IN THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF COLUMBIA
UNITED STATES OF AMERICA,
Plaintiff,
v.
MICROSOFT CORPORATION,
Defendant.
STATE OF NEW YORK ex rel.
Attorney General DENNIS C. VACCO, et al.,
Plaintiffs,
v.
MICROSOFT CORPORATION,
Defendant.
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Civil Action No.
98-1232 (TPJ)
Civil Action No.
98-1233 (TPJ) |
DIRECT TESTIMONY OF
FREDERICK R. WARREN-BOULTON
TABLE OF CONTENTS
I.
BACKGROUND.................................................................................................................
1
II. INTRODUCTION
................................................................................................................2
III. SUMMARY OF
CONCLUSIONS......................................................................................6
IV. MICROSOFT HAS
MONOPOLY POWER IN THE PC OPERATING SYSTEM
MARKET
.............................................................................................................................9
A. PC Operating Systems Comprise
a Relevant Antitrust Market.............................10
1. Background Industry
Facts.........................................................................10
2. Principles of
Market Definition.................................................................13
3. PC Operating
Systems Comprise a Relevant Market................................16
B. Microsoft Possesses Monopoly Power In the PC Operating System
Market........20
1. Market
.......................................................................................................20
2. Barriers to
Entering the PC Operating System Market are High...............21
3. Microsoft's
Monopoly Power is Evidenced by its Use..............................28
4. in the Market Value of its Equity
.............................................................28
V. INTERNET WEB BROWSERS POSE A THREAT TO MICROSOFT'S
PC
OPERATING SYSTEM MONOPOLY
............................................................................29
A. Browsers and Operating Systems
Comprise Separate Products............................32
1. Efficiently be Provided
Separately.............................................................34
2. Internet
Explorer and Windows 95/98 are Separate Products...................38
B. System
Monopoly..................................................................................................39
VI. MICROSOFT'S EXCLUSIONARY
CONDUCT.............................................................41
A. Microsoft's Tying is
Exclusionary.........................................................................42
B. Microsoft's OLS and ISP
Restrictions are Exclusionary.......................................46
1. Microsoft's
OLS Agreements are Exclusionary........................................46
2. Microsoft's Restrictions on
Other ISPs are Exclusionary..........................49
C. Microsoft's ICP Restrictions are
Exclusionary......................................................53
D. Browsers
................................................................................................................ 56
E. Exclude Rival Browsers
........................................................................................60
VII. THE CUMULATIVE
EFFECT OF MICROSOFT'S PRACTICES IS SIGNIFICANTLY
TO IMPAIR COMPETITION AMONG
COMPETING BROWSERS.............................63
A. Anticompetitive
Practices......................................................................................63
B. Anticompetitive
Practices Have Substantially Foreclosed Competition...............64
C. Anticompetitive Practices
Have Substantially Foreclosed Competition...............66
VIII. THERE IS A DANGEROUS PROBABILITY THAT
MICROSOFT WILL GAIN
MONOPOLY POWER IN THE
BROWSER MARKET; AND, EVEN IF IT DOES NOT,
IT COULD SIGNIFICANTLY REDUCE
OR DELAY THE THREAT TO THE OS
MONOPOLY.....................................................................................................................
69
A. Dangerous Probability of
Monopolization.............................................................69
B. System Monopoly May be
Strengthened...............................................................70
IX. MICROSOFT'S EXCLUSIONARY CONDUCT LACKS LEGITIMATE
BUSINESS
JUSTIFICATION
...............................................................................................................70
A. Microsoft's Prohibition on OEMs'
Removing Internet Explorer is Unjustified...71
B. Windows
Platform.................................................................................................74
C. Restrictions on OEM Modification of
Desktop and StartUp Sequence.................78
1. User
Experience.........................................................................................78
2. of the User's Windows
Experience............................................................81
D. Achieve any Legitimate
Business Purpose............................................................82
X. MICROSOFT'S ACTIONS
TO INCREASE ITS BROWSER USAGE SHARE ARE
PREDATORY
....................................................................................................................83
XI. THE COSTS TO
CONSUMERS AND COMPETITION FROM MICROSOFT'S
EXCLUSIONARY CONDUCT ARE
SIGNIFICANT AND FAR REACHING..............86
.
Page 1.
DIRECT TESTIMONY OF
FREDERICK R.
WARREN-BOULTON
I. BACKGROUND
1. My name is Frederick R. Warren-Boulton. I am a Principal with
MiCRA
(Microeconomic Consulting
and Research Associates, Inc.), a Washington-based economics
consulting and research firm
specializing in antitrust and regulatory matters. I hold a B.A. degree
from Yale University, a
Master of Public Affairs from the Woodrow Wilson School of Public
and International Affairs at
Princeton University, and a Ph.D. in Economics from Princeton
University.
2. From 1972 to 1983, I was an Assistant and then Associate Professor
of Economics
at Washington University in
St. Louis. From 1983 to 1989, I served as the chief economist for
the Antitrust Division of the
U.S. Department of Justice, first as the Director of its Economic
Policy Office and then as the
Deputy Assistant Attorney General for Economic Analysis. Since
leaving the Department of
Justice, I have served as a Resident Scholar at the American Enterprise
Institute, a Visiting Lecturer of
Public and International Affairs at the Woodrow Wilson School
at Princeton University, and a
Research Associate Professor of Psychology at The American
University.
3. My area of specialization is in the economics of industrial
organization. I have
authored numerous
publications, primarily in the application of industrial organization
economics to antitrust and
regulatory issues, including a number of papers dealing with aspects
of the computer industry. A
complete description of my background and papers can be found in
my Curriculum Vita, a copy of
which is attached to this testimony as Attachment 1.
4. I have been asked by the plaintiffs in these actions to perform an
economic
Page 2.
analysis of certain actions by
Microsoft Corporation ("Microsoft") with regard to PC operating
system software and Internet
browser software. In conducting that analysis, I have considered (1)
public documents containing
relevant information; (2) certain confidential Microsoft and
third-party documents
supplied to me by the plaintiffs; (3) deposition transcripts of personnel
from Microsoft and other
industry participants; (4) relevant publications from the economics
literature; and (5) filings
made in these actions, including the reports of other expert witnesses.
As additional material
becomes available that is relevant to the testimony offered here, I will, to
the extent that is possible,
seek to include it in my analysis.
II. INTRODUCTION
5. Based on my analysis of Microsoft's conduct and its competitive
effects, I have
drawn the following three
basic conclusions:
6. First, Microsoft has monopoly power in a relevant market. Using the
basic
methodology for defining
markets supplied by the 1992 Horizontal Merger Guidelines1 an
accepted approach for
delineating antitrust markets in Sherman Act cases I conclude that
operating systems
compatible with Intel x86/Pentium architecture personal computers (PCs)
comprise a relevant market.
7. The evidence also demonstrates that Microsoft possesses monopoly
power in that
market. Microsoft for several
years has enjoyed, and is projected for several years to retain, a
market share in excess of
90%.2 This
market share is protected by substantial barriers to entry.
Page 3
Operating system markets exhibit "network effects." The greater the number of users a particular
operating system enjoys, the more likely it is that software developers will write applications for
that operating system. This, in turn, makes the operating system still more attractive to users and,
as a consequence, makes software developers more likely to develop applications for that
operating system, and, given scarce resources, less likely to develop applications for alternative
operating systems. The end result is that in such markets, the very network effects that drive
users toward the dominant firm make displacing that firm difficult.
8. Second, Microsoft has engaged in a number of practices that
significantly impede
the commercial opportunities
of rival producers of Internet web browsers, a product that is a key
element of a threat to
Microsoft's operating system monopoly. Because of the nature of the
barriers to entry created by
network effects, the most likely long-term threat to Microsoft's
monopoly power does not
come directly from other operating systems, but rather from the spread
of cross-platform
technologies, that can serve (like Microsoft's operating system) as a platform to
which application developers
write.
9. Internet web browsers are a key component of precisely such a
threat. PC users
demand browsers principally
to locate, access, display, use, and navigate applications located on
the Internet's World Wide
Web. At the same time, although browsers may never develop into
full-fledged operating
systems, browsers can serve as a platform to which application developers
Page 4
write. Should application
vendors use a browser platform other than the Windows platform, the
applications barrier to entry
that protects Microsoft's monopoly could be diminished, and
competition in the PC
operating system market created. Microsoft itself recognizes the threat
non-Microsoft web browsers
pose. As Bill Gates stated: "They [Netscape] are pursuing a
multi-platform strategy where
they move the key API into the client [browser] to commoditize
the underlying operating
system."3
10. Subsequent
to Netscape's launching of its browser, Microsoft implemented a
number of contractual
restrictions in its licenses with Original Equipment Manufacturers
("OEMs"), Internet Service
Providers ("ISPs"), Online Services ("OLSs") and Internet Content
Providers ("ICPs"). These
restrictions bias consumers' choice of browser in favor of Microsoft's
browser, Internet Explorer
("IE"), disadvantage rival browsers, such as Netscape Navigator, and
restrain effective competition
between them.
