International Think-Tank on Innovation and Competition
The Political Economy of the Microsoft Antitrust Cases
June 25th, 2007
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.
