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«Abstract This case study discusses briefly the economic and legal issues pertaining to the antitrust case of the United States and a number of States ...»

-- [ Page 1 ] --

The Microsoft Antitrust Case

A Case Study For MBA Students

by

Nicholas Economides*

Revised April 2003

Abstract

This case study discusses briefly the economic and legal issues pertaining to the antitrust

case of the United States and a number of States against Microsoft.

* Stern School of Business, New York University, New York, NY 10012, (212) 998fax (212) 995-4218, http://www.stern.nyu.edu/networks/, neconomi@stern.nyu.edu

Copyright ©, N. Economides

Contents

1. Facts

2. Antitrust Law On Monopolization And Attempting To Monopolize

3. Economics Of Markets With Network Effects

4. The Issue Of Low Prices

5. DOJ’s Monopolization Theory

6. Effects On Consumers

7. Court of Appeals Decision

7.1 Analysis of the Court of Appeals Decision

1. Monopolization of the operating systems market for PCs

2. Attempting to monopolize the Internet browser market

3. Tying Internet Explorer with Windows

4. Trial Proceeding and Remedy

5. Judicial Misconduct by Judge Thomas Penfield Jackson

8. Final Settlement

8.1 Summary of Proposed Microsoft Settlement of November 6, 2001

A. Provisions seen as favorable to Microsoft

B. Provisions seen as favorable to the plaintiffs

C. Duration

D. Conclusion

9. Further Reading

10. Questions For Students

11. References

The Microsoft Antitrust Case This case is intended as a teaching tool. It presents essential aspects of the Microsoft case, but is not exhaustive. It rather pays special attention to aspects of the case that are best to illustrate key concepts to students. For a more comprehensive study of all aspects of the case including a full discussion of remedies, the reader is referred to Economides (2001).

1. Facts

Microsoft is a large diversified computer software manufacturer with one of the highest valuations in the world. Microsoft produces the Windows family of operating systems for personal computers and servers. It also produces applications software that run on the Windows family of operating systems, most notably the very successful MSOffice Suite consisting of Word (word processor), Excel (spreadsheet), PowerPoint (presentations), Outlook (e-mail and news), and Access (database). 1 Almost all Microsoft products are complementary to a member of the Windows family of operating systems for personal computers and servers.

During the last few years, the Federal Trade Commission and the Department of Justice of the United States have investigated Microsoft on various antitrust allegations.

The 1991-1993 and 1993-1994 investigations by the Federal Trade Commission (“FTC”) ended with no lawsuits. The 1994 investigation 2 by the United States Department of Justice (“DOJ”) was terminated with a consent decree in 1995. 3 The key provisions of

the 1995 consent decree were:

1. Microsoft agreed to end “per-processor” (zero marginal price) contracts with computer manufacturers (Original Equipment Manufacturers, “OEMs”) but it was allowed to use unrestricted quantity discounts.

2. “Microsoft shall not enter into any License Agreement in which the terms of that agreement are expressly or impliedly conditioned upon the licensing of any other Covered Product, Operating System Software product or other product (provided, Microsoft produces software, including operating systems for PC (Windows 95, 98, NT, 2000), operating systems for local network and Internet servers (Windows NT, 2000), “back-office” products for network and Internet servers, Internet clients, Internet and network servers, desktop applications (Office, Word, Excel, Access, Outlook, PowerPoint, MS-Money, etc.), games, and programming languages (Visual Basic, Java). Microsoft also produces services, including Internet service (MSN, WebTV), Internet content (MSN), and product support, and some hardware such as branded mice, keyboards, etc.

USDOJ sued Microsoft on July 15, 1994, under Section 2 of the Sherman Act, alleging that Microsoft had entered into licensing agreements with OEMs that prevented other operating system vendors from gaining widespread distribution of their products.

The Court entered the consent decree as its Final Judgment on April 21, 1995.

however, that this provision in and of itself shall not be construed to prohibit Microsoft from developing integrated products); or the OEM not licensing, purchasing, using or distributing any non-Microsoft product.” 4 Thus, the 1995 consent decree imposes two restrictions, one horizontal, and one vertical. The horizontal restriction stops Microsoft from using zero marginal cost pricing.