11. Microsoft's
practices are exclusionary; that is, they impede the commercial
opportunities for rival web
browsers. Microsoft's tying of Internet Explorer as a condition of
licensing its Windows
operating system to OEMs and Microsoft's restrictions on OEMs' ability
to customize the Windows
desktop and start-up sequence inhibit OEMs from offering or
promoting non-Microsoft
browsers with their PCs. Microsoft's agreements with ISPs and OLSs
severely restrict (or, until
recently, significantly restricted) the ability of these firms to distribute
or promote non-Microsoft
browsers. And Microsoft's agreements with ICPs not only place
significant restrictions on the
distribution and promotion of competing web browsers, but also
restrict the ability of ICPs to
pay competing browser suppliers for promoting their services. The
restrictions, moreover, are
mutually reinforcing and, when considered in the aggregate, make it
Page 5
significantly more difficult for
Netscape and others to gain usage of their browser products.
12. Microsoft's
restrictions have constricted, and continue to constrict the distribution
channels available to
Netscape and other independently-supplied browsers. The majority of users
obtain a browser through
OEMs, ISPs, or OLSs. Downloading of browsers from Internet sites is
increasingly time-consuming
and fraught with technical difficulties. Although Netscape can
distribute disks containing its
browser software to potential users through the mail and other
channels, this marketing
strategy is not an effective substitute for the OEM, ISP, and OLS
channels.
13. The
impairment of rivals caused by Microsoft's agreements matters; Microsoft's
constriction of distribution
channels has significantly impaired the ability of Netscape and other
non-Microsoft browsers to
effectively offer consumers a choice between their browser and
Microsoft's. Since 1996,
when Microsoft imposed most of its restrictions, Netscape's overall
share of browser usage has
fallen markedly. More importantly, in the wake of Microsoft's
exclusionary practices,
Netscape's share of new browser users has declined even more.
According to Microsoft's
estimate of the "run rates" for browsers the percentage of new
Internet connections that use
a particular browser IE's current run rate is approximately 62%,
and is projected to rise to
70%.4
14. Third,
Microsoft's practices cannot be justified on efficiency grounds.
Microsoft's ISP, OLS, and
ICP restrictions are not necessary to further pro-competitive purposes.
Similarly unjustified is Microsoft's tying of Internet Explorer to OEMs.
If users want the combination
of operating system and IE provided by Windows 95 or Windows 98, they will
select the combination on
their own volition. Microsoft's restrictive practices, however, prevent
Page 6.
operation of a "market test," in
which OEMs would be free to offer the product configuration of
their choice and those
product configurations would be tested against consumer preferences in
the market. Furthermore,
Microsoft's restrictions on OEM modification of the Windows desktop
and start-up sequence are
more restrictive than reasonably necessary to achieve any
pro-competitive goals.
15. The costs to consumers from Microsoft's maintenance of its PC
operating system
monopoly, and its creation of
a new monopoly in Internet browsers, through its exclusionary
practices would be
substantial. The price paid for personal computer systems likely will be
higher than it otherwise
would have been. Moreover, and perhaps more importantly, the artificial
barriers to entry erected by
Microsoft's conduct will slow or halt the natural tendency of the
marketplace to provide
alternative technologies in the affected markets, and Microsoft's
operating system monopoly
would be further entrenched.
III. SUMMARY OF CONCLUSIONS
16. I have reached the following conclusions:
(1) First, operating systems
("OSs") for the x86 architecture PCs comprise a relevant
antitrust market within which
Microsoft has, and has exercised, monopoly power.
(2) Second, Internet browsers and PC operating systems,
including Microsoft's
Internet Explorer browser and
Windows 95 and 98 operating systems, comprise separate
products. Products are
separate in an economic sense when they would be provided separately
under competitive conditions;
that is, when there is sufficient demand such that separate
provision is efficient. In
competitive markets, we would observe products being provided
separately when that is
efficient, and one could therefore ordinarily determine whether doing so
Page 7
is efficient simply by looking at
what products are supplied in the market. Here, however,
Microsoft's use of its
monopoly power to tie the browser to the operating system has prevented
such a "market test." Under
the circumstances, therefore, it is appropriate to examine other
evidence to determine
whether the requisite separate demand exists. And the available evidence
of demand for IE alone and
for the Windows 95 and 98 OSs without IE, and of the costs of
providing them separately,
supports the conclusion that browsers and operating systems are
separate products.
(3) Third,
independently-developed browsers represent, as Microsoft itself has
recognized, a threat to the
continued dominance of its Windows operating system product. This
threat arises from the ability
of the browser to provide a user interface and platform for
applications so that, either by
itself or in combination with cross-platform technologies such as
Java technologies,
widespread use of independent browsers can facilitate the availability of a
substitute for the Windows
platform and operating system. Thus, while browsers and operating
systems are complements in
demand (e.g., in terms of features as experienced by users), the
widespread usage of
non-Microsoft browser products can serve to facilitate the entry and
expansion of a substitute for
Microsoft's operating system.5
(4) Fourth,
Microsoft has acted to forestall this threat to its operating system
monopoly by imposing a set
of restrictive agreements on, or taking advantage of restrictions in
existing agreements with,
other market participants, including PC manufacturers, Internet service
Page 8
providers, on-line services
providers and Internet content providers. Microsoft's doing so has
had the purpose and effect of
biasing consumers' choice of browsers in favor of Microsoft's
browser, Internet Explorer;
hindering the distribution of rival browsers, notably Netscape
Navigator; and injuring
effective competition between them.
(5) Fifth, the cumulative effect
of these restrictive agreements has been to make it
more difficult for competing
browsers to acquire new users. These agreements, together with
Microsoft's tying of IE to its
operating system, both in upgrade sales and in sales to OEMs, and
its pricing at zero to the
installed base of Windows users, have increased IE's market share
significantly.
(6) Sixth, under
current conditions, Microsoft's share of browser usage can be
expected to continue to
increase rapidly. Should Microsoft's anticompetitive conduct continue,
there is a dangerous
probability that Microsoft will monopolize the browser market.
(7) Seventh, Microsoft could
significantly reduce or delay the threat to its operating
system monopoly even
without fully monopolizing the browser market, a relevant antitrust
market. Preserving the
barrier to entry created by the large stock of Windows applications
requires only that Microsoft's
expected or actual browser usage share be high enough to induce
independent software
developers ("ISVs") not to develop a stock of cross-platform applications
sufficient to encourage entry
or expansion of competing operating systems.
(8) Eighth, the imposition and
use by Microsoft of contractual restrictions on OEMs,
ISPs, OLSs, and ICPs to
exclude competition are not justified by the need to achieve significant
efficiencies or are more
restrictive than reasonably necessary to achieve such efficiencies.
(9) Ninth, based on the
evidence I have seen, I conclude that Microsoft's distribution
of its browser at a zero price,
the tying of its browser to its operating system, and its other
Page 9.
exclusionary contractual
restrictions with ISPs, OLSs, ICPs, and OEMs were undertaken without
regard to whether those
actions were profit-maximizing -- or even profitable -- absent the future
revenue gains from
weakening rival browsers and thereby preserving Microsoft's Windows
operating system monopoly
and from gaining a monopoly in the browser market. Microsoft
regarded the goal of winning
the browser "war" as an overriding strategic objective, driven by the
need to preserve its PC
operating system monopoly and was prepared to pursue this goal despite
the large costs it
incurred.
(10) Tenth, if Microsoft is permitted to crush
the incipient threat to its PC operating
system monopoly that
independent browsers and cross-platform technologies pose, the adverse
consequences for
competition and innovation are likely to be substantial. They include the
reinforcement of barriers to
entry into the operating system market and the reduction of
incentives to innovate by
other firms, especially new technologies whose independent provision
may be regarded as a
substitute for, or threat to, the Windows operating system.
IV. MICROSOFT HAS
MONOPOLY POWER IN THE PC OPERATING SYSTEM
MARKET
17. The starting
point for an antitrust analysis of Microsoft's actions is the question:
Does Microsoft have
monopoly power in a properly defined relevant market? In answering this
question, it is important to
keep in mind that the purpose of defining markets in this case is to
determine whether
Microsoft's conduct has the potential to harm consumer or social welfare. If
Microsoft lacks monopoly
power in any relevant market, any profit-maximizing unilateral
conduct is unlikely
significantly to harm consumer welfare.
18. My
assessment of whether Microsoft possesses monopoly power proceeds in the
Page 10.
following steps. First, I will define the relevant market. I
begin by setting out certain relevant
industry facts and defining some terms for the purpose of
the ensuing discussion. I then briefly
summarize the principles of market definition I believe are
appropriate here. Next, I apply those
principles to the facts, and explain how they lead me to
the conclusion that PC operating
systems are an antitrust market. Second, having defined
the market, I then assess Microsoft's
power within it. I show that Microsoft possesses
monopoly power in the PC operating system
market, and that this power, in large measure, is secured
by barriers to entry created by the large
number of applications available exclusivelyfor
Microsoft operating systems.
