry impossible: the correct definition in these cases would be that these factors endogenously limit entry or endogenously determine how many and which firms profitably enter. The difference is not just in the definition but also in the economic consequence, since modern economic theory has shown that when entry is impossible market leaders may behave in an anti-competitive way, but when entry is constrained by technological or demand conditions they (always) behave in a pro-competitive way even if the cited factors limit entry and the market leaders obtain high market shares.

Despite the Discussion Paper claims that “the purpose of Article 82 is not to protect competitors from dominant firms’ genuine competition based on factors such as higher quality, novel products, opportune innovation or otherwise better performance, but to ensure that these competitors are also able to expand in or enter the market and compete therein on the merits, without facing conditions which are distorted or impaired by the dominant firm.” (# 54), these principles are not fully carried through into certain aspects of the analytic framework. In particular, it would be better to  stress more that the interests of consumers are always paramount of those of competitors, to move even further away from form-based rules and presumptions towards a more economics- and fact-based approach, and to expand the avenues through which account may be taken of the efficiency-enhancing effects of challenged conduct. The analysis of whether a firm has engaged in abusive conduct under Article 82 should ultimately turn on the conduct’s actual effects on efficiency and consumer welfare.  Thus, if the pro-consumer benefits of a dominant undertaking’s conduct are significant, it should be immune from liability even if it disadvantages certain competitors: inventing better products or more efficient methods of distribution, reducing prices or offering better terms of trade, and more quickly adapting to changes in the market can disadvantage rivals and maybe even cause them to exit the market, but these forms of conduct often also enhance efficiency and consumer welfare.

In spelling out the concept of foreclosure, the Discussion Paper states that “it is sufficient that the rivals are disadvantaged and consequently led to compete less aggressively” (# 58). This proposition gives cause for concern. First, this statement is not consistent with the theory of market leaders which has made clear that an aggressive behaviour of the market leader inducing a less aggressive competition of its competitors is not sufficient to create any harm to consumers (actually the net effect is typically the opposite happens). The inconsistency of this statement is even more clear when it is claimed that “[r]ivals may be disadvantaged where the dominant company is able to … reduce demand for the rivals’ products” (# 58) which is really what any aggressive or pro-competitive strategy would do. Putting together the two sentences, we are told that it would be sufficient to establish foreclosure that the strategy of the dominant firm reduces demand for the rivals’ product: but this amounts to banish any pro-competitive strategy by market leaders. Moreover, the above statement could arguably support the conclusion that a dominant company in a market characterized by network effects could be guilty of abuse if it is able to attract new customers on the basis of a new, superior technology. This view is contrary to the basic principle that dominant companies should be permitted (and indeed encouraged) to compete aggressively on the merits. Allowing a finding of abuse merely where competitors are “disadvantaged” would penalise dominant firms for engaging in a wide range of conduct that is ultimately pro-competitive. In our view, this aspect of the analytic framework should be revised to clarify that conduct by a dominant firm would be deemed to be an abuse only if its net effect is to harm consumer welfare.

The Discussion Paper states that the Commission may at times prohibit the use of price discounts where doing so will “protect competitors that are not (yet) as efficient as the dominant company” (# 67). In our view, there is no economic justification for barring dominant firms from decreasing prices simply in order to protect less efficient rivals (particularly since such a prohibition will mean that these rivals will face even less competitive pressure to become more efficient). This condition also places dominant firms in the untenable position of having to guess what level of rival inefficiency will be used to judge whether the dominant firm’s own efficiency-enhancing conduct is lawful. The Discussion Paper also states, in its discussion of the meeting competition defense, that a dominant firm has an obligation to weigh “the interests of its competitors to enter or expand” into the market when deciding upon alternative courses of action, and that dominant firms can only benefit from this defence if they prove there was no less anticompetitive alternative (# 82-83). In the real world, the best businesses are focused on advancing the interests of their customers, not their competitors (which, of course, is one sign of a competitive market).  Thus, most dominant firms will be ill-equipped to evaluate which of various possible options will least disadvantage their competitors.  We would therefore recommend that this requirement that dominant firms weigh the interests of competitors be dropped from the analysis.

EU Competition Law has been criticised for focusing more on the form of unilateral conduct than on its actual effects in the marketplace. There is broad consensus among economists that (unilateral) price- and non-price conduct of dominant firms may produce both pro- and anticompetitive effects. The ambiguous nature of conduct of dominant firms militates in favour of a full appreciation of the (positive and negative) effects on consumers. It is therefore vital that the framework for analysis under Article 82 provides for a rigorous, economics-based examination of the market context in which unilateral conduct occurs. For instance, the Commission should clarify that, despite the references to the “form and nature” of conduct in the general discussion of exclusionary abuses (# 58-59), whether market foreclosure will be found to exist will ultimately turn on the actual effects of the conduct in the marketplace.  Also, while we commend the Commission for placing less reliance on per se rules and irrebutable presumptions of market foreclosure and abuse, the Discussion Paper retains elements of this approach.  For example, in several places, certain forms of conduct or market shares will make it “highly unlikely” that some legal determination will result (# 30, 90, 91).  We would urge the Commission to lessen its reliance even on these quasi-per se rules and to adopt a more thoroughgoing, economics- and effects-based analysis that focuses on increasing consumer welfare and is based on sound economic theory of the behaviour of market leaders and on solid empirical analysis.

Rey et al. (2005) correctly emphasized the need of solid theoretical and empirical foundations in the antitrust procedure: “a natural process would consist of asking the competition authority to first identify a consistent story of competitive harm, identifying the economic theory or theories on which the story is based, as well as the facts which support the theory as opposed to competing theories. Next, the firm should have the opportunity to present its defense, presumably to provide a counter-story indicating that the practice in question is not anticompetitive, but is in fact a legitimate, perhaps even pro-competitive business practice.”

Conduct that generates efficiencies should not, in our view, be deemed abusive unless it is demonstrated that the impact of this conduct on competition will result in consumer harm outweighing these efficiencies. While the Discussion Paper acknowledges that promoting efficiency is one of the primary objectives of Article 82, the framework for analysis itself actually provides relatively limited scope for taking efficiencies into account.  This manifests itself in a variety of ways.

