Strategies Used by Microsoft to Leverage its Monopoly Position in

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Managerial Economics and Business Strategy, 4e Page 1 Strategies Used by Microsoft to Leverage its Monopoly Position in Operating Systems to Internet Browser Markets Michael Baye and Patrick Scholten prepared this case to serve as the basis for classroom discussion rather than to represent economic or legal fact. The case is a condensed and slightly modified version of the public copy of the Complaint filed in Civil Action No. 94-1546 on July 15, 1994 in United States of America v.

Microsoft Corporation. MICROSOFT Microsoft is the world 9s largest supplier of computer software for personal computers (PCs), may have engaged in anti-competitive conduct and created anti-competitive effects of its past unlawful conduct. Microsoft sells and licenses PC operating systems throughout the United States and the world and delivers copies of its operating systems to PC manufacturers (often referred to as Original Equipment Manufacturers or cOEMs d) and retail customers across state lines and international borders.

Microsoft is engaged in, and its activities substantially affect, interstate and foreign commerce. Microsoft may possess (and for several years may have possessed) monopoly power in the market for personal computer operating systems. Microsoft 9s cWindows d operating systems are used on over 80% of Intel-based PCs, ... more. less.

the dominant type of PC in the United States. More than 90% of new Intel-based PCs are shipped with a version of Windows pre- installed. OEMs have no commercially reasonable alternative to Microsoft operating systems for the PCs that they distribute. There are high barriers to entry in the market for PC operating systems. One of the most important barriers to entry is the barrier created by the number of software applications that must run on an operating system in order to make the operating system attractive to end users. Because end users want a large number of applications available, because most applications today are written to run on Windows, and because it would be prohibitively difficult, time-consuming, and expensive to create an alternative operating system that would run the programs that run on Windows, a potential new operating system entrant faces a high barrier to successful entry. Accordingly, the most significant potential threat to Microsoft 9s operating system monopoly is not from a direct, frontal assault by existing or new operating systems, but from new software products that may support, or themselves become, alternative cplatforms d to which applications can be written, and which can be used in conjunction with multiple operating systems, including but not limited to Windows. To protect its valuable Windows monopoly against such potential competitive threats, and to extend its operating system monopoly into other software markets, Microsoft may have engaged in a series of anticompetitive activities. Microsoft 9s conduct includes Page 2 Michael R. Baye agreements tying other Microsoft software products to Microsoft 9s Windows operating system; exclusionary agreements precluding companies from distributing, promoting, buying, or using products of Microsoft 9s software competitors or potential competitors; and exclusionary agreements restricting the right of companies to provide services or resources to Microsoft 9s software competitors or potential competitors. One important current source of potential competition for Microsoft 9s Windows operating system monopoly comes from the Internet, described by Microsoft 9s CEO, Bill Gates, in May 1995 as cthe most important single development to come along since the IBM PC was introduced in 1981. d As Mr. Gates recognized, the development of competing Internet browsers -- specialized software programs that allow PC users to locate, access, display, and manipulate content and applications located on the Internet 9s World Wide Web ( cthe web d) -- posed a serious potential threat to Microsoft 9s Windows operating system monopoly. Mr. Gates warned his executives: A new competitor cborn d on the Internet is Netscape. Their browser is dominant, with a 70% usage share, allowing them to determine which network extensions will catch on. They are pursuing a multi-platform strategy where they move the key API [applications programming interface] into the client to commoditize the underlying operating system. Internet browsers pose a competitive threat to Microsoft 9s potential operating system monopoly in two basic ways. First, as discussed above, one of the most important barriers to the entry and expansion of potential competitors to Microsoft in supplying PC operating systems is the large number of software applications that will run on the Windows operating system (and not on other operating systems). If application programs could be written to run on multiple operating systems, competition in the market for operating systems could be revitalized. The combination of browser technology and a new programming language known as "Java" hold out this promise. Java is designed in part to permit applications written in it to be run on different operating systems. As such, it threatens to reduce or eliminate one of the key barriers to entry protecting Microsoft's potential operating system monopoly. Non-Microsoft browsers are perhaps the most significant vehicle for distribution of Java technology to end users. Microsoft has recognized that the widespread use of browsers other than its own threatens to increase the distribution and use of Java, and in so doing threatens Microsoft 9s