FTC:WATCH® NO. 532
November 8, 1999
ISSN. 0196-0016

Washington, DC

Bad week for Microsoft

While most of the attention to Microsoft Corp.'s antitrust problem was directed to Washington, D.C. and U.S. District Judge Thomas Penfield Jackson's findings that Microsoft has behaved like a classic predatory monopolist, farther west, U.S. District Judge Dee Benson was finishing his rejection of all but one of Microsoft's pre-trial summary judgment motions in Caldera, Inc. vs. Microsoft Corp. (Case No. 2:96-CV-645 B; Dist. of Utah - Central Div.)

In Caldera, the plaintiff is seeking treble damages for allegations that Microsoft set out to use monopoly power not to compete in the computer operating systems market on the merits, but to destroy the most formidable challenger to MS-DOS, DR DOS.

Judge Benson, who previously dismissed four of Microsoft's summary judgment motions, has the ninth one under advisement: Plaintiff's State Law Tortious Interference Claims.

Caldera goes to a jury trial in January.

In the course of his Memorandum Opinion, Benson suggested that Microsoft may have deliberately attempted to mislead the court when it scanned an opinion "for language favorable to its position and then quoted that language entirely out of context with the intent of leading this Court to believe that the [opinion] held something it did not."

He also scolded the U.S. Court of Appeals for the District of Columbia for failing to understand the purpose of the antitrust laws when it overturned Judge Jackson's 1998 decision enjoining Microsoft from violating a consent decree by tying its browser application to its Windows™ operating system. The Appeals Court held that the judiciary ought not try to design software and should give substantial credence to a defendant's assertion that it did something simply for technological reasons.

"[T]he D.C. Circuit has given too much deference to the technology argument and not enough to current antitrust law," Benson said. " Certainly a company should be allowed to build a better mousetrap, and the courts should not deprive a company of the opportunity to do so by hindering technological innovation. Yet, antitrust law has developed for good reason, and just as courts have the potential to stifle technological advancements by second guessing product design, so too can product innovation be stifled if companies are allowed to dampen competition by unlawfully tying products together and escape antitrust liability by simply claiming a 'plausible' technological advancement."

Two days later, in Washington, D.C., Judge Jackson unleashed a 207-page condemnation of Microsoft's anticompetitive behavior, relying often on internal Microsoft communications that he concluded give the lie to the firm's insistence that it is just a tough, innovative competitor that has single-handedly delivered the personal computer revolution to the adoring masses.

Microsoft has not only harmed its competitors and potential competitors, Jackson found.

"Many of the tactics that Microsoft has employed have also harmed consumers indirectly by unjustifiably distorting competition. The actions that Microsoft took against Navigator hobbled a form of innovation that had shown the potential to depress the applications barrier to entry sufficiently to enable other firms to compete effectively against Microsoft in the market for Intel-compatible PC operating systems. That competition would have conduced to consumer choice and nurtured innovation.

"The campaign against Navigator also retarded widespread acceptance of Sun's Java implementation. This campaign, together with actions that Microsoft took with the sole purpose of making it difficult for developers to write Java applications with technologies that would allow them to be ported between Windows and other platforms, impeded another form of innovation that bore the potential to diminish the applications barrier to entry.

"There is insufficient evidence to find that, absent Microsoft's actions, Navigator and Java already would have ignited genuine competition in the market for Intel-compatible PC operating systems. It is clear, however, that Microsoft has retarded, and perhaps altogether extinguished, the process by which these two middleware technologies could have facilitated the introduction of competition into an important market.

"Most harmful of all is the message that Microsoft's actions have conveyed to every enterprise with the potential to innovate in the computer industry. Through its conduct toward Netscape, IBM, Compaq, Intel, and others, Microsoft has demonstrated that it will use its prodigious market power and immense profits to harm any firm that insists on pursuing initiatives that could intensify competition against one of Microsoft's core products. Microsoft's past success in hurting such companies and stifling innovation deters investment in technologies and businesses that exhibit the potential to threaten Microsoft. The ultimate result is that some innovations that would truly benefit consumers never occur for the sole reason that they do not coincide with Microsoft's self-interest."