First, the Discussion Paper indicates that, consistent with existing practice, it will fall on dominant firms to prove the extent to which their conduct was justified on grounds of efficiency (# 77, 79).  Bringing efficiencies into the analysis only as an affirmative defense will send the wrong signal to the business community: it means that investigations will often have moved quite far along before efficiency considerations fully come into play.  Placing the burden of proof on competition authorities, by contrast, makes more sense as they are likely to be in a better position to obtain relevant evidence from the dominant firm as well as other market participants (such as consumer organizations) on whether challenged conduct promotes efficiency—and have the expertise and resources to undertake such an inquiry.  Accordingly, we believe it is for the authority investigating an alleged infringement of Article 82 to support any finding of abuse by evidence that the conduct at issue is not justified by efficiencies, in particular in those instances where the dominant company proposes a prima facie efficiency justification.

Second, according to the Discussion Paper, to assert a successful efficiency defense under the proposed analytic framework, dominant firms will be required to show that their conduct was “indispensable” in order to achieve the resulting efficiencies and that “competition in respect of a substantial portion of the products concerned [was] not eliminated” (# 84).  To meet the first of these conditions, the defendant must “demonstrate that there are no other economically practicable and less anticompetitive alternatives to achieve the claimed efficiencies” (# 86). This condition means that liability could be imposed even on conduct whose efficiency and consumer benefits far outweigh its adverse effect on competitors simply because there exists an alternative that would have disadvantaged rivals less.  In our view, this rule has no economic justification: at most, it will merely provide an excuse for rivals to second-guess the business decisions of their dominant competitors. The latter condition implies that efficiency claims by dominant firms, particularly those with high market shares, will systematically be given short shrift because of the difficulty of satisfying this condition: in essence, dominant firms effectively will be required to place the interests of competitors and the competitive process over the interests of efficiency and consumer welfare.

Finally, the Discussion Paper also seems to suggest that, where a dominant firm holds a market share above 75 %, the protection of competitors will be given priority over efficiency. In our view, efficiencies should be assessed in the same manner in all cases, regardless of the defendant’s market share. Under the Treaty, and consistent with the goals of Article 82 as articulated by Commissioner Kroes, firms that generate pro-competitive efficiencies that benefit consumers should not be penalised regardless of the level of market share or potential impact on less efficient competitors. Moreover, the Discussion Paper introduces a concept of market position “approaching that of a monopoly” (# 92), for market shares above 75%, which has not any foundation in economic analysis. And the same economic analysis does not justify any separate treatment for firms with high market shares. Moreover, as emphasized by the theory of market leadership, market leaders tend to have higher market shares exactly when they face an effective competitive pressure which induces them to adopt aggressive (pricing and investment) strategies and hence to expand their market shares in a pro-competitive way: under these conditions, exceptionally high market shares (but not monopolistic ones) can be due to relevant scale economies or to the existence of learning by doing or network effects, but they do not justify exclusion from efficiency defence.

Bundling and Competition Policy

In many occasions this website has discussed the new theory of market leaders and its implications for competition policy. One of the issues were the new theory applies and provides new insights is bundling, that is the combination of two separate products in a single one sold alone. Notice that tying refers to selling one product (the tying product) conditional on the purchase of another one (the tied product), but there will not be any substantial difference between the two for our purposes. Virtually any product is a bundle since it combines multiple basic products which could be or are sold separately: a car bundles many separate components, a dinner at a restaurant bundles food and drinks of different brands, Coke bundles many ingredients (covered by trade secret), a computer bundles hardware, a operating system and basic softwares of general interest, Sunday issues of many newspapers bundle the basic journal with a magazine or special offers.

The Chicago school has advanced efficiency rationales in favour of bundling with positive, or at worst ambiguous, consequences on welfare, including production or distribution cost savings, reduction in transaction costs for the customers, protection of intellectual property, product improvements, quality  assurance and legitimate price responses. Moreover, according to the so called “single monopoly profit theorem”, as long as the secondary market is competitive, a monopolist in a separate market cannot increase its profits in the former by tying the two products. Actually, in presence of complementarities, it can only gain from having competition and high sales in the secondary market to enhance demand in its monopolistic market. This point is made just stronger in presence of network effects, as made clear by Economides (2001) in his recent discussion of the software market.

The post Chicago approach has shown that, when the bundling firm has some market power, bundles can have a predatory purpose, that is they can deter entry in the tied product market to expand monopolistic power and reduce consumer welfare at least in the long run (Whinston, 1990). Summarizing the past economic research in the field, Tirole (2005) has pointed out that the impact of tying on competition in the tied market ranges from a negligible impact on the rivals’ ability to compete to entry deterrence, depending on a number of factors like “the marginal cost of manufacturing the tied product; the rivals’ ability to differentiate horizontally or vertically their offering from the tied product (that is, to offer some features that are not available in the tied product); and, if the market is multi-sided, the ability to differentiate, in the side where there is no tie, through technological features, in-house supply, or exclusive contracts with third-party vendors, and the ease with which users on the tying side can multi-home.”  According to Tirole (2005), and we agree on this, tying should be submitted to a rule-of-reason standard, since it can have both efficiency and anti-competitive purposes.

The theory of market leaders emphasizes that bundling by the incumbent 1) is just an aggressive (pro-competitive) strategy of the incumbent for a competitive tied product market, 2) may not have a specific entry deterrence purpose, and 3) may increase welfare even without taking efficiency reasons into account.

To derive these results, let us adopt the strongest bias against the bundling firm, imagining that this is a monopolist in a primary market with the possibility to enter in a secondary market, and that there are no clear technological efficiencies to obtain by bundling goods in the two markets. The Chicago school has studied such a situation when the secondary market is perfectly competitive, that is firms price at marginal cost and earn no extra profits: in such a case, the monopolist has no incentives to bundle because this could only reduce demand in the primary market. The post-Chicago approach has studied the same situation when the secondary market is not perfectly competitive and there is actually one single firm active strategically and no possibility for other firms to enter: then the only reason why the monopolist would like to adopt a bundling strategy is to induce exit of the rival in the secondary market (Whinston, 1990).

