International Think-Tank on Innovation and Competition
Tying, Media Player and Shoelaces
January 4th, 2007
Economists today generally acknowledge that tying multiple products in a single one can produce positive efficiencies and consumer benefits, and that a rule of reason should be adopted in evaluating its effects on markets and the possibility that tying could create anticompetitive effects. The positive effects of tying are particularly pronounced in the case of technical tying (when companies innovate by linking formerly separate technologies or products, efficiencies often emerge through improved performance and quality), but they also emerge because tying is often used as an aggressive strategy which leads to lower prices. Nevertheless, the current EU approach to abuse of dominance and also its recent proposals of revision perpetuate a bias against tying per se.
The EU approach to tying places too much emphasis on consumer demand for the tied product. Such demand does not shed light on whether there exist distinct products for the purposes of tying analysis. In other words, while there is clearly consumer demand for shoelaces, this should not mean that shoes and shoelaces are distinct products for the purposes of tying analysis. This issue can only be addressed by asking whether there is consumer demand for shoes without shoelaces. In sum, whether or not consumer demands exists for the tied product is the wrong question; the correct question is whether there is any significant consumer demand for the tying product without the tied product. Unless the analysis focuses on this question, there is a danger that the mere existence of consumer demand for the tied product may prevent the emergence of efficient tying arrangements and end up protecting suppliers of tied products at the expense of consumers and innovation.
Moreover, in the case of technical integration of two products that were previously distinct, the distinct products test itself may not be helpful for understanding market dynamics because, by definition, this test is backward-looking. A better approach in these cases would be simply to ask whether the company integrating the previously distinct products can make a plausible showing of efficiency gains: since technical tying is normally efficient, market leaders would be able to continue producing innovative products benefiting consumers without running afoul of the prohibitions on tying. Finally, since tying usually enhances price competition, it should never be abusive when it is standard commercial practice (which is also indirect evidence that such tying generates efficiencies, or that there is no demand for the unbundled product).
We are also concerned that the current EU approach fails to acknowledge that bundling can be used to create value for consumers in markets that experience network effects or in multi-sided markets. For instance, in the first case, bundling is a valuable strategy to gain broader distribution of the products or service that is subject to network effects. And the broader the distribution, the greater the value produced for all consumers. This is particularly true when the product or service in question has a low (or no) marginal costs, because the supplier can costlessly include the product or service in bundles with other products.
Finally, the standard of proof the antitrust authority is required to meet to establish harmful foreclosure effects is too low, particularly in light of the fact that the analysis of foreclosure effects can be speculative in nature. In the case of bundling, actual market foreclosure effects are not required: it is enough that such effects are "likely" to occur. In other words, the mere risk of foreclosure can result in a finding against a dominant company. A standard of proof that requires convincing evidence would rather help ensure that companies will not be deterred from bringing new products to market as a result of concerns about remote, potential foreclosure effects.
There are contrasting views on bundling. The Chicago school has advanced efficiency rationales in its favour with positive, or at worst ambiguous, consequences on welfare, including production or distribution cost savings, reduction in transaction costs for 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 the presence of complementarities, it can only gain from having competition and high sales in the secondary market to enhance demand in its monopolistic market. A similar theory has been advanced at a theoretical level by Davis and Murphy (2000, American Economic Review) and by Economides (2001) to explain the tying strategies of Microsoft. With particular reference to the US case, Economides (2001) notes that Microsoft could not have been interested in the browser market when this was perfectly competitive, but only when this market became dominated by Netscape for two main reasons. "First, Netscape had a dominant position in the browser market, thereby taking away from Microsoft's operating system profits to the extent that Windows was used together with the Navigator. Second, as the markets for Internet applications and electronic commerce exploded, the potential loss to Microsoft from not having a top browser increased significantly... Clearly, Microsoft had a pro-competitive incentive to freely distribute IE since that would stimulate demand for the Windows platform." The very same point could be made for the free distribution of Media Player with Windows, the subject of the tying part of the EU case.