19. I then explain
how non-Microsoft browsers, both by themselves and in
conjunction with Java cross-platform technologies,
threaten that monopoly. I will show that
browsers and Java threaten to eliminate the most
significant of the entry barriers that shields
Microsoft's monopoly from effective competition and,
therefore, that Microsoft stands to gain
significantly from eliminating the browser threat.
A. PC Operating Systems
Comprise a Relevant Antitrust Market
1. Background Industry
Facts
20. Personal
computers are computers designed to be used by one person at a time.
They include desktop and laptop models. Because
personal computers are actually computer
systems, they are made up of many components, each of
which must be technically compatible
with the others for the system to function properly. A
typical personal computer includes at
least one CPU ("Central Processing Unit"), dynamic
memory, a hard disk drive, a floppy drive,
a keyboard and monitor, and an operating system. The
operating system is "the software that
controls the allocation and usage of hardware resources
such as memory, central processing unit
time, disk space, and peripheral devices. The operating
system is the foundation on which
Page 11
applications are built."6
21. When
desirable for clarity in this testimony, I distinguish the operating system
itself from the operating system product sold to
consumers, which may include software or
features that are not part of the operating system. For
example, Microsoft's Windows 95
operating system product includes a software Solitaire
card game which is not part of the
Windows 95 operating system. Operating system
software is software that can be part of the
operating system (e.g., either substitutable for
part of the operating system, or closely related to
the functioning of the operating system for example, a
hard disk clean-up utility is closely
related to the operating system and would be operating
system software). Operating system
software may be sold as a product that is separate from
the operating system and produced by
vendors other than the OS vendor.
22. Applications
are software programs designed to assist in the performance of a
specific task. They include such things as spreadsheets,
word processors, and database
management programs. Applications are said to "run on
top" of the operating system. In
particular, applications must communicate with the
operating system to request services from
the operating system. Applications do so by using (or
"calling") the operating system's
application programming interfaces ("APIs").
23. The
components of PCs are assembled by computer makers or OEMs. The great
majority of operating systems installed on PCs are
installed on new machines by OEMs.7 The
Page 12
OEM stage of the PC industry is competitive, as indicated
by the large number of computer
makers, thin profit margins, and the absence of a
dominant firm.8
24. Both
businesses and households purchase PCs. Businesses and households have
different preferences and make different purchase
decisions. Customers who purchase an OS as
an upgrade (e.g., the Windows 98 upgrade) to
the operating system already on their PC have
different demand characteristics from customers who
purchase an OS for a new PC either at
retail or pre-installed from an OEM.
25. IBM
introduced the original PC in November, 1981 and offered Microsoft's MS-
DOS as one of its operating systems. Since then,
Microsoft has become the leading supplier of
operating systems for PC OEMs. In the early 1990s,
Microsoft began to enjoy widespread
acceptance of its "Windows" graphical user interface
("GUI") that runs on MS-DOS. Windows
and MS-DOS were often pre-installed on OEM PCs. In
1995, Microsoft introduced a successor
self-contained operating system product called "Windows
95."9 In June
1998, Microsoft
released Windows 98, the successor to Windows 95. As
with Windows 95 prior to June 1998,
OEMs believe it is commercially necessary to offer
Windows 98 on the PCs they sell to end
users.10
2. Principles of Market
Definition
26. The first step
in ascertaining whether a firm possesses monopoly power is to
Page 13.
define the market. For this task, I draw upon the principles
for defining markets set forth in the
1992 Horizontal Merger Guidelines, promulgated
jointly by the U.S. Department of Justice and
the Federal Trade Commission. The Guidelines
supply a well-accepted method for delineating
markets and arecommonly relied upon by both
economists and courts to define relevant
antitrust markets.11
27. The basic
idea underlying the Guidelines is to find the smallest group of
products, and smallest geographic area, over which a
monopolist in those products could
exercise market power by profitably imposing "at least a
small but significant and
nontransitory' increase in price."12 This test, known as
the "hypothetical monopolist" test,
reflects the underlying rationale for defining markets: to
assess whether conduct has the
potential to cause anticompetitive effects. If a
"hypothetical monopolist" in the relevant product
could not effectively exercise monopoly power, then we
can be confident that attempts by firms
operating in such a market to impose anticompetitive
restraints could effectively be checked by
other forces, such as competing firms, entry by new firms,
or a shift by consumers to a substitute
product. In contrast, if the "hypothetical monopolist" can
exercise power over the product in
question, then a dominant producer of that product might
well be able to inflict harm on
consumers through its conduct.
28. Just as it is
important to define the market broadly enough to ensure that a
monopolist over all the products in that market would
cause significant harm, it is also
important not to define the market too broadly, for that
might understate the power of the firm
Page 14
whose conduct is being examined. Thus, the
Guidelines' hypothetical monopolist inquiry
begins with a product (and geographic area) that the
relevant firm produces and asks if the
hypothetical monopolist could exercise power over those
products. If the answer is "no," the
market has not been drawn broadly enough; other forces
would defeat the hypothetical
monopolist's attempt to exercise market power. In such
circumstances, the next closest
substitute for the product considered is added, and the
question of whether the hypothetical
monopolist could exercise power in this possible market
asked again. This process is repeated
until the answer is "yes"; at that point, the market has
been properly defined. Completing the
analysis at the earliest point at which the hypothetical
monopolist could exercise power is
known as the "smallest market principle."
29. There is an
important distinction I should mention about applying the Guidelines
to this case. As I have explained, the Guidelines
inquire as to the profitability to a hypothetical
monopolist of raising price. In a merger case, the prices
used as the starting point in the analysis
are prevailing or existing prices. This is because, in a
merger case, the concern is not so much
whether the merging firms presently are exercising
market power, but rather whether the merger
will increase the market power of the merging
firms.
30. In contrast,
in a monopolization case such as this, the question is whether the
firm in question already possesses monopoly power. In
such circumstances, the appropriate
benchmark is not the prevailing price but rather the
competitive price; and the question is
whether a hypothetical monopolist of the candidate
market could profitably charge a price in
excess of the competitive level. Because the
prevailing price might be a monopoly price, it is
not meaningful to ask whether a hypothetical monopolist
could profitably increase the price
above the prevailing price; even a monopolist cannot
charge greater than a monopoly price
Page 15
without having its conduct constrained sufficiently to make
that price increase unprofitable.
Using the competitive price thus yields a proper market
definition in the circumstances of this
case.
31. In applying
the hypothetical monopolist test to possible markets (that is,
determining whether such a firm could profitably impose a
"small but significant and
nontransitory" price increase over the competitive price),
an economist ideally would like to
have reliable and precise estimates of what is known as
the "own price elasticity" (considered
over the relevant price range) for the product or group of
products that comprise the possible
market.13 The own price elasticity, together with the
marginal cost, essentially tells an
economist when the imposition of a particular price
increase will be profitable.
32. Such data,
however, are often not available -- either to economists or to antitrust
tribunals.14 It is thus appropriate to rely, as the
Guidelines explain, on "all relevant evidence"15
in applying the hypothetical monopolist test. This
includes, but is not limited to, the perceptions
of market participants and the characteristics of the
industry in question.
3. PC Operating Systems Comprise a
Relevant Market
33. Applying the
hypothetical monopolist test, it is my opinion that PC operating
systems comprise a relevant antitrust market. I reach
this conclusion based on two distinct
Page 16.
types of evidence. First, the characteristics of the product
in question, and the demand for it,
readily support the conclusion that operating systems
designed for other (non-PC) hardware
platforms would not constrain, and have not constrained,
the ability of a monopolist of PC
operating systems to exercise monopoly power. Second,
evidence from OEMs, the major direct
purchasers of PC operating systems, confirms that even a
large increase in the current price of
the dominant PC operating system, Windows, would not
result in significant switching by them
or their consumers to other PC operating systems, let
alone to operating systems designed for
other processors.
34. As an initial
matter, it is important to observe that consumers do not demand
operating systems simply for the sake of having an
operating system. Rather, consumers
demand computers, for which an operating system is one
(albeit a key) component. In economic
terms, this means that demand for an operating system is
a derived demand: demand for an
operating system is derived from demand for a computer
system. Moreover, an operating
system is essential on every PC and consumers generally
demand only one operating system per
personal computer.
35. A
consequence of these facts -- that operating systems are demanded in fixed
proportions and that demand for operating systems
derives from consumer demand for PCs -- is
that consumers faced with an increase in the price of PC
operating systems can effectively
substitute away from PC-compatible operating systems
only by substituting away from PCs.
Such substitution, however, would impose significant
costs on end users and on
PC-manufacturers.
36. Both end
users contemplating switching to alternatives to PCs and new users
considering such alternatives would face significant costs
or disadvantages. End users purchase
Page 17
computers, not for the operating system itself, but rather to
run applications; and applications
are typically designed for a particular operating system.