potential operating system monopoly. For this reason, a presentation to Microsoft CEO Bill Gates on January 5, 1997, on how to respond to the Java threat emphasized "Increase IE share" as a key strategy. Second, Microsoft recognized that Netscape's browser was itself a "platform" to which many applications were being written -- and to which (if it thrived) more and more applications would be written. Since Netscape's browser could be run on any PC operating system, the success of this alternative platform also threatened to reduce or eliminate a key barrier protecting Microsoft's potential operating system monopoly. This is the threat that Microsoft's CEO Bill Gates referred to as the threat that Netscape would "commoditize" the operating system. Managerial Economics and Business Strategy, 4e Page 3 To respond to the competitive threat posed by Netscape's browser, Microsoft embarked on an extensive campaign to market and distribute Microsoft 9s own Internet browser, which it named cInternet Explorer d or cIE. d Microsoft executives have described this campaign as a cjihad d to win the cbrowser war. d Because of its resources and programming technology, Microsoft was well positioned to develop and market a browser in competition with Netscape. Indeed, continued competition on the merits between Netscape 9s Navigator and Microsoft 9s Internet Explorer would have resulted in greater innovation and the development of better products at lower prices. Moreover, in the absence of Microsoft 9s anticompetitive conduct, the offsetting advantages of Microsoft 9s size and dominant position in desktop software and Netscape 9s position as the browser innovator and the leading browser supplier, and the benefit to consumers of product differentiation, could have been expected to sustain competition on the merits between these companies, and perhaps others that have entered and might enter the browser market. Microsoft, however, has not been willing simply to compete on the merits. For example, as Microsoft 9s Christian Wildfeuer wrote in February 1997, Microsoft concluded that it would cbe very hard to increase browser 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." Thus, Microsoft might have began, and might continue today, a pattern of potential anticompetitive practices designed to thwart browser competition on the merits, to deprive customers of a choice between alternative browsers, and to exclude Microsoft 9s Internet browser competitors. Microsoft's conduct with respect to browsers is a prominent and immediate example of the pattern of potentially anticompetitive practices undertaken by Microsoft with the purpose and effect of maintaining its PC operating system monopoly and extending that monopoly to other related markets. Initially, Microsoft attempted to eliminate competition from Netscape by seeking an express horizontal agreement not to compete. In May 1995, Microsoft executives met with top Netscape personnel in an attempt to induce Netscape not to compete with Microsoft and to divide the browser market, with Microsoft becoming the sole supplier of browsers for use with Windows 95 and successor operating systems and with Netscape becoming the sole supplier of browsers for operating systems other than Windows 95 or its successors. Netscape refused to participate in Microsoft 9s illegal scheme. Having failed simply to stop competition by agreement, Microsoft set about to exclude Netscape and other browser rivals from access to the distribution, promotion, and resources they needed to offer their browser products to OEMs and PC users pervasively enough to facilitate the widespread distribution of Java or to facilitate their browsers becoming an attractive programming platform in their own right. First, Microsoft invested hundreds of millions of dollars to develop, test, and promote Internet Explorer, a product which it distributes without separate charge. As Paul Maritz, Microsoft 9s Group Vice President in charge of the Platforms Group, was quoted in the New York Times as telling industry executives: cWe are going to cut off their air supply. Page 4 Michael R. Baye Everything they 9re selling, we 9re going to give away for free. d As reported in the Financial Times , Microsoft CEO Bill Gates likewise warned Netscape (and other potential Microsoft challengers) in June 1996: cOur business model works even if all Internet software is free. . . . We are still selling operating systems. What does Netscape 9s business model look like? Not very good. d But Mr. Gates did not stop at free distribution. Rather, Microsoft purposefully set out to do whatever it took to make sure significant market participants distributed and used Internet Explorer instead of Netscape 9s browser -- including paying some customers to take IE and using its unique control over Windows to induce others to do so. For example, in seeking the support of Intuit, a significant application software developer, Mr. Gates was blunt, as he reported in a July 1996 internal e-mail: I was quite frank with him [Scott Cook, CEO of Intuit] that if he had a favor we could do for him that would cost us something like $1M to do that in return for switching browsers in the next few months I would be open to doing that. Second, Microsoft unlawfully required PC manufacturers, as a condition of obtaining licenses for the Windows 95 operating system, to agree to license, preinstall, and distribute Internet Explorer on every Windows PC such manufacturers shipped. By virtue of the monopoly position Windows enjoys, it was a commercial necessity for OEMs to preinstall Windows 95 -- and, as a result of Microsoft 9s illegal tie-in, Internet