International Think-Tank on Innovation and Competition
Competition Policy and Market Leaders
by Prof. Krešimir Žigić, CERGE-EI and Charles University of Prague (on the same topic see Judgment Day (Wall Street Journal) by Prof. Y. Katsoulacos, Athens University)
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? (see Competition Policy and Market Leaders, by I. Maci and K. Zigic, October 2007)
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.