Finally, the new theory of market leaders has studied again the same situation but with a secondary market where firms decide “endogenously” whether to enter or not. In this case, the purpose of bundling has nothing to do with entry deterrence, it is just an aggressive strategy (but not a predatory one) which has pro-competitive effects: it reduces the combined price level and increases welfare. Technically, the market leader can exploit a larger scale of production for the bundle to offer it at a competitive price: bundling the two products works as a commitment device to be aggressive, that is to produce more for the secondary market and hence to be able to adopt a lower price. As a consequence, the leader can exploit larger scale economies, reduce the average price level for the consumers and hence increase welfare (see Etro, 2006, for a detailed proof).

Summarizing, while approaching a bundling case we need to verify the entry conditions of the secondary market. If there is a dominant firm in this market as well, the main problem is not the bundling strategy, but the lack of competition in the secondary market, and it should be addressed within this market: punishing the bundling strategy would just guarantee the monopolistic rents of the dominant firm in the secondary markets. However, things are different when the secondary market is not monopolized but open to endogenous entry (even if it is not perfectly competitive, in the sense that firms do not price at marginal cost). In such a case bundling is a pro-competitive strategy and punishing it would hurt consumers. Finally, notice that we achieved these conclusions ignoring the possibility that the bundling firm could create technological efficiencies by bundling its products, excluding that this firm could have a somewhat limited market power in the primary market and even ignoring the benefits from bundling in case of complementarities between the products: taking these factors in consideration could only strengthen the results against the punishment of a bundling strategy.

A New Approach toward Exclusionary Abuses in Antitrust Policy

A new Discussion Paper of the European Commission on the application of Article 82 of the Treaty to exclusionary abuses is likely to inspire a wide debate on the proper aims and methods of antitrust policy in Europe. In the current proposal of the guidelines for EU antitrust there are some positive aspects, mainly in the central concern to enhance consumer welfare and to protect competition and not competitors, but such a welfare-based approach is not enough supported in the overall design of these guidelines. The section on the efficiency defences for the dominant firms appears to be going in the right direction since it allows otherwise abusive strategies if they create a net efficiency gain which benefits consumers: through an objective necessity defence “where the dominant company is able to show that the otherwise abusive conduct is actually necessary conduct on the basis of objective factors external to the parties involved and in particular external to the dominant company” or a meeting competition defence “where the dominant company is able to show that the otherwise abusive conduct is actually a loss minimising reaction to competition from others” (# 78). Nevertheless the effectiveness of these rules in safeguarding consumer welfare is weakened in # 90-92, where without any economic justification, some firms are virtually excluded from the possibility of an efficiency defence. In particular, a strange concept of market position "approaching that of a monopoly" is introduced and associated with market shares above 75%, something without any justification in economic theory: a firm has a monopolistic position or it has not, but it cannot be an "almost monopoly" or a "near monopoly"! Needless to say, the definition of dominance in the cited guidelines is still strictly related with the concept of market share, in line with outdated views.

Beyond the many weak points of these guidelines, the general need for a new approach to competition policy and in particular to exclusionary abuses is strong. Recent developments in the economic research on market structures argue in favour of a move beyond the socalled post-Chicago approach, which has been dominant in the last twenty years. In particular, the new theory of market leadership tries to integrate the Chicago approach, which emphasizes the importance of competition in constraining market leaders and the post-Chicago approach, which emphasizes the strategic interaction between market leaders and competitors. While the former approach has ignored strategic interactions, the latter has ignored the role of endogenous entry, focusing only on the relation between an incumbent and a competitor. Only a comprehensive understanding of the strategic interaction between market leaders and their competitors, taking into account the endogenous incentives of all these to enter in the market, can provide a sound approach to antitrust issues, and this is what the new theory of market leaders is aiming at.

In the 80s and 90s, the post-Chicago research on industrial organization studied market structures within a solid economic (game-theoretic) framework and introduced welfare considerations so as to derive normative implications from its research: such a welfare based approach to competition policy represents one of the main contribution of this approach. However, in most cases, this literature limited its analysis to the behaviour of an incumbent monopolist facing a single competitor. To cite the most famous works with strong relevance for antitrust issues, this was the case of the Dixit (1980) model of entry deterrence, of the model by Milgrom and Roberts (1982) on predatory pricing, of the work by Fudenberg and Tirole (1984) of strategic investments, of the Bonanno and Vickers (1988) model of vertical restraints, of the Whinston (1990) model of bundling for entry deterrence purposes, and of many other works, often based on analysis of duopolies. In this set up where the possibility of entry by third firms is not taken into account, it is easier for the incumbent to adopt strategies which hurt the rival and protect a dominant position. These anti-competitive strategies would be less effective or even counterproductive in case other firms could enter the market and interact strategically (so not even under perfect competition as in the older Chicago school) with both the incumbent and its immediate rival.

It is not surprising that the results of the post-Chicago approach are systematically biased toward an anti-competitive strategic role of incumbents: according to this view, incumbents tend to engage in predatory pricing, threaten and undertake overinvestments in complementary markets, impose exclusive dealing contracts or bundle their goods with the main purpose of deterring entry of the competitor, otherwise they engage in accommodating pricing, underinvest in quality and product differentiation and they stifle innovation. In such a simple world, what antitrust authorities should do is fighting against incumbents: punish their aggressive pricing strategies as predatory, and their accommodating pricing strategies as well (but in this case as monopolistic behaviours), punish investments in complementary markets (“embrace and extend” strategies) as attempts to monopolize them, forbid bundling strategies, and so on. The bottom line is that antitrust authorities should sanction virtually any behaviour of the incumbents which does not conform to that of their competitors. It is true that the majority of the post-Chicago economists admit the possibility that most strategies adopted by the dominant firms can also have efficiency rationales and consequently suggest the need of a rule of reason to judge every single market case by case, but starting from such a bias against incumbents, it is often hard to find efficiency effects which compensate for the hypothetical anti-competitive strategic effects (and even harder, when these effects exist, to prove them). The consequences are on one side that competition policy is often ineffective, and on the other that market leaders tend to avoid potentially pro-competitive strategies because they may be covered by biased antitrust rules. Unfortunately, the cited guidelines proposed from the European Commission, following the post-Chicago tradition, do not fully solve these problems.

