Network Externalities and Its Importance for Industrial Economics - Case Study Example

Microsoft Introduction The Microsoft issue may be reduced to the question: “Has Microsoft’s conduct been driven by considerations of efficiency or ofuncompetitive exclusion?” (Hazlett, Litan & Rockefeller, 2000, p. 45). In separate cases, governments (the US and EU) and attorneys in class action suits claimed that Microsoft’s contracts with original equipment manufacturers (OEMs) were exclusionary and anticompetitive, thereby maintaining its operating system (OS) and later its internet browser monopoly (Page, 2009; Ahlborn & Evans, 2009). These allegedly caused consumers to pay higher prices, discouraged innovation, and restricted trade in violation of the Sherman Act. Microsoft countered that (1) it was not a monopoly because it still faced strong competition in a dynamic industry; (2) its success was procompetitive because consumers benefited from its software distribution; and (3) imposition of antitrust remedies would reduce innovation instead of encouraging it (Rubinfeld, 2009). Network externalities and its importance for industrial economics When an increase in the number of users of a product conveys incremental value to each user, then a network is said to exist. While each additional user derives benefits for himself or herself (i.e. private benefits), he/she also provides external benefits, known as network externalities, to existing users of the product. This fundamental observation has inspired a flurry of research among economists because of perceived implications on competitive strategies firms in network markets may employ. Two (among many) areas of influence are consumers’ decision criteria as to whether to purchase a new technology, or the decision of producers to adopt standards in designing their products (Katz & Shapiro, 1985; Page & Lopatka, 1999). Network externalities are of two kinds – direct and indirect externalities, which refer to the source of benefit to participants. Direct externalities are related to physical two-way network, such as the use of fax machines; a fax machine owner will benefit by each new user of fax machines because there is one more person to communicate with. Indirect externalities create benefits for users of compatible devices although they are not physically connected – i.e. they are connected in a virtual network. Examples of compatible products are computer hardware and software, phonographs and records, and television sets and programing. In extreme cases, network externalities may cause markets to fail as when an inferior product ‘tips’ the network towards adopting it over a superior product because it arrived first (Page & Lopatka, 1999, p.955). A market is said to have ‘tipped’ when it settles on a single standard for a product, such as software platforms (p.960). Proposition: ‘Microsoft acted illegally to extend its monopoly power.’ Corporate acts deemed anticompetitive are those that foster competition not on the merits, and lead to insufficient distribution compensation. An example is when a sufficiently large number of distributors agree to exclusivity over a sufficiently lengthy period, because this tends to drive rival firms out of the market. Distributors who have not by then signed up with the dominant firm will then have to pay a monopoly price (Rasmusen, Ramseyer & Wiley, 1991). Microsoft, as dominant firm intending to defend its market position, undertook four actions with regard to Internet Explorer (IE) vis-à-vis original dominant browser, Netscape Navigator: (1) Microsoft invested massively in browser technology; (2) IE was zero-priced; (3) Microsoft signed exclusive distribution contract with Internet access providers; and (4) Microsoft bundled IE with Windows. The court found that investment in browser technology and zero pricing were not uncompetitive, but declared exclusive distribution contracts and tying or bundling arrangements as uncompetitive (Klein, 2001, pp.46-47). Arguments in favor of illegality Microsoft engaged in actively ‘tipping’ the market, thus preventing the adoption of what could have been better programs. While tipping in general does not automatically signal uncompetitive practices aiming at exclusion, where the acts appear extreme and blatantly exclusionary then the ‘tipping’ itself aids in the unfair furtherance of the monopoly (Page & Lopatka, 1999). Microsoft’s acts were anticompetitive in that they are aimed at serve to protect its power in the market while extending its power to another market (Fisher & Rubinfeld, 2001). The Court ruled that Microsoft’s behavior concerning exclusive contracts and the tying of IE with the Windows OS were uncompetitive because they led to Microsoft’s control of the two ‘most effective distribution