However, it allows for quantity discounts, disregarding the fact that zero marginal cost pricing is a special case of a quantity discount contract. 5 The vertical restriction of the 1995 consent decree prohibits product bundling created by contract, but allows Microsoft to keep expanding the number and type of functions of its products, including Windows.

In short, in the 1995 consent decree contractual bundling was disallowed, but technological bundling was explicitly allowed. 6 During 1997, Senator Orin Hatch (R-Utah) held congressional hearings on Microsoft that featured Microsoft’s CEO Bill Gates, Netscape’s CEO Jim Barksdale, and PC manufacturer Michael Dell, among others. Senator Hatch took the position that if present antitrust law cannot deal with various anti-competitive acts attributed to Microsoft, Congress should change or enhance the antitrust laws. 7 Sun Microsystems, Oracle, IBM, Netscape, and Novell formed a loose coalition lobbying intensely for antitrust action against Microsoft. 8 On October 20, 1997, DOJ alleged that Microsoft violated the 1995 consent decree by bundling Internet Explorer (“IE”) with the Windows operating systems, and requiring computer manufacturers to distribute IE with Windows 95. DOJ petitioned the District Court to find Microsoft in civil contempt. On December 11, 1997, Judge Thomas Penfield Jackson issued a preliminary injunction barring the bundling of IE with Final Judgment, Civil Action No. 94-1564.





This is a contradiction in the terms of the consent decree. Clearly, the zero marginal price contract is a special case of a quantity discount contract, more generally referred to by economists as a non-linear pricing contract. If quantity discounts are allowed, but zero marginal price is not (as the consent decree reads), it is not clear how low the marginal price is allowed to be so that the consent decree is not violated.

Microsoft has expanded over the years before and after the 1995 consent decree the functionality included in Windows, leading to the elimination of some stand-alone add-ons markets. For example, Microsoft included a disk defragmenter in Windows 1995 and the market for defragmenters promptly died.

Similarly, when hard disk compression was included in Windows 1995, the market for disk compression software died. However, the market for fax software survived and expanded after the inclusion of fax capabilities in Windows 1995.

See Hatch (1998).

See, for example, Reback et al. (1994). Gary Reback represented Netscape and was instrumental in creating this loose coalition, as well as providing the main arguments that the government used in this case. Brinkley and Lohr (2000), page 326, also mention a Netscape “white paper” written by Wilson Sonsini lawyers Gary Reback and Susan Creighton and entitled “White Paper Regarding the Recent Anticompetitive Conduct of the Microsoft Corporation,” dated 1996, which was never made public but was made available to the NY Times reporters.

Windows. 9 On May 12, 1998, the Court of Appeals (DC Circuit) ruled that the 1995 consent decree did not apply to Windows 98, which was shipped with an integrated IE as part of the operating system and an IE icon on the PC desktop. On June 23, 1998, the Court of Appeals voided the 1997 preliminary injunction, arguing that “courts are ill equipped to evaluate the benefits of high-tech product design.” 10 During the week following the Court of Appeals defeat of its 1995 consent degree enforcement suit, DOJ filed a major antitrust suit against Microsoft. In this action (DOJ Complaint 98-12320), filed on May 18, 1998, DOJ was joined by the Attorneys General of 20 States and the District of Columbia. This paper focuses on this last and continuing lawsuit against Microsoft.