The fallacy of the post-Chicago approach derives from a simple fact: it is based on a partial theory which does not take into account that, at least in most cases, entry by competitors is not an exogenous fact, but an endogenous decision. This holds not only for the market where the leader is primarily active, but also for the secondary markets where its strategies are supposed to have consequences. Virtually, all the research by the post-Chicago school examines the behaviour of incumbents when it is assumed that one competitor (or a fixed exogenous number of competitors) could enter their markets, but completely disregards the possible choice of other firms to enter these markets: in other words, this school does not endogenize entry of competitors. This leads to misleading results. Whether entry is more or less costly, entry is an endogenous decision by the potential competitors (except for cases of natural monopoly or legal barriers to entry, which should not be a subject of antitrust analysis), especially in globalized markets where entry can originate everywhere in the world, as for most markets in the New Economy. There are two different kinds of constraints on entry: barriers to entry are traditionally defined as sunk costs of entry for the competitors which are above the corresponding costs of the incumbent (or have been already paid by the incumbent), while simple fixed costs of entry are equally faced by the incumbent and the followers to produce in the market. While there is a fundamental difference between the two concepts, their role in constraining entry, and hence in endogenizing it, is basically the same. Only a comprehensive understanding of the behaviour of incumbents when entry is endogenous and when it is not can provide the required tools to judge real world markets. Unfortunately, the endogeneity of entry makes a lot of difference and overturns most of the results of the post-Chicago school, which would imply a revision of the traditional approach to antitrust policy.

Within the new theory of market leaders, the following main results emerge: 1) market leaders are always aggressive (pro-competitive: set lower prices and hence have higher market shares) when entry is free or endogenously constrained by barriers to entry or pure fixed costs of entry (Etro, 2006): as a consequence, very large market shares for dominant firms are more likely to be a symptom of a competitive environment rather than market power; 2) competitive markets characterized by high fixed costs and constant variable costs or, more generally, by decreasing average costs, generate absolute or close to absolute dominance: under these conditions even an apparently monopolistic market share has not any relation with effective market power, while it is likely to be the symptom of a competitive environment (a first discussion of such a result is by Modigliani, 1958; for a modern proof see Etro, 2005); 3) aggressive introductory pricing, bundling strategies (without entry deterrence purposes!) and over-investments in complementary markets are always parts of a natural competitive behaviour of leaders in competitive markets; 4) dominant firms invest more in R&D when threatened by a competitive pressure, while they tend to stifle innovation in absence of such a pressure: hence, a leadership in high-tech sectors tends to be persistent if and only if there is effective dynamic competition, which leads to a faster rate of technological progress in the interest of consumers (Etro, 2004; see Blundell et al. (1999) and the recent book by Aghion and Griffith (2005) for supporting empirical evidence).

Notice that these results show the total inconsistency of definitions of market positions "approaching that of a monopoly" when the market share is above a certain threshold (a 75% threshold is suggested by the cited guidelines of the European Commission to exclude the possibility of efficiency defence): high market shares for the leaders are perfectly compatible with strong competition in and for the market.

As an example, consider the software market. The technological conditions in this market are well known and quite uncontroversial. Producing software (whether it is an operating system or a particular application) takes a very high up-front investment, which corresponds to what we called a high fixed cost of production, and a constant marginal cost, in the sense that the cost of each additional unit of software is always the same, and, as well known, this is  close to zero. The entry conditions in this market are more debated, but there are good reasons to believe that entry in the software market may entail large costs, but is substantially open. First of all, there are already many firms active in this sector, and even more potential entrants – think of the giants in adjacent sectors of the New Economy (hardware and telecommunications in particular). Second, it is hard to think of a market which is more “global” than the software market: demand comes from all the world, transport costs are virtually close to zero for the all world, knowledge to build software is easily accessible worldwide and competition is global. Nevertheless, it has been claimed that in the market for PC (or client) operating systems the high number of applications developed by many different firms for Windows represent a substantial barrier to entry. Unfortunately, such a claim usually leads to misleading conclusions. It is true that Microsoft competitors need to offer (and some do offer already) a number of standard and technologically mature applications upon entry to match the high quality of the Windows package, but the cost of offering these applications is unlikely to be prohibitive compared to the global size of this market. There are at least two reasons for this. First, notice that the alleged “applications barrier to entry” is often erroneously associated with thousands of applications written for Windows, while it is actually limited to a handful of applications such as word processing, spreadsheet, graphics and communications software, which really exhaust the needs of most active computer users in the world. Second, the competitors of Microsoft should not (and the existing ones do not) even finance the development of all the needed applications: as Microsoft did in most cases, they should just fund and encourage other firms to write applications for their operating system (or have old applications originally written for other operating systems “ported to” their one). Finally, it is important to emphasize that if we look at competition in the software market in a dynamic sense, that is competition for the market (as opposed to competition in the market) or through innovations, there is no doubt that the opportunity to invest in innovations for future better software is widely open not only to large companies in the New Economy, but even to smaller ones.

Summarizing, the software market is characterized by high entry costs, constant marginal costs close to zero and substantially open access by competitors able to create new software. According to the new theory of market leaders these are the ideal conditions under which we should expect a leader to produce for the all market with very aggressive (low) prices. Hence, it should not be surprising that, at least in the market for operating systems, a single firm has such a large market share. We can see the same fact from a different perspective: since entry in the software market is an endogenous factor depending on the behaviour of the leader, this finds convenient to keep prices low enough to expand its market share to almost all the market. Notice that network externalities require these prices to be even lower because competitors could (and indeed try to) offer their alternative softwares at even lower prices to build their own network effects.

The extremely low price of the main software of Microsoft, Windows, represents an inverse proof of our arguments above. It is easy to realize that the behaviour of Microsoft in this sense has nothing to do with the behaviour of a real monopolist. To verify this, imagine for simplicity that the marginal cost of producing Windows is zero, and that the price of hardware is constant and independent from the price of Windows. Standard economic theory implies that the monopolistic price for an operating system should be the price of the hardware divided by E-1,  where E  is the elasticity of demand for PCs (it means that a 1% increase in the price of PCs reduces demand by E %). Now, the above relation tells us that, if the basic price of the hardware is 1000 Euros, which is about the current average price for PCs, the monopolistic price for Windows would be 1000 Euros if E=2, 500 Euros if E=3,  333 Euros if E=4 and so on. It would take really unreasonable values of demand elasticity (above 10) to even get close to the real average price of Windows, which is around 50-100 Euros. Moreover, this is a very conservative estimate of the monopolistic price. In the real world, we can imagine that the price of hardware is not independent from the price of Windows: if the latter would increase a lot, hardware producers would be forced to reduce somewhat their prices. Even if this effect may be limited by the high level of competition in the hardware sector, it goes in the direction of increasing further the monopolistic price of Windows: and to emphasize how low is the actual price of Windows compared to that.