Because the PC platform is dominant,
other platforms (and, as discussed below, non-Microsoft
operating systems that also run on the
PC platform) typically have far fewer applications
available. Thus, both new end users and
users considering switching to another platform would
face the disadvantage of a smaller
portfolio of available applications. Switchers would also
need to expend time and money
learning how to use a computer designed for a different
processor. And both switchers and new
users would have to bear costs resulting from any
incompatibility or impaired compatibility
between their computer and PCs used by colleagues or
others with whom the users may wish to
communicate or share files.
37. Because
there is generally one operating system on a PC, the increase in the price
of the PC that would result from a given percent increase
in the price of the operating system
would be at most the increase in the price of the operating
system times the share of the
operating system cost in the price of a PC. But the
operating system for PCs accounts for only a
small share of the price of the PC on average about
2.5% and at most 10% for very
inexpensive PCs.16 Thus, even a 10% increase in the price of the OS
would result at most in a
1% increase in the price of even inexpensive PCs. Given
the cost to users of switching to
another platform, such a small increase in the price of the
PC platform would not be expected to
result in a large reduction in the demand for PCs, and
thus for PC operating systems. In
economic terms, the price elasticity of derived demand for
PC operating systems must be very
low for at least a significant price range above the
competitive price for PC operating systems,
leading me to conclude that PC operating systems are a
separate market.
Page 18
38. The large
costs that PC manufacturers and end users would incur in substituting
away from the PC platform reinforces this conclusion.
OEMs make a significant investment in
developing the machines they sell; to substitute to
another hardware platform (one not based on
the Intel-chip), such as the "PowerPC" chip, would require
incurring significant costs.17
39. The
testimony of, and documents authored by, OEM executives further supports
this conclusion. These executives explain that, if
confronted with a 10% increase in their
Windows license, they would not switch to operating
system products for other hardware
platforms.18 To the contrary, they make clear that preloading
Microsoft's Windows operating
system is commercially necessary.19
40. OEM
executives also explain that Intel-compatible operating system products
that are designed, not for personal computers, but rather
to operate "servers" are not viable
substitutes for a desktop operating systems.20 Server operating
systems are generally more
expensive yet do not provide the features consumers
demand when they purchase PC operating
systems.21 Therefore, the existence of server operating
systems would not constrain the ability
Page 19
of a monopolist of operating systems for PCs to exercise
monopoly power. Accordingly, I
conclude that operating systems for Intel-compatible
personal computers comprise a relevant
product market.
41. I should add
that, even if the market were defined more broadly to include
operating system products for all personal computers
such as those offered by Apple and some
vendors of UNIX based operating systems that do not use
an Intel-compatible microprocessor
my conclusion that Microsoft possesses monopoly power
in a relevant market would still stand.
B Microsoft
Possesses Monopoly Power in the PC Operating System Market
42. Once the
market is properly defined, the next step is to determine whether
Microsoft possesses monopoly power within it. Monopoly
power is the ability of a firm
profitably to raise market price above the competitive
level for an extended period of time or to
exclude competition.
43. There are
four reasons why I believe that Microsoft possesses monopoly power
in the PC operating systems market. First, Microsoft's
share of this market has been at a very
high level since at least the early 1990s and is expected
to remain high. Second, barriers to
effective entry into the PC operating system market are
high, and other PC operating systems
cannot easily increase their shares of that market
because the huge stock of applications written
for Windows 95/98 will not run on those systems. Third,
Microsoft has engaged in conduct that
would not be effective or profitable if it did not have
monopoly power. Fourth, the pattern of
OS prices, Microsoft's margins, and the market value of
Microsoft equity are themselves
consistent with Microsoft possessing monopoly power.
Page 20.
1. Microsoft has an Overwhelming
Share of the PC Operating System
Market
44. The first step
in determining whether a firm has monopoly power is usually to
determine the level and stability of its share of the
relevant market. According to Microsoft's
figures, 80.8% out of the estimated 209.2 million PCs
shipped worldwide since July of 1995
include a Microsoft operating system.22 During this period,
naked PCs, e.g., PCs shipped
without any operating system at all, accounted for 31.5
million units, or 15% of the total PCs
shipped. In other words, of the PCs shipped with an
operating system, Microsoft's share was
95.1%.23
45. This high
market share has been remarkably stable. As shown in Pl. Ex. 1,
Microsoft's share of PCs shipped with an operating
system has been above 90% since at least
the early 1990s and this dominance is forecast through at
least 2001.
2. Barriers to Entering the PC
Operating System Market are High
46. Microsoft's
high market share has been protected by high -- indeed formidable --
barriers both to the entry of new PC operating systems
and to the ability of rival PC operating
systems to acquire market share, even in response to
prices above competitive levels. First, as I
will explain, PC operating systems are characterized by
scale economies and sunk costs that
make the cost of entry high. Second, switching operating
systems would impose significant
costs on users; this tends to "lock" users into Microsoft
operating systems. Third, operating
systems exhibit network effects, a consequence of which
is greatly to increase the costs of, and
Page 21.
reduce the probability of, a successful challenge to
Microsoft's market dominance.
47. First,
operating systems in particular, and software in general, are characterized
by economies of scale. The bulk of the costs are
development costs -- the costs that must be
expended to create the software, irrespective of how
many copies ultimately are sold. These
costs include, for example, writing, testing and debugging
program code. The cost of producing
and marketing individual copies of the product ("the
marginal costs") are, by comparison, quite
small.
48. The costs of
developing an operating system to compete with Microsoft's
Windows operating system would be immense.24 For instance, IBM,
a company that is very
experienced in developing competitive software, was
reported to have spent a staggering
amount on the OS/2 project through 1996.25 Moreover, these
cost are what in economic terms
are called "sunk" because only a small portion of either
initial fixed development costs and any
subsequent negative cash flow could be recovered if the
entrant were to exit the market.
Moreover, competition between two suppliers, each with
very high fixed costs and very low
marginal costs, would likely result in a decrease in prices,
further reducing the profitability of
entry to the would-be entrant. Entry into head-to-head
operating system competition with
Microsoft thus would be time consuming, risky, and costly;
profiting from such entry would be
at best very uncertain and long in coming.
49. A second
barrier both to entry and to expansion by an existing competitor is that
users tend to become "locked in" to a particular operating
systems. As discussed above, users
Page 22
are reluctant to switch from Windows to another operating
system, even another PC operating
system, because to do so requires them to replace
application software, to convert files, and to
learn how to operate the new software. Often, switching
operating systems also means
replacing or modifying hardware. Businesses can face
even greater switching costs, as they
must integrate PCs using the new operating systems and
application software within their PC
networks and train their employees to use the new
software. Accordingly, both personal and
corporate consumers are extremely reluctant to change
PC operating systems. The software
"lock-in" phenomenon creates a barrier to entry for new
PC operating systems to the extent that
consumers' estimate of the switching costs is large
relative to the perceived incremental value of
the new operating system.
50. Additional
switching costs arise from the fact that, for most users, operating
systems are only a means to an end it is the application
software that was designed to work
with the operating system that users want.26 Once they have
purchased an operating system,
users are naturally reluctant to consider a different
operating system. Unless their current
operating system product prevents them from using new
applications or hardware, they are
likely to continue to use that operating system; for
operating systems, unlike other goods, do not
wear out.
51. A third entry
barrier is created by the well-understood fact that operating systems
are characterized by "network effects." Network effects
occur when the value of an item to a
Page 23
user increases as the total number of users increases.
Examples of products subject to network
effects include fax machines and both local and long
distance telephone networks. A fax
machine is not particularly valuable until a large number
of other people have fax machines that
use the same standards and protocols. Similarly, the
more users within a given region that a
local phone network serves, the more valuable that
network is to each user.
52. Operating
systems are subject to network effects because, among other things,
the value of an operating system product is largely
dependent on the number of applications
available for it. Today, applications written for one
vendor's operating system product generally
will not work on another vendor's operating system.
Thus, to write an application for more than
one operating system, a software developer generally
must incur additional development costs,
and doing so could also divert scarce resources from the
task of enhancing the application for
use with the first operating system. As a consequence,
ISVs are often reluctant to "port" (or
convert) their software from one operating system to other
operating systems.
53. As an
operating system gains popularity, the incentive to develop software for
that operating system increases because the larger
number of users for the operating system
product implies a greater potential market for software
developers. The development of yet
more applications for that operating system, in turn,
increases the value of the operating system
to end users who, as explained, purchase operating
systems in significant part based upon the
quality and variety of applications available for it.27 As
Hewlett-Packard's Frank Santos
explained, demand for an operating system is driven by
the availability of "applications that run
Page 24
on the operating system."28 The operating
system's market share, therefore, is likely to increase,
and that, in turn, is likely to cause software developers to
devote yet more resources to writing
applications for that operating system product.
54. This
phenomenon known in economics as "positive feedback" creates what is
best termed the "applications barrier to entry." Simply
put, an operating system product can rise
to dominate the market, and once that dominance is
achieved maintain it, because of both the
large number of complementary software applications
available for it and the flow of new
applications that are written to it. This too is
well-recognized by Microsoft. As observed by Dr.
