The Microsoft Case

One of the most important antitrust cases brought in the 1990s was the Microsoft case. This is an extremely interesting case both because of its similarities to the IBM case and because of the issues it raises about competitive process, and government’s role in that competitive process.

Microsoft makes computer software. From the company’s small start some 20 years ago, sales of Microsoft software have grown to account for about 50 percent of the world’s software market. Its PC operating system, Windows, accounts for an even larger share-more than 90 percent-of the world’s operating system software market.

Since all software must be compatible with an operating system, the widespread use of Windows gives Microsoft enormous power that competitors claim it has used to gain competitive advantage for its other divisions. Competitors’ calls for action, and reports of monopolistically abusive acts by Microsoft, led the U.S. Department of Justice in 1998 to charge Microsoft with violating antitrust laws.

The government suit against Microsoft charged the company with being a monopoly and using that monopoly power in a predatory way. Specifically, it charged Microsoft with:

1. Possessing monopoly power in the market for personal computer operating systems.

2. Tying other Microsoft software products to its Windows operating system.

3. Entering into agreements that keep computer manufacturers that install Windows from offering competing software.

Microsoft had dominated the market for PC operating systems for about a decade. The U.S. Department of Justice argued that this long-standing monopoly position was the result of unfair business practices. Microsoft argued that Windows sold so well because it was a superior product. Microsoft further argued that, because it faced competition from technological change, it was not a monopolist.

Because of their experience with AT&T and IBM cases, prosecutors were initially hesitant to bring charges against Microsoft. They knew that the case would be extremely complicated, contentious, and long. And they fully expected that the competitive issues would change significantly in the interim. They eventually decided to bring the case, however, because the judge granted them an expedited process-meaning that the case would be resolved much faster than previous cases-and because they felt that Microsoft had violated a 1994 consent that it had entered into following an earlier antitrust investigation.

Is Microsoft a Monopolist? The computer software industry is a market with barriers to entry that originate from two sources-network externalities and economies of scale. Network externalities exist because as the number of applications supported by a single platform increase, the value of the platform also increases. Economies of scale exist because the cost of developing a new platform and new software is significant, while the cost of producing it is minimal. It is a potential candidate for monopoly.

Is Microsoft a monopoly in the market for operating systems? Looking only at the market within a static framework, Microsoft, given its stable 90 percent share, almost definitely has a monopoly. Looking at the market from a dynamic perspective, the issue is much more complicated. Competing operating systems exist; Jaguar (developed by Apple), and Linux are both competitors to Windows.

The Linux operating system is a particularly strong potential competitor because it is an “open-source” operating system. All programmers can get the code and modify it, allowing them to tailor it for their software and streamline the structure of their programs. Linux reduces the costs of software development and leads to more efficient programs.

Another potential competitive force is the merging of software and hardware. As the power of computers increases according to Moor’s law, it is becoming more and more feasible to design specific chips to do specific jobs, incorporating into a single chip aspects that were previously separated into hardware and software. Within 10 years the entire PC structure-a machine to handle a multitude of tasks-could become obsolete, and instead the market may consist of $10 or $15 machines that will perform specific tasks more efficiently than can a multipurpose machine like the PC. Each of these changes could eliminate Microsoft’s monopoly advantage. In this dynamic view of the market, Microsoft’s monopoly is at best temporary, and will survive only if it outcompetes the other technologies.

Is Microsoft a Predatory Monopolist? The U.S. Department of Justice argued that Microsoft used its monopoly in the operating systems market to gain a larger share of the software market and engaged in unfair practices against its competitors to maintain the barriers to entry in the operating systems market. Let’s first look at its actions to gain market share in the software market.

Competing software companies like Novell (now Corel), which had the leading word-processing software, WordPerfect, were put at a significant disadvantage because Microsoft combined its software with the Windows operating system. Not surprisingly, Microsoft’s Word has become the dominant word-processing system. By directing the development of new software to favor Windows, Microsoft strengthened the barrier to entry created by network externalities. Microsoft also penalized computer manufactures that installed Windows if they installed competing software. IBM, for example, was denied Windows 95 when it decided to pre-install its PCs with Lotus, a direct competitor to Microsoft’s Excel.

Microsoft was also alleged to have engaged in unfair practices in how it addressed the threat of competition in the operating system market. Direct competitive threats came mainly from two firms-Netscape and Sun Microsystems. Netscape and Sun were developing programs that operated across multiple platforms and were developing potential rival operating systems.