What does all this tell us? Simply that the software market is not monopolistic and its prices are constrained well below the monopolistic level because the leader has to compete aggressively with the other firms active in the market and with the potential entrants. However, we can say more than that. What the post-Chicago approach suggested about leaders in markets with price competition was that they should be accommodating and exploit their market power setting higher prices than the competitors or engage in predatory pricing and, after having conquered the all market, increase prices. But in the last ten-fifteen years of global leadership, Microsoft has done neither one or the other of these things: since 1990 the (retail and street) price of Windows has been constantly declining (in nominal terms and even if the quality was widely increasing) and the same can be said for its Applications (Word and Excel in particular), something quite in contrast with what a monopolist should do while achieving and consolidating a monopolistic position. In reality, Microsoft has been constantly aggressive as any firm under the threat of competitive pressure would be. The new theory of market leaders has shown that a leader in these conditions would price above marginal cost in such a way to compensate for the fixed costs of investment and obtain a profit margin (over the average costs of production) thanks to the economies of scale derived from the larger (worldwide in the case of Microsoft) scale of production. The price should be below that of its immediate competitors or just low enough to avoid that they could exploit profitable opportunities. Similar considerations apply in many other markets of the New Economy.

In conclusion, the market share of some market leaders can be very high because their behaviour is forced to be extremely aggressive by strong competitive pressure. Nevertheless, this entry threat may remain mostly potential and not create massive entry in the market. In such a case, firms with high market shares have nothing to do with monopolists protected by barriers to entry: they are leaders but not dominant firms.

IPRs, trade secrets and interoperability: from Coca-cola to the New Economy

New ideas are often protected with patents, but these are not the only form of protection for innovations. Not all inventive and innovative activities fall under the scope of patentability and it is not always in the interest of a firm to patent every single innovation: some of them are just kept secret. Trade secrets exist in any business, they are also the result of years of investments and experience, and often represent a deserved comparative advantage in the market. In most high tech sectors, firms adopt a combination of patents and trade secrets to protect products which are the result of multiple innovations. Defending (intellectual or material) property rights is one of the fundamental conditions for a proper functioning of the market economy: defending trade secrets has not a minor role in this context. But there is more than that. Let us start from one of the most famous trade secrets.

A key of the success of  Coca-Cola has been, for more than a century, the formula of its famous soft drink. More precisely, in 1886, in Atlanta, the pharmacist Dr. Pemberton’s prepared the popular syrup added of carbonated water for the first time in his backyard. At first he distributed the new product by carrying Coca-Cola in a jug down the street to Jacobs Pharmacy. The bookkeeper of the pharmacy, Frank M. Robinson, suggested the name and penned Coca-Cola in the unique flowing script that now is well known worldwide. As the company expanded, the new owner Candler could not prepare the syrup all himself, so the ingredients were all simply labelled 1 to 9 and the managers at the branch factories were only told the proportions required and the mixing procedure. Today, the secrete of Coke lies in a safe deposit vault at the Trust Company of Georgia (USA) and, it is said, only the company directors can authorise the opening of the vault. Although numerous outlets around the world have a franchise to bottle or can and to distribute the beverage, none knows the precise ingredients. They are simply supplied with syrups and other ingredients from the Coca-Cola company and mix them with carbonated water.

This trade secret represents a competitive advantage for Coca-Cola, but many companies around the world invest to prepare new and original soft drinks competing with Coke. While there is at least one well known global competitor, Pespi, which has created a similar successful drink (as well known, behind the vanilla, coca and kola tastes, Coke is more orange-biased, and Pepsi is more lemon-flavoured and sweeter), the market for soft drinks is quite competitive and there is substantially free entry at the local level. Many competitors have tried to discover Coke’s trade secret. William Poundstone did some painstaking research when he published in his 1993 book “Big Secrets”. He suggests that the basics ingredients of Coke are: 1) sugar, 2) caramel, 3) caffeine, 4) phosphoric, 5) coca leaf extract (with its cocaine content removed) and a small amount of cola nut extract, 6) citric acid and sodium citrate, 7) lemon, orange, lime, cassia (a type of cinnamon), nutmeg oils, and probably others, 8) glycerine, 9) vanilla. Although the proportions of some of these ingredients all mixed with carbonated water can be discovered by chemical analysis; the most important and most elusive is the mixture of essential oils is merchandise 7). The flavour of the mixture is not simply the sum totals of the oils, because other flavours are created by the interaction of the oils. Anyone trying to reproduce the mixture would need to know the exact ingredients which are difficult to analyse with certainty and their precise proportions. It is rumoured that not less than two and no more then three picked people ever know it at the same time, and they never travel together.

Now imagine that Coca-cola was required to disclose its secret formula. Anybody could reproduce the very same drink, “clone” it under a different name if you like, but it is hard to believe that this would create large gains for consumers. Close substitutes to Coke already exist and there are small margins to substantially reduce prices. However, the incentives for any other firm to invest and create new products could be drastically reduced if trade secrets would not be protected (again, not all innovations are patentable and, in general, trade secrets can be advantageous over patents for certain innovations).

Things get more complicated in high-tech sectors. In these sectors trade secrets often cover fundamental innovations and protecting them amounts to promote new fundamental innovations, which 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, which is, broadly speaking, the ability to exchange and use information and data, especially in networks (like telecommunications, on line business, software). For instance, take in consideration the leading on line search engine in the world, Google. We may look at its patented innovations, but after that, we would need to know its trade secrets to fully discover the mechanism of its precious algorithms. This would help many 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, we can bet, few companies would invest huge resources and take substantial risks to create a leading search engine or other brilliant ideas like Google when they can just free ride on other’s ideas.

