Antitrust in Cyberspace: New Rules of the Game

In every major industry’s golden era, whether it be late 19th-century railroads or early 20th-century oil, powerful corporations have emerged whose outstretched tentacles, reaching for ever-greater market dominance, have drawn the scrutiny of the federal government.

Today, in the heyday of the information age, the spotlight is on Microsoft Corp., which is using its control over Windows--the basic operating software of most personal computers--to take over almost every important software market in sight.

But the laws regulators once used to rein in industrial age conglomerates like Standard Oil don’t easily apply to a company like Microsoft.

In the digital world, where production costs are close to zero, monopolists expand their power by lowering prices, not raising them. Such intangibles as technical standards and public perception can act more quickly and powerfully to influence markets than the old-style monopolists’ control of supply and distribution channels.

Now, as Justice Department antitrust lawyers investigate Microsoft’s aggressive tactics in battling Netscape Communications for control of Internet software, an obscure new branch of economics is offering new ways to understand market power.

These theories, based on a concept called “network effects,” could provide legal groundwork for the government to move quickly against dominant companies like Microsoft that seek to use their power to conquer new markets.

The development of the new legal strategy doesn’t mean federal lawyers will go after Microsoft, or should. Antitrust enforcement always has been in part a matter of politics and public perception, and it’s not clear that current public sentiment would support an aggressive government offensive against one of the nation’s most successful technology companies. There’s little consensus on whether such an attack would benefit the high-tech industry and the economy in the long run.

But if Microsoft were to achieve its all-but-stated goal of putting Netscape out of business, public opinion--and the attitudes of politicians, economists and jurists--could change in a hurry.

“The predatory consequences [of Microsoft’s assault on Netscape] are very clear. The intent is so blatant,” says W. David Slawson, a USC expert in antitrust law who thinks the courts should be more active in reining in monopolists. “This might be the thing that turns the Supreme Court around.”

The antitrust laws, written at the beginning of the century, do not provide a great deal of guidance as to what exactly constitutes an illegal monopolistic practice. But over the decades, courts have developed a set of interpretations that would seem to make it difficult to bring a case against Microsoft.

The company’s battle against Netscape offers some clear examples of this legal quandary.

Netscape was the first to commercialize a key piece of software known as the browser, which is used to explore the portion of the Internet known as the World Wide Web. Netscape’s Navigator quickly became the standard.

Microsoft Strikes

Then Microsoft struck back, developing and improving its Explorer browser and giving it away for free--and, just as important, providing big financial incentives for Internet service providers to offer it instead of Navigator. Microsoft is rapidly whittling away Netscape’s lead, and many in the business believe it won’t be long before Microsoft rules the market.

Many antitrust experts believe a strong case could be made that Microsoft has used predatory practices with an intent to monopolize the browser market.

But the Justice Department can’t make a case unless that intent is judged to have what a 1905 Supreme Court decision called a “dangerous probability of success.” Under antitrust law as it has traditionally been interpreted, it is difficult to show such “dangerous probability” unless a company has a 50% market share. Microsoft’s browser share, while it has more than doubled in the last two months, is still less than 20%.

However, if the Justice Department waits too much longer, argues Gary Reback, Netscape’s attorney, “it will be too late.”

That’s where the idea of “network effects” comes into play. Economists, including UC Berkeley’s Carl Shapiro, who recently headed Justice’s economics division, have begun to examine the huge business advantages that arise as the number of users of, say, a software program increase.

Microsoft’s Windows, for example, was successful in large part because the company persuaded thousands of software companies to develop products for what they predicted would be the next standard PC operating system. The widespread availability of Windows-compatible software products, in turn, broadened the appeal of the operating system, creating an upward spiral of market share.

Locking In Customers

The typical user’s reluctance to learn how to use a competing software system means that a firm, once it becomes dominant, is able to “lock in” customers for long periods or until a substantially better product comes out.

This bandwagon phenomena is what the economists call “network effects.”