Jackson found that Microsoft has benefited from and tenaciously defended what he calls the "chicken and egg" conundrum, otherwise described as "the applications barrier to entry."

As long as Microsoft can keep other software developers from incorporating application programming interfaces (APIs) into their products, Jackson said, none of those developers can produce a product that can compete with Windows™ on the Intel processor family.

That was the threat posed by both Netscape's Navigator software for browsing the Internet and Sun Microsystems' Java cross-platform computer language, Jackson said. And it led Microsoft to attempt to destroy Netscape by giving away the browser that it developed at a cost of more than $100 million; by insisting that computer manufacturers that install Windows™ at the factory give Microsoft's Internet Explorer prominent positioning or even exclude Netscape's product from the preinstalled software; by paying Internet Access Providers to feature Internet Explorer; and by eventually building the browser into the Windows™ operating system in such a way that if it were removed by anyone but an expert, Windows™ would be "crippled."

"Microsoft enjoys so much power in the market for Intel-compatible PC operating systems that if it wished to exercise this power solely in terms of price, it could charge a price for Windows substantially above that which could be charged in a competitive market," Jackson found. "Moreover, it could do so for a significant period of time without losing an unacceptable amount of business to competitors. In other words, Microsoft enjoys monopoly power in the relevant market.

"Viewed together, three main facts indicate that Microsoft enjoys monopoly power. First, Microsoft's share of the market for Intel-compatible PC operating systems is extremely large and stable. Second, Microsoft's dominant market share is protected by a high barrier to entry. Third, and largely as a result of that barrier, Microsoft's customers lack a commercially viable alternative to Windows."

"Microsoft possesses a dominant, persistent, and increasing share of the world-wide market for Intel-compatible PC operating systems. Every year for the last decade, Microsoft's share of the market for Intel-compatible PC operating systems has stood above ninety percent. For the last couple of years the figure has been at least ninety-five percent, and analysts project that the share will climb even higher over the next few years. Even if Apple's Mac OS were included in the relevant market, Microsoft's share would still stand well above eighty percent."

Further, "Consumer demand for Windows enjoys positive network effects. A positive network effect is a phenomenon by which the attractiveness of a product increases with the number of people using it. The fact that there is a multitude of people using Windows makes the product more attractive to consumers. The large installed base attracts corporate customers who want to use an operating system that new employees are already likely to know how to use, and it attracts academic consumers who want to use software that will allow them to share files easily with colleagues at other institutions. The main reason that demand for Windows experiences positive network effects, however, is that the size of Windows' installed base impels ISVs [independent software vendors] to write applications first and foremost to Windows, thereby ensuring a large body of applications from which consumers can choose. The large body of applications thus reinforces demand for Windows, augmenting Microsoft's dominant position and thereby perpetuating ISV incentives to write applications principally for Windows. This self-reinforcing cycle is often referred to as a 'positive feedback loop.'"

Unfortunately, "What for Microsoft is a positive feedback loop is for would-be competitors a vicious cycle."

"Indicative of Microsoft's assessment of the situation is the fact that, in a 1996 presentation to the firm's executive committee, the Microsoft executive in charge of OEM licensing reported that piracy continued to be the main competition to the company's operating system products. Secure in this knowledge, Microsoft did not consider the prices of other Intel-compatible PC operating systems when it set the price of Windows 98."

Microsoft has so arranged its licensing strategy that "any consumer who buys a new Intel-compatible PC and wants Windows must buy a new copy of the operating system. Microsoft takes pains to ensure that the versions of its operating system that OEMs pre-install on new PC systems are the most current.

"It does this, in part, by increasing the price to OEMs of older versions of Windows when the newer versions are released. Since Microsoft can sell so many copies of each new operating system through the sales of new PC systems, the average price it sets for those systems is little affected by the fact that older versions of Windows never wear out."