Explorer -- on virtually all of the PCs they sold. Microsoft thereby unlawfully tied its Internet Explorer software to the Windows 95 version of its monopoly operating system and unlawfully leveraged its operating system monopoly to require PC manufacturers to license and distribute Internet Explorer on every PC those OEMs shipped with Windows. Third, Microsoft intends now unlawfully to tie its Internet browser software to its new Windows 98 operating system, the successor to Windows 95. Microsoft has made clear that, unless restrained, it will continue to misuse its operating system monopoly to artificially exclude browser competition and deprive customers of a free choice between browsers. Microsoft designed Windows 98 so that removal of Internet Explorer by OEMs or end users is operationally more difficult than it was in Windows 95. Although it is nevertheless technically feasible and practicable to remove Microsoft 9s Internet browser software from Windows 98 and to substitute other Internet browser software, OEMs are prevented from doing so by Microsoft 9s contractual tie-in. Internet browsers are separate products competing in a separate product market from PC operating systems, and it is efficient to supply the two products separately. Indeed, Microsoft itself has consistently offered, promoted, and distributed its Internet browser as a stand-alone product separate from, and not as a component of, Windows, and intends to continue to do so after the release of Windows 98. For example, Microsoft will make available separately the same Internet browser that is bundled with Windows 98, through an upgraded version of Internet Explorer 4 that will be distributed and installed wholly apart from Windows 98, including for non-Windows, non-Microsoft operating systems. In addition Microsoft already plans to introduce a subsequent version of IE (Internet Explorer 5) Managerial Economics and Business Strategy, 4e Page 5 that also will be distributed and installed separately from Windows 98, including for non- Windows, non-Microsoft operating systems. Microsoft 9s tying of its Internet browser to its potential monopoly operating system reduces the ability of customers to choose among competing browser products because it forces OEMs and other purchasers to license or acquire the tied combination whether they want Microsoft 9s Internet browser or not. Microsoft 9s tying -- which it can accomplish because of its monopoly power in Windows -- impairs the ability of its browser rivals to compete to have their browsers preinstalled by OEMs on new PCs and thus substantially forecloses those rivals from an important channel of browser distribution. Microsoft executives have repeatedly recognized the significant advantage that Microsoft (and only Microsoft) receives by tying its Internet browser to its operating system, rather than having to compete on the merits. As Microsoft Senior Vice President James Allchin wrote to Microsoft Group Vice-President Paul Maritz on January 2, 1997: You see browser share as job 1 . . . . 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 . Pitting browser against browser is hard since Netscape has 80% market share and we have < 20% . . . . I am convinced we have to use Windows 4 this is the one thing they don 9t have ... (emphasis added) Fourth, Microsoft has possibly misused its Windows operating system monopoly by requiring PC OEMs to agree, as a condition of acquiring a license to the Windows operating system, to adopt the uniform cboot-up d sequence and "desktop" screen specified by Microsoft. This sequence determines the screens that every user sees upon turning on a Windows PC. Microsoft 9s exclusionary restrictions forbid, among other things, any changes by an OEM that would remove from the PC any part of Microsoft 9s Internet Explorer software (or any other Microsoft-dictated software) or that would add to the PC a competing browser (or other competing software) in any more prominent or visible way (including by highlighting as part of the startup sequence or by more prominent placement on the desktop screen) than the way Microsoft requires Internet Explorer to be presented. Virtually every new PC that comes with Windows, no matter which OEM has built it, presents users with the same screens and software specified by Microsoft. As a result of Microsoft 9s restrictive boot-up and desktop screen agreements, OEMs are deprived of the freedom to make competitive choices about which browser or other software product should be offered to their customers, the ability to determine for themselves the design and configuration of the initial screens displayed on the computers they sell, and the ability to differentiate their products to serve their perceptions of consumers' needs. These restrictive agreements also maintain, and enhance the importance of, Microsoft 9s ability to provide preferential placement on the desktop (or in the boot-up sequence) to various Internet Service Providers ( cISPs d) and Internet Content Providers Page 6 Michael R. Baye ( cICPs d), in return for those firms 9 commitments to give preferential distribution and promotion to Internet Explorer and to restrict their distribution and promotion of competing browsers. As a result, these restrictions further exclude competing Internet browsers from the most important channels of distribution, substantially reduce OEMs 9 incentives and abilities to innovate and differentiate their products in ways that could facilitate competition between Microsoft products and competing software products, and enhance Microsoft 9s ability to use the near-ubiquity of its Windows operating system monopoly to gain