Nathan Myhrvold, chief technology officer of Microsoft,
"the laws of positive feedback govern
any system where compatibility with other users is either
directly or indirectly a key factor in the
utility of a product or service," and these laws "ha[ve]
been responsible for the phenomenal
strength of leading software products in both applications
and operating systems [products]."29
Microsoft has further stated: "The availability of a rich
variety of quality applications software
that will run on a particular operating system [product] is
fundamental to its success. This fact
has been recognized by publishers of operating systems
[products] for years."30 This was
reiterated by Microsoft's Brad Chase, who explained:
"speaking very generally, a developer's
interested in building applications when there's a lot of
users who could run those applications
on the platform."31
Page 25
55. The
applications barrier to entry is supplemented by other barriers to entry that
derive from network effects. Books, publications, training,
user groups, and news groups for the
incumbent operating system product provide a large
sense of community for its users. Users can
exchange files, and perhaps more readily use their
computers to communicate, with other
members of the group. Finally, when the incumbent
operating system is installed at work, it
leads users to select the same operating system product
for use at home.
56. It is clear that
the applications barrier to entry sustains Microsoft's dominance,
critically contributes to its monopoly power, and helps
explains why other Intel-compatible
operating systems, such as OS/2 and Linux, have
persistently small market shares. As I
previously explained, because of economies to scale, the
marginal costs of producing additional
copies of these operating systems is very low. Thus, one
might expect that, if Microsoft
attempted to exercise monopoly power, vendors of these
operating systems would flood the
market with their product and constrain Microsoft's
behavior. This, however, has not occurred.
No rival has succeeded in mounting a sustained effective
threat to Microsoft's market
dominance.
57. One reason
for the lack of success is that alternative operating systems lack the
installed base of applications that Microsoft's PC
operating system products enjoy. To offer a
product that a significant number of consumers wish to
have installed on their PCs, vendors of
these operating systems would have to create, or induce
others to create, an extensive set of
compatible software applications. This would be not
merely expensive, but also very risky
because it would involve significant sunk costs, as
explained above.
58. The failed
attempt of IBM to enter the PC operating system market with its OS/2
operating system illustrates the strength of the
applications barrier to entry and confirms that
Page 26
Microsoft's dominant share of the operating system market
is indicative of monopoly power.
IBM's OS/2 operating system, first released in 1987, was
designed to replace Microsoft's DOS
and DOS with Windows. In 1994 and 1995, IBM, which
also competes as an OEM, installed
OS/2 on its own Aptiva line of computers. Retailers, and
consumers, however, routinely
demanded application software that was not available for
OS/2.32
Applications written for
Windows 3.x could also run on OS/2, but not the
increasing number of applications written for
Windows 95. In response, IBM abandoned its practice of
installing OS/2 on the Aptiva
computer, choosing instead to license Windows from
Microsoft. As Mr. Kozel of IBM
explained, "the market . . . moved to the Windows 95
platform," so IBM "ship[ped] a hundred
percent of [its] Aptiva products with Windows 95."33
59. Microsoft
itself recognizes that the failure of a new entrant, such as OS/2, to
attract customers is attributable to the "applications
barrier to entry." As Joachim Kempin,
Microsoft's Senior Vice President for OEM Sales,
explained in discussing what might "derail"
Microsoft's pricing strategy in January 1997:
Our high prices could get a single OEM
(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 it 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. No bundling of
OS on low end systems would be the
easiest way to hurt us but who would
want to start with this and loose [sic] business.34
Page 27
3. Microsoft's Monopoly Power is
Evidenced by its Use
60. Microsoft has
engaged in conduct that it could not profitably pursue unless
it possessed monopoly power. For instance, when one
OEM removed the IE icon from the
Windows 95 desktop, Microsoft responded by threatening
to terminate that OEMs'
Windows 95 license. The OEM capitulated to Microsoft's
demands.35
It is plain it did so
because, as OEMs universally explain, a Windows license
is essential to remaining
competitive in the OEM market.36 This capitulation is
itself evidence of Microsoft's
monopoly power.
4. Margins, and in the Market
Value of Its Equity
61. Although
accurate historical data on Microsoft's operating system product
license fees are not readily available, it is my
understanding that since at least 1987 the
operating system has accounted for a steadily increasing
share of the cost of a PC. An
internal Microsoft document acknowledges that it has
increased its operating system product
"prices over the last ten years [while] other components'
prices [for PC computers] have
come down and continue to come down. This is
particularly true of CPU prices."37
Page 28.
62. Microsoft's
monopoly power in operating systems has translated into
extraordinarily high net profit margins that have been
increasing over time.38 Even more
telling is Microsoft's extraordinarily high market
capitalization. With a price/earnings ratio
more than double the S&P 500 average, the financial
markets are signaling very optimistic
investor expectations regarding Microsoft's future growth
in earnings.
63. My analysis
thus far has shown that Microsoft possesses monopoly power
in the desktop operating system market. Although the
barriers to entry and to the growth
of other PC operating systems that protect Microsoft's
monopoly power are formidable, they
are not impenetrable. There is no reason to believe that
the market, if left to function
properly, will not in time generate alternatives to
Microsoft's operating system that will be
sufficiently superior to overcome the entry barrier
advantage that Microsoft enjoys.
64. Microsoft,
however, has interfered with these market forces. As I explain
below, Microsoft has engaged in a course of conduct with
the apparent purpose, and
evident effect, of reinforcing its monopoly power in the PC
operating system market.
V. INTERNET WEB BROWSERS POSE A
THREAT TO MICROSOFT'S PC
OPERATING SYSTEM MONOPOLY
65. Given the
natural barriers to entry described above, a competitive threat to
Microsoft's operating system monopoly is less likely to
come from other operating system
products than from extensions to complements of
Windows that also can serve as platforms
Page 29.
to which ISVs write applications programs. Although a PC
operating system cannot
successfully compete against Microsoft's operating
systems without first overcoming
formidable barriers to entry, the situation is different for a
product (e.g., browsers or Java
technology) that is both initially a complement from an
end user perspective and a potential
substitute for the Windows 95/98 platform to which
applications developers can write.
Because applications written to such a complement are
compatible with Windows, their
developers can sell their applications to users of the
Windows operating system.
Eventually, a sufficient number of such applications may
become available to support an
alternative platform to Windows. This alternative platform
can then be combined with other
operating systems to offer a complete and viable
substitute for Windows.
66. To be sure, if
the technology is to realize its full potential as a substitute for
Windows, it would eventually need to become an
attractive platform for many applications.
However, because such a technology can gain wide
marketplace acceptance based on its
value as a complement to Windows, the hurdle of
attracting application developers is
substantially reduced. The wide dissemination of the
complement among PC end users
means that application developers can reach a broader
base of potential customers by
writing to it than by writing to an operating system that
competes directly with Windows
95/98 and starts with very low market penetration and
installed base.
67. As more applications are written that work with the new platform, it
will
become more attractive to users and ISVs as a substitute
for Windows. Ultimately, the
choice between the Windows platform and the alternative
platform may be made by users
on the basis of the price and other characteristics of those
platforms, rather than on the
availability of compatible applications.
Page 30
68. Internet
browsers are complements that pose precisely this sort of threat to
Microsoft's operating system monopoly. A browser is
software that enables computer users
to navigate and view content on the World Wide Web.39 Today the
typical browser product
includes additional related software such as an e-mail
program, a web-authoring tool and
a news group reader. Browser products support
sophisticated security/encryption and may
include the ability to run Java programs.40 Competition has
resulted in the porting of the
most popular browsers to a variety of desktop
platforms.41
Competition among browsers
for PCs, principally between Microsoft's Internet Explorer
and Netscape's Navigator and
Communicator products,42 has benefitted
consumers significantly.43
69. Internet
browsers may serve as an alternative software development platform
by exposing APIs that other software developers may use
to perform particular functions.
Page 31
An API is essentially a method pre-defined by one
software developer that enables other
software developers to access functions provided by the
original software developer's
product. A platform for the development of software is a
sufficiently rich set of APIs that
ISVs can use them to supply applications. Some
browsers expose APIs that enable ISVs
to create "plug-ins" that expand the capability of the
browser, independently access the
functions of the browser itself, and, through the Java
Virtual Machine that comes with the
browser, provide other useful applications such as word
processors and spreadsheets.44
A. Browsers
and Operating Systems Comprise Separate Products
70. An issue
of central concern in this case is whether IE is a "separate product"
from the Windows 95 and 98 operating systems.
Microsoft contends that IE is an integrated
feature or "technology" of Windows 95/98 that cannot be
"removed" without significantly
degrading the performance or value of Windows 98.
Therefore, according to Microsoft, IE
and the Windows 95/98 operating system are a single
integrated product.