Microsoft Chairman Bill Gates sees this as a good thing that he calls a “positive feedback cycle.” Exploiting it has been a crucial part of his strategy.

The concept is important to regulators because it magnifies monopolists’ power and provides huge incentives for strong companies to use predatory pricing and other tactics to “tip” markets in their favor. Even relatively minor actions, taken at critical moments, can set off an avalanching shift in market share.

Caldera, a Utah-based software company controlled by Ray Noorda, the former chairman of networking software leader Novel Inc. and a longtime Gates nemesis, alleges in a private antitrust suit against Microsoft that such “tipping” destroyed its PC operating system, DR-DOS, which briefly challenged Microsoft’s MS-DOS in the early 1990s.

Caldera argues that Microsoft’s use of misleading product announcements suggesting a better Microsoft offering was imminent, messages in early samples of Windows that made it appear as if DR-DOS was incompatible with Windows, and licensing deals designed to lock out competitors turned the market against a critically acclaimed product.

Because of “network effects,” says Larry Popofsky, Caldera’s attorney, “it doesn’t take a dramatic set of bad acts to destroy a competitor in this kind of market.”

In a study published in May, the Federal Trade Commission drew on work by network economists to suggest that in emerging high-tech markets, monopolists can so swiftly use their leverage to turn the tide that regulators should consider taking action early while they can still make a difference.

If Justice can show Microsoft is using the huge power it draws from its operating system monopoly to shift the momentum against Netscape, experts argue, it could bring a case of attempted monopolization even if Microsoft is still a minority player in browsers.

Gates has no patience with those who question his marketing tactics. “The goal of competition policy is this thing called low prices,” he says dryly. “In the software business, power goes up while prices come down. In extreme cases, you actually get free products.”

Netscape, from the outset, was trying to create network effects too. Navigator was given away, to promote usage of the Web and thus spur demand for the Netscape “server” software used to create and operate Web sites. The company also goaded Microsoft when it declared that Navigator would become the standard for a whole new type of computing.

After initially failing to recognize the significance of the Net, Microsoft struck back. Last December, it announced it would develop Explorer, which does everything Navigator does and more, and would give it away.

“If two people provide equivalent software,” said Gates, “its value is zero.” As analysts phoned in the news of the Microsoft counterattack, Netscape’s share price plummeted.

Since then, Microsoft has begun offering free “server” software as well--thus attacking Netscape’s key source of revenue. Microsoft has spent millions to give Explorer users free access to such “subscription” Web sites as Wall Street Journal Interactive.

Explorer Bonuses

Internet service powerhouses like AT&T;, Netcom, Compuserve, America Online, MCI and Prodigy have agreed to make Explorer their “preferred” browser in exchange for having their offerings packaged with Windows 95 operating system and receiving marketing help from Microsoft.

One major Internet service company says Microsoft even offered a bonus of hundreds of thousands of dollars to help defray the cost of customer mailings on the condition it exclusively distribute Explorer.

“It really made me uncomfortable,” said the provider, who declined to be named. “I want my customers to have a choice.”

Microsoft says such deals aren’t exclusive because customers can readily go to the Netscape Web site and download Navigator.

Microsoft has made no secret of that fact that it considers the Web browser and server business an extension of its Windows business and has no intention of making money off the Web products themselves. Since the cost of distributing each additional piece of software is close to zero, Microsoft executives argue, offering software for free isn’t below cost and, therefore, isn’t predatory.

But critics note Microsoft is essentially paying firms to recommend its software. Even if development costs are excluded, Microsoft is selling Explorer below cost.

The only way Microsoft can justify such spending, argues Stanford Business School economist Garth Saloner, a proponent of “network effects,” is as a tactic to defend its Windows monopoly against an emerging threat. “If you own the market in the old model, there are huge incentives to stop [a new model from emerging].”

But federal courts over the last several decades have steadily narrowed their interpretation of antitrust laws and do not necessarily view these kinds of actions as illegal. Under the influence of free-market economists, the courts have held that leveraging monopoly power into new areas isn’t necessarily bad if it results in business efficiency and a better deal for consumers.