Over the years, Microsoft has integrated in the Windows class of operating systems many functions and features that were originally performed by stand-alone products. 11 Moreover, the Court of Appeals in its June 23, 1998 decision affirmed that Microsoft’s practice of bundling IE with Windows was legal under the terms of the 1995 consent decree. To overcome this interpretation of the law, DOJ argued that Microsoft’s bundling of IE with Windows and its attempt to eliminate Netscape as a competitor in the browser market was much more than adding functionality to Windows and marginalizing a series of add-on software manufacturers. DOJ alleged (and the District Court concurred) that Microsoft added browser functionality to Windows and marginalized Netscape because Netscape posed a potential competitive threat to the Windows operating system. This distinctive threat posed by Netscape was a crucial part of the DOJ allegations. DOJ alleged that applications could be written to be executed “on top” of Netscape. Since Netscape could be run on a number of operating systems, DOJ alleged that Netscape could erode the market power of Windows. In DOJ’s logic, Microsoft gave away IE and integrated it in Windows so that Netscape would not become a platform that would compete with Windows. Thus, DOJ alleged that Microsoft’s free distribution of IE, its bundling with Windows, and all its attempts to win the browser wars were defensive moves by Microsoft to protect its Windows monopoly.

The Microsoft trial took place at an accelerated schedule at the U.S. District Court of the District of Columbia from October 19, 1998 to June 24, 1999. Only twelve witnesses testified from each side. Microsoft’s CEO Bill Gates was not called as a witness, but his video taped deposition was extensively used during the trial. Judge Thomas Penfield Jackson announced that he would announce his “findings of fact” before his “conclusions of law.” This was widely interpreted as implying that the judge The Court also referred the issue to a special master, Prof. Lawrence Lessig of Harvard.

The Court of Appeals further noted that “the limited competence of courts to evaluate high-tech product designs and the high cost of error should make them wary of second-guessing the claimed benefits of a particular design decision.” 147 F.3d at 950 n.13.

For example, disk compression and disk de-fragmentation were not part of Windows 3.1 and were added to Windows 95 and 98.

was trying to give an opportunity to the sides to reach a compromise and resolve the case through a consent decree.

On November 5, 1999, Judge Jackson issued his “findings of fact,” siding very strongly with the plaintiffs. In December 1999, Judge Richard Posner, a prominent antitrust scholar and the Chief Judge of the Seventh Circuit Court of Appeals, agreed to serve as mediator for settlement discussions. 12 On April 1, 2000, settlement talks broke down after some States reportedly disagreed with the proposed agreement. 13 On April 3, 2000, Judge Jackson issued his “conclusions of law” finding for the plaintiffs on almost

all points. In particular, Judge Penfield Jackson found:

1. The relevant antitrust market is the PC operating systems market for Intel-based computers.

2. Microsoft has a monopoly in this market “where it enjoys a large and stable market share.”

3. Microsoft’s monopoly is protected by the “applications barrier to entry,” which the judge defines as the availability of an abundance of applications running Windows.

4. Microsoft used its monopoly power in the PC operating systems market to exclude rivals and harm competitors.

5. Microsoft hobbled the innovation process.

6. Microsoft’s actions harmed consumers.

7. Various Microsoft contracts had anti-competitive implications, but Microsoft is not liable of anti-competitive exclusive dealing contracts hindering the distribution of Netscape Navigator.

On June 7, 2000, after an extremely short hearing, Judge Jackson issued his remedies decision, splitting Microsoft into two companies, and imposing severe business conduct restrictions. The plaintiffs remedies proposal as adopted by the Judge imposed a breakup of Microsoft into two pieces, an “operating systems” company which would inherit all the operating systems software, and an “applications” company with all the with all the remaining software assets. Cash and securities holdings of other companies held by Microsoft would be split between the resulting entities. Bill Gates and other officers / shareholders of the company would not be allowed to hold executive and ownership positions in both of the resulting companies.

The District Court ruling also imposed interim conduct restrictions on Microsoft.

These restrictions, to last three years, were:

1. Microsoft would create a pricing schedule that would apply to all buyers, so that price would not be conditioned on the sale of other Microsoft products.

As mediator, Judge Posner was not acting in his judicial capacity.

See New York Times, April 2, 2000.

2. Microsoft would not be allowed to have exclusive contracts that do not allow the other party to use, display, or feature its opponents products.

3. APIs and other technical information of Windows should be shared with outsiders as it is shared within Microsoft.

4. Microsoft is not allowed to take actions against manufacturers who feature competitors’ software.

5. Microsoft will allow OEMs to alter Windows in significant ways.

6. Microsoft is not allowed to design Windows to disable or compromise rivals’ products.



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