71. The appropriate economic definition of a separate product is an item
for
which there is sufficient demand such that it is efficient to
offer that item separately from
other items. This test is a "demand based" or "market"
test. Thus, for example, the
Windows operating system and IE are separate products
if there is sufficient demand for one
without the other such that competing firms (including
possibly Microsoft itself) could
profitably supply a product consisting of the Windows
operating system but, from the user's
perspective, without IE. The "market" test is an
appropriate separate product test because
it ascertains what product configurations would be
supplied in a market where no firm could
Page 32.
exercise monopoly power.45
72. Applying
the market test when firms producing the items in question lack
monopoly power is straightforward. In the absence of
monopoly power, the product
configurations marketed by firms can be assumed to be
efficient and comport with
consumer demand.
73. When,
however, a firm has monopoly power over one product, that firm may
have an anticompetitive motive to tie the monopolized
product to a complementary product.
One circumstance under which anticompetitive tying is especially likely
to occur is when
the complementary product is also a "partial substitute" for
the monopolized product.46
74. When a
firm possessing monopoly power in a product employs it to force
customers to take another product, it prevents the market
from determining whether the
components of the combined package in this case,
Windows 95/98 and IE are one
product or two. It then becomes necessary to look to
other evidence to determine whether
the components are one product or two. That evidence
would include both evidence of user
demand for one without the other and of the cost of
providing them separately.
75. As the
following discussion explains, the available evidence strongly supports
the conclusion that IE and the Windows 95/98 operating
systems are separate products. IE,
like other browsers, has been, and continues to be,
offered as a separate product, and users
regularly acquire IE and other browsers as separate
products. The evidence also shows that
there is substantial demand for Windows 95 and Windows
98 without IE and that it would
Page 33
inexpensive for Microsoft to provide Windows 95 and
Windows 98 in a way that would
satisfy this consumer demand.
1. be Provided
Separately
76. Internet
browsers are currently provided separately from operating systems.
Netscape Navigator for several different operating system
products is offered as a stand-
alone product through the retail channel, through the
download channel, and supplied with
access services by some ISPs. Similarly, Opera, which
has limited presence in some
distribution channels, is distributed independently of an
operating system product. Mosaic,
the first browser with a graphical user interface ("GUI") is
still available as a stand alone
product. Indeed, there are a large number of lesser
known browsers still distributed
independently from any operating system.
77. Similarly, Microsoft has provided Internet Explorer separately from
its
Windows operating system in the past and continues to
do so to this day. Moreover, as
Microsoft executives have explained, the company's
decision to produce an "unintegrated"
version of Internet Explorer for non-Microsoft operating
systems, including a version of
Internet Explorer for the Apple Macintosh and Sun Solaris
operating systems, indicates that
there is a demand for Internet Explorer separate from
those operating systems and that it is
efficient to provide the browser separately in order to
meet that demand. For instance,
Microsoft Vice President Brad Chase testified:
Q. Going back
to IE4. Why did Microsoft develop a version of IE4 for those
other operating systems --
the Mac, Solaris, Win 3.1?
A. We developed business for other
operating systems because customers
requested it and for some
customers they didn't want to roll out Internet
Page 34.
Explorer unless they had
cross-platform versions and because for certain of
the -- and because that also
impacts developers.47
78. Microsoft tracks the market usage share of its browser separately
from
Windows. As Brad Silverberg, then-Senior Vice-President
of Microsoft's Applications and
Internet Group testified:
Q. Within Microsoft, after Windows 95
was released, did the company track the
share of usage of IE?
A. Yes, it did.
Q. And it tracked that separately from
usage of Windows?
A. Yes, it did.
Q. Why? Why did you track share of
IE?
A. See how -- compare IE share with
competitive products, competitive technologies.
Q. And what competitive technologies
were you comparing IE usage to?
A. Navigator, Cyberdog, others.48
79. Consistent with Microsoft's marketing of Internet Explorer to meet a
demand
separate from that for an operating system, many OS
vendors that do not view the browser
as a threat and that distribute a browser application with
their OS view the browser as a
separate product.49 At one time Apple distributed Netscape Navigator
as its default
Page 35
browsers for the Mac OS, and Apple currently distributes
IE as its default browser.50 In
either case, the browsers were identified as separate
products with their own brand names.
Most UNIX vendors have also distributed browsers with
their operating system products.51
These browsers are always identified as separate
products with separate brand names. Most
important, OEMs that license operating systems from
these vendors are not required to
pre-install browsers on their desktop computers,
indicating that operating systems and
browsers are separate products.52
80. There is also evidence of separate demand for operating systems
generally,
and for Windows 95 and Windows 98 in particular. First,
many corporate users purchase
only an operating system and do not want a browser at
all. For instance, Joseph J. Kanicki,
Jr., Strategic Commodity Manager, Dell Computer
Corporation, stated in a recent
declaration:
Some business and government customers prefer not to have
Internet
Explorer preinstalled on their computer because: (1) the
customer
may have its own software or software standards which do not
include
the latest version of Internet Explorer, (2) the customer may
wish to
install a competitive browser instead of Internet Explorer, or (3)
the
customer may wish to prevent its employees from accessing or
attempting
to access the Internet or the World-Wide Web.53
81. Mal Ransom of Packard Bell expressed
the same point in a recent deposition.
Mr. Ransom stated: "In the
commercial end of the business depending upon what part . . .
Page 36
you're selling to, on some
days all they want is the operating system. They don't want other
things. They don't want any
access to the Internet because companies don't want their
employees potentially being
able to get on the Internet or play games."54
82. Second, whether in response to
perceived corporate demand or for other
reasons, several OEMs
requested that Microsoft permit them to remove an end-user's visible
means of accessing IE
from both Window 95 and Windows 98.55
83. Microsoft responded to this corporate
demand for operating systems without
IE by designing Windows 95
so that Internet Explorer could be "uninstalled" using the
Add/Remove programs utility
that comes with the Windows 95 operating system. This
utility removes the ability of
end users to use Internet Explorer to browse the web (web
browsing functionality) and,
thus, from an economic perspective, unties the browser from
the operating system.
Confirming that the "uninstall" capability for Internet Explorer was
created in response to
consumer demand for a browserless operating system product, David
Cole, the Microsoft Vice
President responsible for overseeing the development of Internet
Explorer, testified that the
capability was added in response to "feedback from corporate
customers that wanted to
prevent access to the Internet, so that when they . . . buy a new
machine from a PC
manufacturer they want the ability to remove easy access to the Internet
so their employees, you
know, aren't spending their time out on the Web doing whatever."56
Page 37
84. Microsoft's creation of the "uninstall" utility
that, from an economic
perspective, removes IE,
shows that it was efficient for Microsoft to meet the demand for an
operating system without a
browser in the case of Windows 95. Indeed, having designed the
utility, it would have been
virtually costless for Microsoft to permit OEMs, in effect, to use
the utility to remove IE.
85. It is my understanding that Windows 98
does not contain the same ability as
Windows 95 to "uninstall"
Internet Explorer. Nonetheless, I understand that Professor Felten
has shown that it is easy to
remove from Windows 98 the ability to browse the Web using
Internet Explorer and to
substitute a different browser in its place.57 It would thus be
efficient for Microsoft to
provide, or to permit OEMs to provide, the operating system
without the ready means of
invoking IE.
2.
Internet Explorer and Windows 95/98 are Separate Products
86. Because the evidence shows that there is
separate demand for IE and the
Windows 95 and Windows 98
operating systems (e.g., demand for each without the other)
and because the evidence
shows that it would be inexpensive for Microsoft to provide both
those products separately, I
conclude that it would be efficient for Microsoft to meet that
separate demand. In a
competitive market, therefore, I would expect that OEMs would have
the option of licensing or
distributing Windows 95 and Windows 98 without the visible
means of access for IE, just
as OEMs have that option from PC operating system vendors
Page 38.
that do not have monopoly
power.58 I
therefore conclude that IE and Windows 95/98 are
separate products.
B. Operating
System Monopoly
87. As I explained above, Internet browsers
produced by firms other than
Microsoft, by themselves and
in combination with the Java technologies they distribute, pose
a threat to Microsoft's
operating system. Microsoft internal documents show that the firm
understood this threat. As
noted above, Bill Gates wrote in May 1995 that "[Netscape is]
pursuing a multi-platform
strategy where [it] move[s] the key API into the client [browser]
to commoditize the
underlying operating system."59 Similarly, Microsoft Vice President
Brad Chase warned
that competing Internet browsers could eventually "obsolete
Windows,"60 and Group Vice
President Paul Maritz worried that Netscape's browser might
make Windows
"replaceable."61 As Brad Silverberg, another Microsoft
Executive,
succinctly put it: "the
Internet Battle" is "not about browsers. Our competitors are trying to
create an alternative
platform to Windows."62 More recently, Microsoft's James
Allchin
explained that, in his
view, "[t]he goal, the stated goal of Netscape was" among other things
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"to create a new set of
APIs that developers would write to."63 When asked how Netscape
could threaten
Windows, Mr. Allchin stated: "You get developers to write the APIs, you
cover up Windows,
you've just got this layer running on top, and if the size [and]
performance was
acceptable, it becomes irrelevant. Windows becomes irrelevant."64
88. Because competing browsers, such
as Netscape Navigator, pose a threat to
Microsoft's operating
system monopoly, Microsoft protects the profits it earns in the OS
market by dominating
the browser market. By reducing the market share of competing
browsers to low levels,
Microsoft could significantly diminish the possibility that
applications
developers will write to those browsers' APIs. Microsoft's browser dominance
also would impede the
distribution of a cross-platform Java technologies. Microsoft,
therefore, has a
significant incentive to gain a large share of the browser market in order to
protect its desktop
operating system monopoly.