"Although there is no legal secondary market for Microsoft's PC operating systems, there is a thriving illegal one. Software pirates illegally copy software products such as Windows, selling each copy for a fraction of the vendor's usual price. One of the ways Microsoft combats piracy is by advising OEMs that they will be charged a higher price for Windows unless they drastically limit the number of PCs that they sell without an operating system pre-installed.

"In 1998, all major OEMs agreed to this restriction. Naturally, it is hard to sell a pirated copy of Windows to a consumer who has already received a legal copy included in the price of his new PC system. Thus, Microsoft is able to effectively contain, if not extinguish, the illegal secondary market for its operating-system products. So even though Microsoft is more concerned about piracy than it is about other firms' operating system products, the company's pricing is not substantially constrained by the need to reduce the incentives for consumers to acquire their copies of Windows illegally."

Beyond that, "Microsoft's actual pricing behavior is consistent with the proposition that the firm enjoys monopoly power in the market for Intel-compatible PC operating systems. The company's decision not to consider the prices of other vendors' Intel-compatible PC operating systems when setting the price of Windows 98, for example, is probative of monopoly power.

"One would expect a firm in a competitive market to pay much closer attention to the prices charged by other firms in the market.

"Another indication of monopoly power is the fact that Microsoft raised the price that it charged OEMs for Windows 95, with trivial exceptions, to the same level as the price it charged for Windows 98 just prior to releasing the newer product. In a competitive market, one would expect the price of an older operating system to stay the same or decrease upon the release of a newer, more attractive version. Microsoft, however, was only concerned with inducing OEMs to ship Windows 98 in favor of the older version. It is unlikely that Microsoft would have imposed this price increase if it were genuinely concerned that OEMs might shift their business to another vendor of operating systems or hasten the development of viable alternatives to Windows.

"Finally, it is indicative of monopoly power that Microsoft felt that it had substantial discretion in setting the price of its Windows 98 upgrade product (the operating system product it sells to existing users of Windows 95). A Microsoft study from November 1997 reveals that the company could have charged $49 for an upgrade to Windows 98 there is no reason to believe that the $49 price would have been unprofitable but the study identifies $89 as the revenue-maximizing price. Microsoft thus opted for the higher price.

"An aspect of Microsoft's pricing behavior that, while not tending to prove monopoly power, is consistent with it is the fact that the firm charges different OEMs different prices for Windows, depending on the degree to which the individual OEMs comply with Microsoft's wishes. Among the five largest OEMs, Gateway and IBM, which in various ways have resisted Microsoft's efforts to enlist them in its efforts to preserve the applications barrier to entry, pay higher prices than Compaq, Dell, and Hewlett-Packard, which have pursued less contentious relationships with Microsoft.

"Furthermore, Microsoft expends a significant portion of its monopoly power, which could otherwise be spent maximizing price, on imposing burdensome restrictions on its customers and in inducing them to behave in ways that augment and prolong that monopoly power. For example, Microsoft attaches to a Windows license conditions that restrict the ability of OEMs to promote software that Microsoft believes could weaken the applications barrier to entry. Microsoft also charges a lower price to OEMs who agree to ensure that all of their Windows machines are powerful enough to run Windows NT for Workstations. To the extent this provision induces OEMs to concentrate their efforts on the development of relatively powerful, expensive PCs, it makes OEMs less likely to pursue simultaneously the opposite path of developing "thin client" systems, which could threaten demand for Microsoft's Intel-compatible PC operating system products. In addition, Microsoft charges a lower price to OEMs who agree to ship all but a minute fraction of their machines with an operating system pre-installed. While this helps combat piracy, it also makes it less likely that consumers will detect increases in the price of Windows and renders operating systems not pre-installed by OEMs in large numbers even less attractive to consumers. After all, a consumer's interest in a non-Windows operating system might not outweigh the burdens on system memory and performance associated with supporting two operating systems on a single PC."

Judge Jackson's decision 207 page decision is available from several Internet sites, including http://www.usdoj.gov/atr/index.html, http://www.nytimes.com, and http://usvms.gpo.gov/ (the Government Printing office file is available in three formats: PDF, HTML and WordPerfect. But not in Microsoft Word.

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