dominance in both the Internet browser market and other software markets. Fifth, Microsoft has entered into anticompetitive agreements with virtually all of the nation 9s largest and most popular ISPs, including particularly Online Service Providers ( cOLSs d), firms which provide the communications link between a subscriber 9s PC and the Internet and sometimes related services and content as well. Windows 95 (and soon Windows 98) presents PC users with cfolders d or lists including the names of certain of these ISPs that have entered into agreements with Microsoft and enable users readily to subscribe to their services. Because Windows is preinstalled on nearly all PCs in the United States, inclusion in these folders and lists is of substantial value to ISPs. As a result, almost all of the largest and most significant ISPs in the United States have sought placement on the Windows desktop. Microsoft 9s agreements with ISPs allow Microsoft to leverage its operating system monopoly by conditioning these ISPs 9 inclusion in Windows' lists on such ISPs 9 agreement to offer Microsoft 9s Internet Explorer browser primarily or exclusively as the browser they distribute; not to promote or even mention to any of their subscribers the existence, availability, or compatibility of a competing Internet browser; and to use on their own Internet sites Microsoft-specific programming extensions and tools that make those sites look better when viewed through Internet Explorer than when viewed through competing Internet browsers. Microsoft 9s anticompetitive agreements with ISPs have substantially foreclosed competing browsers from this major channel of browser distribution. Over thirty percent of Internet browser users have obtained their browsers from ISPs. Microsoft has recently modified certain of its ISP agreements to reduce some of these restrictions. However, " the modifications do not affect Microsoft 9s illegal agreements with On-Line Service Providers (e.g. , America Online, CompuServe), which serve the majority of Internet users in the United States; " even the modified agreements remain unlawful in other respects; " the modifications do not address the anticompetitive effects such agreements have already caused; and " there is no assurance that Microsoft will not re-impose the restrictions in the future. Managerial Economics and Business Strategy, 4e Page 7 Sixth, Microsoft has entered into anticompetitive agreements with Internet Content Providers ( cICPs d). Prominent cchannel buttons d advertising and providing direct Internet access to select ICPs appear on the cActive Desktop d feature that is shipped with the Windows operating system. Microsoft 9s agreements condition an ICP 9s placement on one of these buttons on the ICP 9s agreement to not pay or otherwise compensate Microsoft 9s primary Internet browser competitors (including by distributing their browsers) for the distribution, marketing, or promotion of the ICP 9s content; to not promote any browser produced by any of Microsoft 9s primary browser competitors; to not allow any of Microsoft 9s primary browser competitors to promote and highlight the ICP 9s cchannel d content on or for their browsers; and to design its web sites using Microsoft-specific, proprietary programming extensions so that those sites look better when viewed with Internet Explorer than when viewed through a competing browser. These illegal agreements further inhibit competition on the merits between Internet Explorer and other Internet browsers. As with some of its restrictive ISP agreements, Microsoft has recently announced certain modifications of its anticompetitive ICP agreements. However, these modifications do not remedy the anticompetitive effects such agreements have had and do not prevent Microsoft from entering into the same or similar agreements in the future. Collectively, Microsoft 9s contracts with OEMs, ISPs, and ICPs may have unreasonably restrained and may continue to unreasonably restrain competition in the market for Internet browsers. They artificially increase the share of the market held by Microsoft 9s Internet Explorer, and they threaten to ctip d the market permanently to Internet Explorer, not because OEMs or PC customers have freely chosen Microsoft 9s product in a competitive marketplace, but because of the illegal exercise of monopoly power by Microsoft. This case challenges Microsoft 9s concerted attempts to maintain its monopoly in operating systems and to achieve dominance in other markets, not by innovation and other competition on the merits, but by tie-ins, exclusive dealing contracts, and other anticompetitive agreements that deter innovation, exclude competition, and rob customers of their right to choose among competing alternatives. Microsoft 9s conduct may adversely affect innovation, including by: " impairing the incentive of Microsoft 9s competitors and potential competitors to undertake research and development, because they know that Microsoft will be able to limit the rewards from any resulting innovation; " impairing the ability of Microsoft 9s competitors and potential competitors to obtain financing for research and development; " inhibiting Microsoft 9s competitors that nevertheless succeed in developing promising innovations from effectively marketing their improved products to customers; " reducing the incentive and ability of OEMs to innovate and differentiate their products in ways that would appeal to customers; and " Reducing competition and the spur to innovation by Microsoft and others that only competition can provide. Page 8 Michael R. Baye The purpose and effect of Microsoft 9s conduct with