89. Browsers, like operating systems,
exhibit not only economies of scale, but also
network effects.
Websites can be written to standards that favor one browser over another.
For instance, websites
can use technologies that are accessible only by a particular browser
or work better with that
browser. If Microsoft were to gain a dominant share of the browser
market, it might
succeed in inducing website developers to write their content using
Microsoft-specific
technologies. If a large number of websites are written to such a
technology, more end
users would switch to IE, which in turn would increase the incentives
of website developers
to embrace Microsoft-specific technology. The consequence of this
instance of "positive
feedback" is that the browser market could tip to a Microsoft
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monopoly, in which the
installed base of Microsoft specific web sites, along with switching
costs, create barriers
to entry. Microsoft, of course, would benefit from such a monopoly
because it would mark
the death knell of the threat posed by non-Microsoft browsers to its
operating system
monopoly.
VI. MICROSOFT'S EXCLUSIONARY
CONDUCT
90. The
analysis thus far established has led me to two conclusions: First, that
Microsoft possesses
monopoly power in the market for PC operating systems and, second,
that Internet browsers
marketed by firms other than Microsoft pose a threat to Microsoft's
monopoly and that
hindering the success of rival browsers would thus serve to protect and
extend that monopoly.
I now turn to an examination of Microsoft's practices with respect
to browsers. For ease
of exposition, I will examine each component of Microsoft's conduct
separately. However,
the economic significance of any particular conduct cannot be
understood unless set
in its proper context. Accordingly, I consider the effect of particular
practices in light of
Microsoft's other conduct and its dominance in the PC operating system
market. My principal
conclusion is that Microsoft's practices, taken as a whole, are
anticompetitive and are
likely to facilitate monopolization in the browser market and the
preservation of
Microsoft's monopoly in the PC operating system market.
A. Microsoft's Tying is
Exclusionary
91. Microsoft has engaged in a number of
practices with respect to the
distribution of its Windows operating system to OEMs
that, taken together, have the effect
of excluding competing Internet browsers. First, although
Microsoft did not bundle IE with
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the initial retail version of Windows 95, it subsequently
bundled Internet Explorer with its
Windows operating system for licensing to OEMs. By
bundling, I mean that Microsoft
provides the browser with the operating system in a single
"package" at no additional cost.
Second, Microsoft has tied the Internet Explorer browser
to the operating system in both
Windows 95 and Windows 98. By tying, I mean that
Microsoft requires OEMs to install
IE on, and prohibits them from removing IE or access to
IE from, the PCs they sell. The
combined effect of these practices is exclusionary. They
ensure that OEMs will pre-install
rival browsers on fewer machines.
92. It is true that Microsoft does not
contractually prohibit OEMs from
pre-installing a competing browser, or even pre-installing
a competing browser as the
default browser. But Microsoft's tying of IE to the
Windows 95 and Windows 98 operating
systems has made it more costly and burdensome for
OEMs to install other browsers and
has thus significantly, although not completely, deterred
OEMs from doing so.
93. Pre-installing a second browser imposes
significant costs on OEMs and
yields them few benefits when the second browser is not
perceived to be of significantly
higher quality. Even if the OEM is not required to pay a
license fee in order to install a
second browser, the costs of including a second browser
along with IE may be significant.
They include increases in support costs that result from
customer confusion and increased
testing costs.65
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94. In particular, OEMs report that customers
become confused by the presence
of two or more applications that perform similar functions
and by desktop screens populated
with multiple icons.66 Because Microsoft
requires OEMs to bear all support costs
associated with the PCs they sell, OEMs have a keen
interest in reducing customer
confusion, which can lead to increased support costs.
For this reason, OEMs pre-install
only a limited number of software programs with the PCs
they ship and do not cover the
desktop screen with icons.67 Microsoft also
recognizes that multiple products performing
similar functions may cause consumer confusion. For
instance, Microsoft's OEM account
manager for Gateway, Gail McClain, explained in a recent
deposition that "redundan[t]
icons on the desktop" may "be confusing to end users."68
95. Thus, Jim Von Holle of Gateway
testified that Gateway sought permission
to remove the IE icon from Windows 98 because it
sought to lessen support costs that would
result from also installing Navigator.69 Von Holle
explained that "general usability studies
. . . indicate that the less cluttered the desktop . . . the
less confusing it is for the customer to use
the product."70
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96. The value to an OEM from adding a
product, such as Netscape Navigator,
that performs the same functions as Internet Explorer is
small compared to the increased
costs imposed on OEMs and the resulting customer
confusion. If OEMs were permitted
either not to install IE or to remove the visible means of
access to it, their costs of including
a rival browser would be lower, and the benefits to
consumers from having such a browser
would be greater.
97. Microsoft executives both in depositions
and in its documents confirm that
the requirement that OEMs install IE, combined with the
contractual prohibition on OEMs'
removing any part of that browser, can significantly deter
OEMs from installing competing
browsers. Microsoft's Senior Vice President of OEM
Sales, Joachim Kempin, has testified:
Q. ....[D]oes Microsoft sometimes
essentially make this argument to [OEMs]; Why
do you need to incur the extra testing
costs and the extra user education and maybe
undergo the longer loading time --
A. I believe we have.
Q. Is that sometimes successful in
persuading OEMs that they don't really need to
distribute another browser because they
already have Internet Explorer?
A. That is sometimes successful.71
98. The foreclosure of the Netscape browser
as a result of Microsoft's tying of
its browser to its Windows operating system is significant.
The OEM channel is one of the
two principal channels through which users obtain
browsers.72
Moreover, because of
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reluctance to install new software themselves, many less
sophisticated PC users simply use
whatever browser comes pre-installed on their machines.
For example, one marketing study
explains that the response "`[i]t came with my computer'
is the #1 reason people switch to
Internet Explorer" and concludes that "OEMs are the best
vehicle to gain browser share."73
99. Contemporaneous Microsoft internal
documents confirm this analysis. They
show that Microsoft believed that its forced licensing of
Internet Explorer to OEMs would
serve to deny rivals access to the OEM channel and, by
doing so, increase Internet
Explorer's market share at the expense of other browsers.
For instance, Microsoft's Jim
Allchin wrote in January 1997: "I do not feel we are going
to win on our current path. We
are not leveraging Windows from a marketing perspective
. . . . We do not use our strength
-- which is that we have an installed base of Windows and
we have a strong OEM shipment
channel for Windows . . . . I am convinced we have to
use Windows -- this is the one thing
[Netscape] do[es]n't have."74 Christian Wildfeuer
echoed this a month later. She wrote:
"It seems clear that it will be very hard to increase
browser market share on the merits of
IE 4 alone. It will be more important to leverage the OS
asset to make people use IE instead
of Navigator."75
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B. Microsoft's OLS and ISP
Restrictions are Exclusionary
100. The second set of restrictions I examined were Microsoft's
agreements with
Internet Service Providers, which are firms that provide
PC users with access to the Internet.
Some important ISPs, such as America Online (AOL) also provide
proprietary content to
users: these ISPs are known as Online Service Providers.
Along with OEMs, OLSs and
ISPs comprise the two most significant channels through
which users obtain browsers.76
As with Microsoft's restrictive OEM agreements, the
terms of its contracts with ISPs
exclude competing browsers and significantly
impede competition on the merits among
competing browsers.