channels for browser software’ – i.e., Internet access providers, and personal computer manufacturers (Klein, 2001, p.47). These acts effectively locked out Netscape and prevented it from competing on the merits. Upon examining the details of the exclusive contracts, the Court found that Microsoft withheld or threatened to withhold the Windows OS or its applications program interfaces (APIs) for those Internet service providers or computer manufacturers who deal with principal competitor Netscape. In such cases where Microsoft will allow the use of Windows, it will only do so by charging a higher price or impose some other penalty on the ‘errant’ customer. These are clearly violative of the antitrust provisions (see appendix), pursuant to existing case law, in entrenching the dominant firm’s monopoly. Hazlett, Litan & Rockefeller (2000) cites the case of AT&T, which did the same thing and was eventually broken up, as an example (p. 46). Arguments against illegality Windows is not merely a product but a platform, and the distinction between the two highlights the point that the externalities of Microsoft’s Windows created benefits not because of an increase in the number of users (network effects), but from the enhancement of division of labor (thus serving as a nonmarket coordinating mechanism) (Niman, 2002, p. 642). A platform creates externalities that benefit both sides of the market, and Microsoft’s actions were aimed at furthering the success of Window’s platform, not to reduce competition for its software products (Niman, 2002, p. 641). A platform generates positive externalities for families of devices – e.g., Bluetooth, a wireless communication technology that enhances an entire range of wireless devices. Family effects are distinct from network effects; network effects result from benefits derived from the greater number of products, while family effects are benefits derived when different but compatible products are combined, even if the number of products of any one type is few (p. 646). This was true of the Microsoft platform, which created not only network effects, but family effects. Concerning the bundling of the Internet Explorer (IE), Microsoft signed a sufficient number of exclusive Internet access provider contracts arguably to maintain its platform dominance of Windows; however, this is unlikely to drive other providers such as Netscape, the original dominant browser, out of business. Furthermore, significant network effects and economies of scale in the platform market are not present in the browser market, leading to the plausibility that the two firms could co-exist (Klein, 2001, p.53). Be that as it may, Microsoft did create benefits that justified the ‘tipping’ of customers towards its browser. An example is the case of AOL and other big businesses which originally paid forty-nine dollars for then leader Netscape Navigator. Netscape demanded that all AOL customers using its browser would pass through the Netscape net center. AOL and others subsequently switched to the zero-priced and customized IE; it thereafter experienced a surge in growth from $5 billion to $150 billion, which was largely attributed to the new browser. AOL assessed that it got greater value and a much better deal from Microsoft (Hazlett, et al., 2000, p.47). As for competing on the merits, it is part of the competitive process that firms also compete for distribution, employing such strategies as price reduction and improvement in the speed and quality of distribution. Competition on distribution therefore also results in significant benefits to the customer, making it a valid competitive action. The question, therefore, returns to the intentions behind Microsoft’s conduct, whether it aimed at increased efficiency, or at uncompetitive exclusion (Hazlett, Litan & Rockefeller, 2000, p.45). Where the intention to exclude is absent, then Microsoft’s strong dominant position, to the apparent exclusion of other software providers, may simply be temporarily ‘imperfectly competitive,’ thereby creating supernormal profits for Microsoft in the short term (p.49). Conclusion Page and Lopatka (1999) noted that the theory of externalities is gradually being considered by the courts in settling claims of monopolization. However, there is a limit to which this could go. Many economists warned that network externalities studies should not be used to justify greater intervention by government. Obviously, the government, or any policy-setting institution for that matter, will have extreme difficulty identifying the correct outcome of a market in flux; only the free workings of market mechanisms will eventually determine the resulting equilibrium. The presence of imperfect competition and the acquisition of supernormal profits are a transient condition