The post-Chicago approach has shown that, when the bundling firm has some market power, commitment to bundling can only be used for exclusionary purposes since it enhances competition in the secondary market and increases the profits of the leader only if it excludes rivals from this secondary market (Whinston, 1990, AER). Nevertheless, even the same proponent of this theory has expressed doubts on its applicability to Microsoft: evaluating the tying of Windows and IE, Michael Whinston (2001, JEP) notes that "Microsoft seems to have introduced relatively little incompatibility with other browsers. Since marginal cost is essentially zero, bundling could exclude Netscape only if consumers, or computer manufacturers for them, faced other constraints on adding Navigator to their system", which did not appear to be the case.
The theory of market leaders emphasizes that when entry in the secondary market is endogenous, an incumbent may only gain in this market by adopting an aggressive pricing strategy and in our framework, bundling the primary good and the secondary good is exactly a way to commit to aggressive pricing. Hence, bundling is the standard competitive strategy of the incumbent as long as the reduction in the profits in the primary market is compensated by the gains in the secondary market. Of course, if there is some complementarity between the products, or there are unexploited network effects, the expansion of demand following the bundling strategy with aggressive pricing can make more likely that bundling is optimal. But what matters for our purposes is that bundling is not an extreme strategy adopted by an incumbent firm to deter entry, but a standard aggressive strategy that, by reducing the final prices, may indeed reduce entry by followers but would not exclude entry overall. Hence, in a world of price competition, it appears hard to conclude that bundling could be used as a predatory strategy when it does not lead to the exit of all the competitors, but just to a permanent reduction of the price level.
To sum up, when approaching a bundling case we suggest 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 that same market: punishing the bundling strategy would just guarantee the monopolistic (or duopolistic) rents of the dominant firm in the secondary market. 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. In the case of Microsoft, we have the impression that in both bundling cases, that of Windows with Internet Explorer and that of Windows with Media Player, the tied market was characterized and (most of all) still is characterized by endogenous entry: just think of new successfull browsers as Mozilla or Firefox and media player softwares as RealPlayer, Quick or the more recent Macromedia Flash. Consequently the bundling strategy of Microsoft could be simply seen as an aggressive and competitive strategy of a market leader active in a secondary market where entry is indeed free.
Beyond this theoretical point, it should be added that in dynamic markets as the software market, the same concept of a good is changing over time, since both demand and supply change. If demand by PC users for media player functionalities was limited just a few years ago, now it appears that these functionalities are an essential component of a OS. Because of this, an increasing number of software applications and on line services are associated with media player functionalities, so that demand is even strenghtened by network effects. Finally, as a consequence of this, better OSs must take into account the necessities of these functionalities and bundling has a natural technological rationale. In other words, while a few years ago a OS and a media player could be regarded as separate goods whose union could be associated with a bundling strategy, nowadays a OS must incorporate media player functionalities (as it must incorporate a browser) so that we cannot even talk of a traditional form of bundling (this is common for software: for instance, word processors and spell checkers were in separate markets many years ago, not today; handwriting and voice recognition are separate today, but we can expect that they will be integrated in word processors at some point soon). In this perspective, the attempts of antitrust authorities to stop or delay the evolution of OS through additional features, as browsers and media players, appear quite dangerous: while it is difficult to verify in which moment it would be optimal to bundle secondary products in an evolving primary product, it is not clear why antitrust authorities should have a better guess than market driven firms.
Notice that since the 2004 Commission's decision, Microsoft had to prepare and commercialize a version of Windows without Media Player in Europe. Just after that important students of bundling issues have notice that "all we need to know is that if the remedy does have any impact, that's a sure sign that Microsoft abused its position and hence we should be happy to have the remedy in place. Just as King Solomon's proposal to divide the baby only caused pain to the true mother, the Commission's remedy will only cause pain to a monopolist who abused its position." (Ayres and Nabeluff, 2004). Demand for the version of Windows without Media Player has been virtually zero in all Europe, a likely sign that Microsoft bundling strategy was at least not hurting consumers.