1. Microsoft's
OLS Agreements are Exclusionary
101. As I will explain in detail in connection with Microsoft's screen
restrictions,
the Windows 95/98 desktop and boot-up sequence
provide an attractive advertising vehicle
for OLSs. Placement on Windows screens is
valuable to OLSs because, among other
reasons, it ensures that the OLS reaches many
potential new subscribers at the precise time
when those new subscribers must open an account
to secure access to the Internet. As
Kevin Knott, an executive of CompuServe, Inc.,
testified, placement in the Online Services
Folder was important to CompuServe because
"Windows 95 reaches such a large number
of people and is on such a large percentage of new
computers, it represents a very large
distribution opportunity for us . . . . No other single
hardware [or] software company can
give it that level of distribution . . . . There are other
ways to try to do that, but it would
require separate deals and probably at much
greater expense to try to match what we could
achieve through Windows 95.77
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102. Microsoft used this asset to induce OLSs to enter into agreements
that
restricted the distribution and promotion of competing
browsers. It did so by creating for
the Windows 95 desktop the "Online Service Folder," in
which it featured participating
OLSs, and placed icons for them in the Windows "Start"
menu. Because of screen
restrictions, which I describe below, OEMs could not
remove these items or advertise other
OLSs in a more prominent way. Microsoft, the evidence
shows, was aware of the value
that OLSs attached to favorable desktop placement, and
sought to exchange this valuable
asset for exclusionary restrictions. For example, Brad
Silverberg, former head of
Microsoft's Internet Group, told AT&T during
negotiations:
You want to be part of
the Windows box [desktop], you're going to have to
do something very
special for us. There are very, very few people we allow
to be in the Windows
box. If you want that preferential treatment from us,
which is extraordinary
treatment, we're going to want something very
extraordinary from you.78
103. In exchange for favorable desktop
placement, the OLSs typically agreed to
the following:
(a) To promote and distribute Internet Explorer as the "exclusive"
or primary browser;
(b) not to
distribute a non-Microsoft browser unless specifically
requested by the customer or "express or
imply" that a
competing browser is available;
(c) not to ship non-Microsoft browsers more than 15% of the time,
even upon customer request for
alternative browsers; and
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(d) to restrict
the ability of users to employ or download
non-Microsoft browsers.79
104. These agreements explicitly
(although not completely) exclude competing
browsers from an important channel for acquiring
new users and maintaining existing users.
And, as I will explain below, this exclusion matters. A substantial
number of users obtain their browser through OLSs
such as America Online (AOL). Indeed, recognizing the
importance of their agreements with OLSs to
maintaining IE's overall market share,
Microsoft has not relaxed those restrictions in
Windows 98.
105. It is ordinarily not anticompetitive for
a firm, such as Microsoft, that has
created a valuable asset, like desktop real estate,
to charge customers for the use of that
asset. My concern with Microsoft's conduct is not
that it has extracted compensation for
Windows desktop real estate. Rather, my concern
involves the form or nature of the
payment Microsoft has extracted; namely,
agreements that raise the distribution cost of
competing browsers and tend to exclude those
browsers from the market.
2. Microsoft's
Restrictions on Other ISPs are Exclusionary
106. In addition to creating the Online Service
Folder in Windows 95, Microsoft
developed a feature called the "Internet Connection
Wizard" (ICW). In Windows 95, the
ICW was prominently displayed on the Windows 95
desktop and OEMs were not permitted
to remove it. If selected by a user, the ICW would display
a list of ISPs generated by the
Microsoft Internet Referral Server. As with the Online
Service folder, ISPs viewed the ICW
as an attractive way of promoting their service and
acquiring new subscribers. As discussed
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below, Microsoft took advantage of the screen restrictions
on OEMs to capture the full
value for itself of being the first to recommend ISPs to
new users.
107. As with the Online Service Folder,
Microsoft exchanged this desktop
placement in the ICW for exclusionary agreements.
Indeed, Microsoft's Cameron
Myhrvold testified that Microsoft created the Internet
Connection Wizard in part to induce
ISPs to grant preferences for Microsoft's browser.80 In order to
secure placement in the
ICW, ISPs agreed to restrictions similar to those Microsoft
imposed on OLSs. The ISPs
typically agreed to:
(a)make Internet Explorer the default or preferred browser;
(b)ship a rival browser no more than 15% of
the time;
(c)not express or imply that a competing browser is available;
(d)limit the ways in which a user could link to
a site promoting, or
download, a competing browser; and
(e) in exchange for discounts,
employ technologies that made the service
function better with Internet Explorer than with rival browsers.81
108. The economic effects of the first four
restrictions are essentially the same as
the restrictions imposed on
OLSs. The provision regarding use of Microsoft-specific
technologies, however,
requires separate discussion. The effect of this provision is to reward
ISPs that configure their
services in a way that reduces the cross-platform threat to
Microsoft's operating system
monopoly. The reason is that ISP use of Microsoft-specific
technologies reinforces the
dominance of the Windows platform. For instance, one of the
Microsoft-specific
technologies is known as "ActiveX." As I understand it, ActiveX is "a
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set of technologies . . . built
on Microsoft's Component Object Model (COM) . . . that
enables software
components to interact with one another in a networked environment,
regardless of the language in
which the components were created."82 ActiveX controls are
"reusable software
components that incorporate ActiveX technology [and] can be used to add
specialized functions . . . to
Web pages, desktop applications, and software development
tools."83 The crucial feature
of ActiveX for my purposes is that it is operating system
(typically Windows) specific.
Use of such technologies by ISPs serves to blunt the
cross-platform threat that, as
explained above, rival browsers might pose.
109. I understand that, faced with the threat of
this litigation, Microsoft last Spring
relaxed its ISP restrictions on certain ISPs, but not the most important
ones -- OLSs'. The
only remaining requirement is
that ISPs promote Internet Explorer on a par with
non-Microsoft browsers. For
two reasons, however, the ISP restrictions nevertheless are
important to my analysis.
First, the remaining restriction is itself exclusionary. Some ISPs
will choose to promote or
support only a single browser at any given time in order to reduce
its costs.84 For such ISPs, a
requirement of "parity" for Internet Explorer in order to secure
access to the ICW may
amount to a defacto requirement that the ISP exclusively support
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Internet Explorer. Second,
and perhaps more important, Microsoft's ISP restrictions had
significant anticompetitive
effects while they were in place, and if Microsoft's statements
that some ISPs will support
only one browser are accurate, those effects cannot be reversed
simply by removing the
restrictions. Third, absent intervention, Microsoft would be free to
reimpose all the ISP
restrictions.
110. In addition to entering agreements with
ISPs that involved the Internet
Connection Wizard, Microsoft
by late 1996 had entered into more than 2,500 "IE preferred"
licenses.85 For fifteen of the
top seventy-five providers, these agreements required that a
certain percentage of
browsers shipped be Internet Explorer.86 Moreover, more that fifty of
the top seventy-five providers
had agreed to make Internet Explorer the "preferred" or
"default" browser.87 As with Microsoft's
other agreements with OLSs and ISPs, these
agreements serve to bias
browser distribution toward Internet Explorer in ways that may not
reflect consumer demand
and impaired distribution of other browsers.
111. Testimony of ISP executives confirms that
the restraints at issue restricted
their ability to distribute
competing browsers that users might prefer. Kevin Knott of
CompuServe testified that
CompuServe agreed to the restrictions even though "we prefer to
have flexibility in software
that we use."88 Stephen von Rump of MCI testified that
"there
are certainly users out there
that prefer browsers and e-mail clients that are not Microsoft.
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And our ability to reach them
and entice them to sign up for our service is presumably
enhanced by the ability to
promote and distribute those."89 As discussed above, ISPs have
costs that may induce them
to support only one browser, and some may choose to do so; but
the choice of which browser
to support is one that ISPs try to retain. It is in their interest to
respond to consumer
preferences in determining which browser to ship at any point in time.
112. Indeed, internal Microsoft documents
confirm that ISPs, reflecting consumer
demand for competing
browsers, resisted agreeing to Microsoft's restrictions. In a series of
E-mail messages, Cameron
Myhrvold, who had a key role in dealing with the ISPs and OLSs
on this issue, noted that
"ISPs have to swear allegiance to IE for typically 75% of browsers they distribute
in order to get into the referral server." (emphasis in original) 90 But
Myhrvold emphasized that
ISPs, for their own business reasons, resisted Microsoft's efforts
to bias their browser
distribution in favor of IE: "ISPs are agnostic on the browser. It's
against their nature to favor a
browser or even a platform. This has been damn hard for us
to influence... I have had a
hard time guiding the ISPs to IE loyalty even when I made them
sign explicit terms and
conditions in a legal contract."91
C. Microsoft's ICP Restrictions are
Exclusionary
113. Microsoft developed for Internet Explorer
4 a feature known as the "Active
Desktop." The Active
Desktop, if enabled, overlays the standard Windows desktop with
content that makes the
desktop resemble a web page. Microsoft also created a number of
"channels" on the Active
Desktop. These channels display the content of Microsoft-selected
Internet Content Providers.
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114. Because the IE 4 Active Desktop was
anticipated to be shipped on a
substantial number of PCs,
the channels -- just like Microsoft's On-Line Service Folder and
Internet Connection Wizard --
provided ICPs with an attractive way of promoting their
service. For instance,
Wadsworth of Disney explained that "entering in to a promotional deal
with Microsoft was highly
valuable because of Microsoft's ability to create icons or
channels' that would be
located on the Windows desktop.'"92 Another ICP opined that "a
preferred position on the
active desktop . . . is of almost incalculable value."93
115. And, just as with its agreements with ISPs
and OLS, Microsoft conditioned
ICPs' right to placement on
the desktop on their agreement to exclusionary terms. In
exchange for placement on
the top level of channels, those immediately visible to end users
on the Active Desktop, ICPs
agreed:
(a) not to
promote or advertise any "Other Browser" product;
(b) not to pay
compensation in any manner to the producer of an "Other
Browser";
(c) to use
Internet Explorer "and no Other Browser" as part of any client the
ICP develops
for the Windows or Macintosh oper |