Fortunately, giving up to the precious role of trade secrets, or other 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. The Nobel prize R. Coase (1960, The Problem of Social Cost, Journal of Law and Economics) has clarified that whenever there is social value to generate, the market will properly allocate even the IPRs, insuring the accessibility of the information that fuels interoperability and acknowledging legitimate ownership rights of the innovators, and hence enhancing R&D investments. This result is just strengthened in the markets of the New Economy, where interoperability enhances network effects and hence it is in the interest of the largest firms to promote it adequately to strengthen demand for their products. In particular, as the new theory of market leaders as shown, market leaders have a further incentive to promote high levels of interoperability through licenses of their IPRs so as to increase the size of their networks and markets, while any exogenous weakening of IPRs can only reduce the incentives to invest in R&D by both the leaders and their competitors.

And dynamic market forces can do even more. As long as IPRs are well protected and firms can invest with the safe confidence that successful innovations will be rewarded, market forces can select the best standard when multiple standards are available and interoperability is only partial. In a famous book, S. Liebowitz and S. Margolis (1999, “Winners, Losers, and Microsoft: Competition and Antitrust in High Technology”) have shown that this was the case in many episodes. For instance, in the adoption of the QWERTY keybord, the one which is probably in front of you while reading Intertic (look at the first five letters on the top left of your keyboard): for years it has been claimed that the usual allocation of letters of this keyboard was an inefficient standard, while these researchers found out that all the evidence suggests that the Qwerty keyboard, somehow selected by the market, is not worse than any other alternative.

It can be very dangerous to weaken the protection of trade secrets and IPRs in high tech sectors, even under the purpose of promoting interoperability. Markets can properly balance the short run and long run interests of the consumers: promote innovation, enable an efficient degree of interoperability and select the best standards.

Persistence of Leadership as an Antitrust Issue?

How good are dominant firms for conducting innovation? Whether and when these innovations lead to persistence of leadership? What are the policy implications in such situation where the competition takes place along other dimensions than pricing? These kinds of questions are not exactly new among economists, but they seem to be actual again judging by a provocatively entitled text ''Slackers or Pace-Setters: monopolies may have more incentives to innovate than economists have thought'' in the celebrated rubric ''Economics Focus'' of “The Economist” (May 2004). Apparently, there is a controversial role of market leaders in creating innovations and the key to the answer lies in the underlying incentives to undertake innovations. The recent empirical evidence seems to support these Schumpeterian allegations from ''The Economist'' in the sense that there is a positive relationship between market power and intensity of innovation. Moreover, this evidence is, in fact, consistent with pre-emptive, strategic R&D investment by the leaders. As a consequence of such strategic behavior, there may be only one firm that survives in the market for a while, but then this firm would display far more competitive behavior than a standard monopolist. It would respectively generate higher flow of R&D, charge lower price and produce more.

There are many real-world examples of dominant firms that invest more in innovation and R&D than their rivals and that persists over long period of time. We may mention AT&T, Intel and many other leaders of the New Economy and of many advanced sectors including the pharmaceutical one. While many commentators are used to associate persistent leaderships with monopolistic positions, recent research has suggested that in many cases, it may work the other way around: leadership persists because markets are highly competitive and leaders are forced by the competitive pressure to invest a lot, innovate and hence maintain their techonological and market leadership.

The nature of the above relation between innovativeness, leadership and market power has tremendous implications for the antitrust policy. It is important to study the situation in which the market leader undertakes aggressive pre-emptive R&D investment that eventually leads to a limitation of entry by followers and contrast this situation with the one in which the leader (within the same setup) ''accommodates'' the followers, that is, it co-exists with followers in a oligopolistic market structure. This comparison will enable to study both positive aspects of the two main strategies – accommodating and aggressive (like, for instance, which strategy yields higher R&D intensity or R&D stock) and normative aspect (social welfare implications) of the two resulting market structures.

Since strategic innovations are inherently dynamic phenomenon, suitable methods aimed at capturing both accommodating and aggressive behavior of the dominant firm should be explicitly dynamic. Furthermore, the relationship between the leader and the follower is often accompanied with R&D spillovers stemming from leader to follower (the importance of R&D spillovers, imitations and its economic implications is well and broadly documented in both theoretical and empirical literature). However, most of the research by economists is static in nature and it focuses on the accommodation strategies: in such situations unilateral R&D spillovers create disincentives to invest in R&D and consequently hamper innovations. However, in the case when aggressive strategies are optimal, the economic implication of R&D spillovers is exactly opposite: they enhance the incentive to invest in R&D.

Contrary to the static set-up where (constrained) monopoly is usually a marginal market structure, in the dynamic setup, this market structure becomes more prevalent as the speed of adoption of the new technology increases and the efficiency of R&D process is high. Put together, these two facts yield a testable prediction in that the most propulsive innovative firms, that commercialize their investment in innovation quickly and efficiently, are the ones likely to use aggressive strategies through investing large sums of money into innovative activity that in turn, help them to attain or keep technological and market leadership. As for the social welfare considerations, aggressive investment strategies are socially preferable as well since they lead to both higher consumer surplus, and to higher social welfare generated despite the fact that only one firm (the leader) remains in the market in the long run.

This all bears important competition policy implications. First, the size of market share per se might not be sufficient condition for a legal offence and, second, abuses of dominant positions may not even be an issue in dynamic markets where competition takes place through investments in R&D rather than through static pricing and competitors constraint the behaviour of market leaders. The challenge for the design of antitrust policy against predation is related to the ability of the antitrust authority to distinguish between the price that is low for other predatory purposes from a price that might be set very low as part of an efficiency enhancing process that in turn results in enhanced competition leading in the end to the exit of the competitors but not to price increases. For instance, in the presence of network effects or learning effects it would be legitimate and consistent with vigorous competition that firms set very low prices when they are introducing new products, when they are targeting new customer segments or rivals, installed bases, or when they are in the first phase of the learning curve. Thus, the competition authority with limited knowledge of industry- and firm-specific data faces a complex problem when attempting to identify those circumstances under which loss-inducing predatory prices cause harm to competition. For that reason the antitrust authorities have to be fully aware of the risks of misclassification when approaching a predation case.