Global markets and rapid technological change have been viewed as the ultimate prophylactic against enduring monopoly power.

“I assume Microsoft is going to be the dominant firm as long as we operate in the present paradigm,” says William Baxter, a Stanford law professor who, as head of antitrust at Justice under President Reagan, led the effort to break up AT&T; but also made the decision to drop a 13-year-old suit against IBM.

He argues that Microsoft, like all monopolists, eventually will plant the seeds of its destruction and any effort to regulate it will only extend the status quo. “That’s the last thing you want. We want everybody to compete to be the new monopolist.”

A Losing Battle?

Richard Rule, Justice’s antitrust head under President Bush, says it is pointless for regulators to try to enforce antitrust laws in the high-tech world because they never will be able to act fast enough: “The problem with antitrust enforcers is that they are too busy fighting yesterday’s war.”

Since the 1992 election of President Clinton, who taught antitrust law at the University of Arkansas at Fayetteville, regulators have become more active, if not necessarily more effective.

When the FTC deadlocked in 1993 over whether to bring a case against Microsoft after a three-year investigation, antitrust chief Anne Bingaman took up the case.

But in spite of extensive testimony regarding Microsoft’s anti-competitive behavior--testimony Justice staff attorneys believed was strong enough to convict--Bingaman settled for a consent decree in 1994 that placed controls over licensing practices involving its operating system. By then, Microsoft had established a monopoly in that business--and the decree was moot.

In 1995, Justice threatened to take action against Microsoft for bundling its proposed commercial online service with its operating system, but chose not to act. Most consider that a correct decision since the service did poorly.

That year, Justice blocked a Microsoft effort to buy Intuit--the leader in personal finance software--that could have expanded its dominance to the promising field of electronic banking.

In that case, Stanford’s Saloner and attorney Gary Reback, representing a group of anonymous Microsoft critics, argued in a “friend of the court” brief that network effects could enable Microsoft to use Intuit to vastly increase its control over financial transactions, and, ultimately, all information.

Critics say Reback and Saloner took the networking arguments too far. Nevertheless, the arguments gained important adherents within Justice.

Speaking in San Francisco in January, Shapiro, then a deputy assistant attorney general, said that because of the significant “network effects” in software and other high-tech sectors, Justice was “prepared to scrutinize and challenge” tactics that are likely to give monopolists dominance in related markets.

But the same forces that provide a legal argument for antitrust claims, ironically, also discourage companies from seeking redress.

A Netscape suit against Microsoft, for example, could look good in court but would boost public perception that Netscape is losing in the marketplace, ultimately speeding its demise.

Other Concerns

The Justice Department has other worries. With the political winds favoring less regulation, it would have to show clearly how Microsoft’s actions would hurt consumers by undermining competition.

That’s not an easy case to make. When Microsoft bundles new software into its operating system and sells the expanded product at the same price, consumers benefit, at least in the short run. Internet service providers, for the most part, are happy with Microsoft’s aggressive sales tactics. Not only are their costs down, but, in an effort to remain competitive, Netscape is offering better service.

And even if Justice does make a strong case that Microsoft is using its power unfairly in a way that hurts consumers, what can it do about it?

Microsoft’s biggest advantages come from deciding what features Windows should contain and being in a position to exploit those features in new products earlier than its competitors. Some have suggested creating a “Chinese wall” between the part of Microsoft that handles Windows and the part that deals with applications. But enforcing such a rule would be a regulatory nightmare.

An outright breakup of the company would be hugely controversial and risky.

The easiest solution would be self-restraint. But that goes against Microsoft’s culture as an aggressive, ever-expanding company.

Still, its take-no-prisoners attitude eventually could force regulators to draw a line. Competition, after all, is still the key to innovation and continued price declines.

“Ultimately, if one company dominates everything, it’s dangerous,” says Samuel Miller, who led the Justice team that investigated Microsoft two years ago. “You kill innovation and you lose the capacity to create alternatives. Ultimately, that isn’t good for the consumer or the country.”