Netscape designed and marketed a very popular Web browser called Netscape Navigator. Navigator posed a threat to Microsoft not only because it could serve as a platform for other software applications and circumvent the need for Windows but also because Navigator could work on many operating systems, increasing the ability of software to work on systems other than Windows. In response to that threat, Microsoft attempted to get Netscape to agree to stop developing Navigator as a competing platform in exchange for a “special relationship: with Microsoft. Netscape wouldn’t agree. In response, Microsoft withheld the source code Netscape needed to provide its browser on the Windows platform for three months. This gave Microsoft an advantage to offer its own Web browser, Internet Explorer, with Windows starting in 1995. Microsoft then bundled its browser to Windows (essentially offering it at no cost) and made it virtually impossible for consumers to remove the Internet Explorer icon from the PC screen. Installing Windows actually disabled competing Internet browsers. Microsoft also prohibited computer manufactures such as Compaq from offering Netscape as an alternative browser when they sold PCs with Windows.

The government argued that this competition was unfair and predatory. Microsoft argued that Internet Explorer was a Windows program improvement; it was part of Windows. Netscape Navigator, which had been more popular than Internet Explorer and had seen its sales climbing rapidly, was in a matter of a few years nearly replaced by the Microsoft browser.

Another potential competitor was Sun Microsystems, which was developing Java, a programming language designed to create software applications on a variety of platforms, not just Windows. Sun Microsystems had entered into an agreement with Microsoft that allowed Microsoft to distribute the Java code under explicit instructions not to change it. But Microsoft created a version of Java that kept it tied to Windows and changed the platform-neutral characteristics of Java. Microsoft also instructed other companies not to cooperate with Sun. These actions stunted the development of a program that would allow software to run across multiple platforms, which would have reduced the network externality barriers to trade enjoyed by Microsoft.

Resolution of the Microsoft Case. So is Microsoft a monopoly? And has it been involved in anticompetitive practices? The answer the court gave was yes. In 2000 the judge concluded that Microsoft violated Section 2 of the Sherman Act by attempting to maintain its monopoly power by anticompetitive means. He also ruled that Microsoft violated Section 1 Sherman Act by unlawfully tying its Web browser to its operating system. In a strongly worded decision he stated that “Microsoft mounted a deliberate assault upon entrepreneurial efforts that, left to rise or fall on their own merits, could well have enabled the introduction of competition into the market...” As a remedy the government proposed breaking up Microsoft into two companies. Microsoft quickly appealed, and in mid-2001 the appeals court ruled that, while Microsoft was indeed a monopoly, a breakup was not necessary-instead, the case should be resolved by mediation. A few months later the federal government, nine states, and Microsoft agreed to a settlement. Microsoft agreed not to engage in contracts that prohibited PC makers from using competing products or in practices that favored PC makers that offered only Microsoft products. It also agreed to release technical information about Windows improvements to software developers. Microsoft maintained its right to keep e-mail systems and software programs such as media players bundled with Windows. Nine other states (co-plaintiffs) objected to the settlement because they believed the restrictions on Microsoft were too mild.

The nine states continued suing Microsoft, contending that software developers in applications such as media players could compete only if Microsoft made its operating system modular and provided the relevant code to competitors so they could integrate their software into the Windows operating system as seamlessly as they could integrate Microsoft products. Both sides brought in experts on whether this was easy to do or not.

In November 2002 the Court decided against the dissenting states. Thus, the agreement that Microsoft had entered into with the federal government stood. However, the judge stated that she would be following Microsoft’s actions carefully to see that it abided by the agreement. (Two states appealed.) So the end result of the Microsoft case was that even though Microsoft had been declared a monopoly, it was not broken up. Instead it agreed to a set of rules of competition that required it to provide technical information to competitors and to allow firms to use software from Microsoft competitors.

Most observers believe that these limitations do not place a serious constraint on Microsoft’s domination of the software industry since, for a number of its competitors, that technical information will be too late, because in the four years that had passed since the beginning of the case, Microsoft had already integrated Windows operating system with Microsoft media players, and had developed a head start in integrating a number of other new technologies into its Windows operating system. So even if it doesn’t live up to its agreement, since any legal action against Microsoft will take additional years to litigate, the same process can be expected to continue and Microsoft will have likely established its position in even newer technologies before any limitations can be imposed on it by the government.

Excerpt taken from Economics by David Colander. Fifth Edition. McGraw-Hill: 2004.