Toward a New Approach to Antitrust Policy

Recently many economists have pointed out the necessity of a closer focus on consumer welfare in the implementation of competition policy. While antitrust legislation was written with this objective in mind, its concrete application has been often biased against market leaders and in defense of their competitors rather than toward the defense of free competition and of the interests of consumers. The two objectives do not necessarily overlap. The development of the New Economy, characterized by very dynamic and innovative markets, has increased the pressure for a new approach. In July 2005 a Report by a group of important economists of the Economic Advisory Group for Competition Policy of the European Union has argued in favor of an effect-based approach to competition policy, which associates abuses of dominant positions with anti-competitive strategies that harm consumers (“An Economic Analysis to Article 82” by J. Gual, M. Hellwig, A. Perrot, M. Polo, P. Rey, K. Schmidt and R. Stenbacka). The proposal is an interesting starting point to build a new approach to antitrust and deserves close attention.

A new approach to competition policy should be based on rigorous economic analysis, from both a theoretical and an empirical point of view. The Report emphasizes this element in the antitrust procedure: “a natural process would consist of asking the competition authority to first identify a consistent story of competitive harm, identifying the economic theory or theories on which the story is based, as well as the facts which support the theory as opposed to competing theories. Next, the firm should have the opportunity to present its defense, presumably to provide a counter-story indicating that the practice in question is not anticompetitive, but is in fact a legitimate, perhaps even pro-competitive business practice.” Now, any theory of the market structure able to provide guidance in detecting abuses of dominant positions should: 1) take into account the role and the strategies of dominant firms; 2) describe the equilibrium outcomes in function of the access of competitors to the market and of the demand and supply conditions; and 3) provide welfare comparisons under alternative set ups. In other words, we need a theory of market leadership simple but general enough to be applicable to analyze markets under many possible situations: different demand conditions or production technologies characterized by different cost functions, possibly by network externalities or learning by doing, different modes of competition as “in prices” or “in quantities”, different strategic investments as in advertising, product differentiation or R&D, bundling strategies, multimarket and dynamic strategies, and so on.

Recent theories of the market leadership have provided a simple unified framework which matches these requirements (technically we speak of generalized theories of Stackelberg competition). They are not the only available theories for this purpose, but they are simple and able to found a comprehensive guidance to understand whether any specific behavior of a dominant firm is harmful to the consumers or not. Rather than discussing all possible situations, it is useful to provide the general insights of these recent theories and go over a few explanatory cases. The general principle proved in this new research is that dominant firms may behave in an anti-competitive (accommodating) way in markets with barriers to entry, while they always behave in a pro-competitive (aggressive) way whenever entry in the market is endogenous. More precisely, when there are not exogenous barriers to the entry of competitors, dominant firms produce more, invest more to reduce costs or improve product quality, engage in more informative advertising, innovate more and so on: this allows them to increase their market shares, reduce prices and gain from a reduction in the average costs of production, but it also disciplines the competitors and keeps market prices at a low level, with unambiguous benefits for the consumers.

Some factors make leaders even more aggressive and tend to increase their market share (eventually until other firms exit): these are scale economies, network effects and learning by doing in dynamic contexts, product homogeneity and rapid technological development, all factors typical of the markets in the New Economy. The consequence is that markets with high concentration due to the presence of a dominant firm are perfectly consistent with efficiency. This has drastic consequences for the competition policy: while the old approach to abuses of dominant positions needs to verify dominance through structural indicators and the existence of a certain abusive behavior, a new economic approach would just need to verify the existence of harm to consumers. As the Report correctly points out, “the case law tradition of having separate assessments of dominance and of abusiveness of behavior simplifies procedures, but this simplification involves a loss of precision in the implementation of the legal norm. The structural indicators which traditionally serve as proxies for ‘dominance’ provide an appropriate measure of power in some markets, but not in others”, as indeed in the New Economy.

Moreover, in line with the new theories of market leadership, the same Report clarifies that “in an effects-based, non-dirigiste approach the analysis of competitive harms naturally focuses on keeping the competitive process open and avoiding the exclusion of actual or potential rivals from the market”: again the main role of competition (antitrust) policy should be to guarantee (verify) that entry is - at least potentially - free in every market. Another implication of this recent research is that aggressive pricing by the leaders can have a predatory role under barriers to entry, but not under free entry (even if it leads to exit of some competitors). The same holds for other strategies which typically have exclusionary motivations under barriers to entry, like dumping (in presence of learning by doing and network effects) or bundling and tying strategies. As long as entry of firms is endogenous and remains potentially free, the adoption of these strategies by a dominant firm ends up beneficial to consumers.

Finally, notice that what matters is not only welfare of current consumers but also that of future ones. The Report provides a simple example on “the problem of monopoly pricing. One response to the problem might be for the competition authority to intervene, citing excessive pricing by a monopolist as an infraction of the abuse-of-dominance prohibition in Article 82 of the Treaty. Another response might be to leave the matter alone, hoping that the profits that the monopolist earns will spur innovation or imitation and entry into the market, so that, eventually, the problem will be solved by competition.” What the theory of market leaders suggests on this matter is that the dynamic gains in efficiency can be quite high, once again if entry in the market for innovation is free. The leadership of dominant firms may persist because of their high incentives to invest in R&D under the threat of entry; nevertheless, this should not be seen as a signal of abusive conduct, but, oddly enough, as the result of competitive pressure.

In conclusion, a new effect-based approach to antitrust founded on solid economic theory would represent a major step forward in the implementation of competition policy in the interest of consumers, and we now have the theoretical and empirical tools to adopt it.

Patents and Innovation

Since the work of the Austrian economist Joseph Schumpeter, economic research has repeatedly emphasized the positive relation linking patents to investments in innovation and these investments to technological progress and growth. In high-tech sectors (think of hardware, software, pharmaceuticals, biotechnologies,…) firms compete mainly by innovating. This is possible as long as there are well defined IPRs, and especially patents, defending their innovations and investments, which is ultimately what leads technological progress in our economies.