which, in due time, will resolve itself towards a breakdown of the monopoly and greater competition. It is possible, however, that this may take too long, and so the legal recourse helps consumers by speeding up the process towards equilibrium. The paradoxical relationship between the law and economics will necessarily continue into the future (Brennan, 2003). The case of Microsoft’s market dominance is more than just the result of either transient market inefficiency, or solely fueled by exclusionary intentions. Microsoft’s OS provided a platform with network and family effects, and its contracts, while exhibiting some arguably anticompetitive characteristics such as imposing penalties, also includes terms that provide exceptional value to its customers that, as in the case of AOL, tangibly improve their businesses. Thus, the presence of network externalities is competition on the merits, upon which Microsoft clients based their decision to avail of Microsoft’s softwares. References Ahlborn, C, & Evans, D 2009, The Microsoft Judgment And Its Implications For Competition Policy Towards Dominant Firms In Europe, Antitrust Law Journal, 75, 3, pp. 887-932, Business Source Complete, EBSCOhost, viewed 21 November 2012. Brennan, T 2003, The Legacy of U.S. v. Microsoft, Regulation, 26, 4, pp. 22-28, Business Source Complete, EBSCOhost, viewed 21 November 2012. Cheng, H, Liu, Y, & Tang, Q 2011, The Impact of Network Externalities on the Competition Between Open Source and Proprietary Software, Journal Of Management Information Systems, 27, 4, pp. 201-230, Business Source Complete, EBSCOhost, viewed 24 November 2012. Coase, R H 1972 ‘Durability and Monopoly’ Journal of Law and Economics, 15, 1, pp. 143-149 Fisher, F M & Rubinfeld, D L 2001 ‘U.S. v. Microsoft – An Economic Analysis,’ Antitrust Bulletin, 1, 8, p. 46. Hazlett, T, Litan, R, & Rockefeller, E 2000, Legal and Economic Aspects of the Microsoft Case: Antitrust in the Information Age, Business Economics, 35, 2, p. 45, Business Source Complete, EBSCOhost, viewed 21 November 2012. Katz, M L & Shapiro, C 1985 ‘Network Externalities, Competition, and Compatibility’ The American Economic Review, 75, 3, pp. 424-440 Katz, M L & Shapiro, C 1994 ‘Systems Competition and Network Effects.’ The Journal of Economic Perspectives, 8, 2, pp. 93-115 Klein, B 2001, The Microsoft Case: What Can a Dominant Firm Do to Defend Its Market Position?, Journal Of Economic Perspectives, 15, 2, pp. 45-62, Business Source Complete, EBSCOhost, viewed 21 November 2012. Kwoka, J E Jr., & White, L J 2009 The Antitrust Revolution: Economics, Competition and Policy, 5th edition. Oxford University Press, New York Levy, S 2000, Microsofts Crapshoot, Newsweek, 135, 16, p. 42, MAS Ultra - School Edition, EBSCOhost, viewed 21 November 2012. Niman, NB 2002, Platform externalities and the antitrust case against Microsoft, Antitrust Bulletin, 47, 4, p. 641, Academic Search Complete, EBSCOhost, viewed 21 November 2012. Ohlhausen, MK 2009, Symposium: The End Of The Microsoft Antitrust Case?, Antitrust Law Journal, 75, 3, pp. 691-703, Business Source Complete, EBSCOhost, viewed 21 November 2012. Page, WH 2009, Mandatory Contracting Remedies In The American And European Microsoft Cases, Antitrust Law Journal, 75, 3, pp. 787-809, Business Source Complete, EBSCOhost, viewed 21 November 2012. Page, W H & Lopatka, J E 1999 0760 Network Externalities pp. 952-978. Available at http://encyclo.findlaw.com/0760book.pdf Rasmusen, E B; Ramseyer, J M, & Wiley, J R Jr. 1991 ‘Naked Exclusion’ American Economic Review, 81, 5, p1137. Rasmusen, E B; Ramseyer, J M, Wiley, J R Jr. & Shepard, J 2000 ‘Naked Exclusion: Reply’ American Economic Review, 90, 1, p310-311. Rubinfeld, D L 2009 ‘Maintenance of Monopoly: U.S. v Microsoft (2001)’ In The Antitrust Revolution 5th edition. Kwoka, J E Jr. & White. L J, eds., pp. 530-557. Oxford University Press, New York. United States of America v. Microsoft Corporation. 2002 Civil Action No. 98-1232 (CKK), U.S. District Court for the District of Columbia Yousef-Sibdari, S 2001 ‘The Behavior of Technology Suppliers in the Presence of Network Externalities.’ Virginia Polytechnic Institute and State University. Available at http://scholar.lib.vt.edu/theses/available/etd-10162001-155423/unrestricted/Soheil.pdf Appendix Text from the Sherman Act of 1890 Section 1: ‘Every contract combination in the form of trust or otherwise or conspiracy in restraint of trade or commerce among the several states or with foreign nations is declared to be illegal.’ Section 2: ‘Every person who shall monopolize or attempt to monopolize or combine or conspire with any other person or persons to monopolize any part of the trade or commerce among the several states or with foreign nations shall be guilty of felony.’ Read More