US v. Microsoft (2001)

Case summary

  • Trial occurred October 1998 - June 1999
  • MIcrosoft was eventually found guilty of monopolization
  • The DOJ applied the Grinnell test
  • Microsoft argued that typical views of competition were obsolete in analyzing an industry where technology and products are changing so fast

Industry background

  • Personal computers (PCs) flourished in the 1980’s, as they were cheaper and more powerful than the alternative
  • PCs have three main components
    • Hardware: the physical components of the PC
    • Operating systems: the most basic software that tells the hardware what to do
    • Application software: the software a user can interact with for typing, data analysis, gaming, etc.
  • When IBM introduced PCs, they chose Microsoft’s operating system, which caused Microsoft’s windows OS to flourish
    • The US government claimed Microsoft used Windows’ success to exclude other application software developers from the market

Conflicting view of competition

  • The US and Microsoft differed (drastically) in their respective views of the competitiveness of the industry
    • The US argued Microsoft had a dominating market share due to significant barriers to entry in the software industry, and that Microsoft took actions to defend their dominant position from competitive entry
    • Microsoft argued that software competition is fundamentally different than competition in other industries, and that Microsoft gained their market share and excess profit due to winning a competitive battle

Microsoft’s expert economist

“Competition in the sofware industy is based on sequential races for the leadership of categories such as word processing, spreadsheets, personal financial software, games, operating systems, and utilities - not to mention currently unknown categories from which the next generation of ``killer applications” will emerge. Many firms enter the race to lead or create a category. A firm can win the race for a category by virtue of being first to market with an innovative product desired by consumers, or by offering a product that consumers consider substantially better than existing products.”

→ In the tech industry, you are rewarded with profit for either having an innovative product, or a product that is significantly better than what was on the market

That winning firm obtains a large share of sales in its category as a result of product superiority and scale economies.

→ Technology has increasing returns to scale, thus a good product will necessarily make huge profit

“It charges prices that reflect the value to consumers of the intellectual property it has created, and it enjoys the profits that arise from its success and risk taking.”

→ The product price is merely a reflection of how much consumers value the product and the profits generated from the product is the reward for its success and risk taking

“However, its prices are constrained by the risk of being displaced, which also forces it to continue to innovate.” - Richard Schmalensee

→ The risk of displacement offsets the huge profit and put constraint on the product price.

Elements of market power

  • Using the Grinnell test, the US needed to define the market and provide evidence of monopoly power
    • The US defined the relevant market as the licensing of all Intel-compatible PC operating systems worldwide
    • Up to this point, Microsoft was the only firm in this market
  • Microsoft defined the relevant market differently
    • They believed Apple’s Macintosh should be included in the market, as well as “middleware” products that are compatible with any OS
  • The Supreme Court sided with the US
    • The court believed that if Microsoft raised their prices a little, most consumers would not move to middlewares of Apple
  • The DOJ provided evidence that Microsoft had 95% market share in the relevant market, and that they were exerting market power
  • Microsoft countered
    • Microsoft was not exerting market power, but rather won the competitive race to be a “category leader”
    • Their observed market share was a result of many periods of successful (and costly) innovation

Barriers to entry

  • The DOJ argued that software development has substantial barriers to entry
    • Operating systems have large economies of scale and large sunk costs
    • Consumers prefer an OS that has a lot of applications already available
    • Software applications and OS’s have substantial network effects
      • Network effects exist when consumers’ value of belonging to a network increases the larger the size of the network
  • Microsoft countered
    • There are no barriers to entry for a startup to enter the tech race
    • Trivial advances over the current category leaders are inefficient, since no one would buy the product
    • Thus, firms try to “leapfrog” the category leader with substantial improvement, and Microsoft was vulnerable to this
  • Although Microsoft’s defense of leapfrog vulnerability appeared strong, an internal memo revealed they did not actually believe this was realistic

“Our high prices could get a single OEM (original equipment manufacturer) (Compaq might pay us $750m next year) or a coalition to fund a competing effort (say in India). While this possibility exists I consider it doubtful even if they could get a product out that they can market successfully, leapfrog us and would not deviate from their own standard to differentiate. Could they convince customer [sic] to change their computing platform is the real questions [sic]. The existing investments in training, infrastructure and applications in Windows computing are huge and will create a lot of inertia.”

Exclusionary conduct

  • After proving Microsoft had monopoly power, the DOJ wanted to show they engaged in exclusionary practices
  • Java and Netscape were middleware companies that created products that made OS’s interchangable, such as Netscape’s internet browser
  • Microsoft developed Internet Explorer and distributed it at a negative price
  • Microsoft bundled the Windows OS with Internet Explorer
  • The DOJ argued this behavior excluded middleware companies that produced browsers competitive to Internet Explorer
  • Microsoft countered that bunding Internet Explorer benefited customers, the quality of Internet Explorer steadily improved, and bundling Internet Explorer was merely competitive practice

Judicial decision

  • Using the Grinnell test, Microsoft was found guilty of antitrust behavior
  • Satisfied the first prong of Grinnell test
    • Microsoft had huge market share (95%) in the relevant market (Intel-compatible operating systems world wide)
    • Their behavior was consistent with monopoly, as they charged a high price and constructed barriers to entry
    • Microsoft’s strategy prior to the trial helped provide evidence for the decision
      • Microsoft did not consider competitor prices when pricing their OS
      • Microsoft raised the price of Windows 95 right before the release of Windows 98
      • The price of upgrading from Windows 95 to 98 was $89, when a price of $49 was economically feasible
  • Microsoft has willfully acted to maintain its market power with means that have no procompetitive interpretations which satisfied second prong of the Grinnell test