Moreover, even if most economists are used to thinking about market leaders as firms with weaker incentives to invest in R&D, recent theoretical and empirical research has also noticed that market leaders play a crucial role in the innovation sector for competitive markets. Market leaders invest a lot in R&D: for instance, in 2000 Microsoft spent more than 16 % of its turnover, but even apart from this special case, Intel spent 11,5 %, Motorola 11,8 %, Nokia 8,5 %, IBM, Hewlett Packard and Xerox between 5 and 6 %, and so on. The fact that these companies remain at the top of the technological frontier in their respective industries is not the sign of a monopolistic position in the traditional sense, but the fruit of their investments and of the competitive threat deriving from other firms and potential entrants. Theoretical research in the New Industrial Organization (the industrial economics and policy for the New Economy) has recently clarified the mechanics of these results. In a sense, patents drive competition through innovation in these markets and induce technological progress led by market leaders.

To understand the role of IPRs in promoting innovation we rely on a old argument by William Nordhaus. In general, the arguments goes, patents create a temporary monopolistic power for the innovators, which creates price distortions and hence a social cost, but they also create the incentives for many firms to invest and try to gain market leadership, and this investment leads to social benefits through technological progress and growth. Clearly social benefits and costs can be different for different inventions and in general for different fields of technology. For simplicity and to avoid discriminations between fields of technology, patents have typically a uniform length. Nevertheless, from a strictly economic point of view one may question such a uniformity and evaluate the advantages for different levels of protection in different sectors (at least this could avoid the inefficient choice of radically excluding certain innovations from patentability rather than allowing a more limited protection). More importantly, an evaluation of the social benefits and costs of patents for different fields is essential in judging the net benefit of a patents system.

Let us consider an example concerning the pharmaceutical sector, where the role of patents on new drugs is, to say the least, at the basis of competition in the market and of scientific progress in the world. These kinds of patents have been often criticized for jeopardizing health defense around the world and especially in developing countries, where western drugs are very important but very expensive: in other words the social cost of patents on drugs can be high. Nevertheless, one should not forget that those same patents induced many firms to invest and some of them to invent new drugs which are now available, something which would have hardly happened otherwise: in other words the social benefit of patents on drugs is very high. Fortunately there are ways to reduce the problems related with the pricing of drugs and their adoption depends mostly on the public sector. For instance, governments could buy drugs and distribute them at lower prices through the medical system, or just pay part of the prices. They may even directly buy the same patents from the innovators and produce the drugs (or outsorce their production) and sell them at lower prices. Finally, western governments could redirect their international aids toward similar initiatives in favour of developing countries. These solutions, widely discussed in the economic literature, may preserve the proper incentives to invest and discover new drugs while spreading their effects globally. Ultimately, this suggests that patents in the pharmaceutical sectors are a crucial determinant of innovations and should be enforced while finding alternative solutions to guarantee health defense for poor classes and poor countries.

Consider now another example which is essentially related with the New Economy and the main kind of research which is underlying it: that concerning computer based innovations. This is quite interesting since in the last years the European Union tried to complete a process of harmonization of the patent system for computer-implemented inventions with the aim to provide proper incentives to invest and innovate in the New Economy, something which was realized in the United States since the 80s. After a long procedure, the Common Position adopted by the European Council in March 2005 proposed the patentability of computer implemented innovations when they provide a technical contribution to a field of technology. While this positive proposal simply reaffirmed the requirements already adopted in Europe for the last two decades and it excluded from patentability any pure software, business methods and consulting practices (which are patentable in US), part of the European Parliament proposed a number of amendments aimed at radically changing the current situation which excludes most of the innovations in the Information and Communication Technology from patentability. As a consequence of such a confusing situation, the European Parliament ended up rejecting the all Directive in July 2005. While this avoided the introduction of those dangerous restrictions on patentability, there is still a need for a deeper harmonization of the European patent systems (not just for computer based ones, but for all fields since each one of the Member States still has its own patent system!) and the debate is likely to continue in the near future.

Notice that the rationale for patents on computer based innovations is quite strong. While the main social gain from all patents on computer based innovations is to promote innovation in the most dynamic sectors, the social cost, traditionally associated with market power of patentholders, is smaller than for other patents since in these sectors competition mainly works through frequent price-reducing and quality-improving innovations. Neglecting these traditional economic insights, opponents of the patent system have often claimed that patents stifle innovation. Unfortunately, even the evidence on the US experience provided by few works against these patents does not convincingly support such a view. The extension of patent protection to software related inventions started in 1980 (the first patent of this kind was granted by the US Patent and Trademark Office in 1981) and it was associated with a clear increase in R&D investment during the eighties. The R&D/sales ratio for US firms innovating on computer, telecommunications and electronic components (the relevant field here) increased from 5.5% to above 8% in 1989. Moreover, the works against patentability did not compare investment in computer based innovations with investment in other technologies and did not take into account other (macroeconomic or sector-specific) factors, hence there is no any rigorous econometric evidence against patents which could be drawn from the American experience. Nevertheless a misleading interpretation of this research has created a lot of confusion in the debate.

These examples and the economic research underlying them allow us to draw a number of conclusions and suggestions for the future debate on rules for high-tech patents, with particular reference to the European debate:

1) protecting IPRs is necessary to properly promote innovations, but an optimal patent system should trade-off social benefits and costs, eventually enforcing more IPRs in those fields, as the New Economy, where the net benefits of patents are higher or those fields, like the pharmaceutical sector, where social benefits are higher and there are proper policies which can reduce the social costs;

2) restrictions to the patentability of innovations in high-tech sectors for one country or a group of countries could severely jeopardize investment in innovation and technological progress in the leading high-tech sectors with negative consequences on growth and competition in the global economy and would shift investments toward other countries where IPR are better protected;

3) limitations to the enforcement of the current patent system would open doors to foreign low cost productions which, without patent protection, would be free to imitate even high-tech production, with negative consequences on employment and on innovative firms;

4) improvements of the effectiveness of the current patent systems should rather promote access to patents especially for SMEs, traditionally less able to exploit this opportunity (in this sense, it would helpful to establish institutional ways to provide financial, technical and administrative support to SMEs dealing with patents);

5) enhancement of the spillovers created by the patent system on the diffusion of knowledge could be obtained through further requirements on a disclosure of the patented inventions which should be sufficiently clear and complete to be carried out by a person skilled in the art.