respect to Internet browsers have been and, if not restrained, might be: " to preclude competition on the merits between Microsoft 9s browser and other browsers; " to preclude potential competition with Microsoft 9s operating system from competing browsers and from other companies and software whose use is facilitated by these browsers; " to extend Microsoft 9s Windows operating system monopoly to the Internet browser market; and " To maintain Microsoft 9s Windows operating system monopoly. HISTORY OF CASES AGAINST MICROSOFT The July 1994 Monopolization Case On July 15, 1994, the United States commenced an action against Microsoft for unlawfully maintaining its monopoly in the market for PC operating systems. The complaint alleged, among other things, that Microsoft had engaged in anticompetitive agreements and marketing practices directed at OEMs. These agreements included agreements that required OEMs to pay Microsoft for each non-Microsoft operating system that they distributed and long-term agreements that required unreasonably large minimum commitments from OEMs. The effect of Microsoft 9s practices and agreements was unlawfully to maintain its monopoly in the PC operating system market. The Final Judgment prohibited Microsoft from continuing the challenged practices and agreements and prohibited Microsoft from engaging in certain other conduct that could have similar anticompetitive results, including enjoining Microsoft from conditioning licenses to its operating system on an OEM 9s either licensing another Microsoft product or agreeing not to license or distribute a non-Microsoft product. The purpose of this part of the judgment was to prevent Microsoft from conditioning access to its monopoly operating system in order to protect or extend that monopoly. On October 20, 1997, the United States petitioned the court to show why Microsoft should not be found in civil contempt for violating the 1995 Final Judgment by requiring OEMs to license and distribute Microsoft 9s Internet browser as a condition of obtaining a license for Microsoft 9s Windows 95 operating system. On December 11, 1997, the Court entered a preliminary injunction enjoining Microsoft cfrom the practice of licensing the use of any Microsoft personal computer operating system software (including Windows 95 or any successor version thereof) on the condition, express or implied, that the licensee also license and preinstall any Microsoft Internet browser software (including Internet Explorer 3.0, 4.0, or any successor versions thereof) pending further order of Court. d The December 1997 Contempt Proceeding Managerial Economics and Business Strategy, 4e Page 9 On December 15, 1997, Microsoft -- without seeking any modification or clarification of the Court 9s order and without consulting the United States -- publicly announced that any OEM that did not agree to license and distribute Microsoft 9s Internet Explorer could not obtain a license to a working, current version of Microsoft 9s Windows operating system. Microsoft announced that the only versions of Windows 95 available to OEMs that declined to license and distribute Microsoft 9s Internet browser would be (1) a version of Windows 95 that Microsoft itself admitted would not work and (2) a two-and-a- half-year-old version of Windows 95 that Microsoft admitted was not commercially viable. On December 17, 1997, the United States moved to have Microsoft held in contempt for this clear violation of the Court 9s December 11, 1997 Order. On January 21, 1998, the United States entered an order that required Microsoft to provide OEMs with two options in addition to those previously provided by Microsoft: " the option of installing on their PCs a version of Windows 95 that was the same as the current December 1997 version of Windows 95 (OEM Service Release 2.5) cwith the sole exception of Internet Explorer 4.0 functionality d not included; and " the option of shipping their PCs after removing the Internet Explorer cicon d from the desktop and from the cStart menu d within Windows 95. The Appeal of the Court 9s December 1997 Order Microsoft appealed the Court 9s December 1997 order, arguing that since the United States had there brought an action for contempt and for permanent injunctive relief and not explicitly for a preliminary injunction, it was improper for the Court to have entered a preliminary injunction (even though the restraint of a preliminary injunction was less than the restraint that would have been imposed by a finding of contempt); that since the United States was there seeking to enforce the Final Judgment and had not commenced a new action under the antitrust laws, the alleged cintegration d of Windows 95 and Microsoft 9s IE browser was a complete defense; and that antitrust tie-in principles and precedents could not be used to construe the Final Judgment. Microsoft believed the Court 9s December Order cprima facie applied to Windows 98. d Nevertheless, Microsoft did not seek a cfurther order d of the Court regarding Windows 98, nor did it plan to offer an unbundled version of Windows 98. When the United States was informed of Microsoft 9s Windows 98 plans, it offered to join Microsoft in a motion to the Court seeking clarification of the December Order. Instead, Microsoft moved on May 5, 1998, in the Court of Appeals for a stay of the December Order as it applied to Windows 98. On May 12, 1998, the Court of Appeals granted Microsoft 9s application for a stay, holding: cTo the extent that the preliminary injunction awards the United States relief to which it has made no effort to show an entitlement under the consent decree, we must grant the stay. d The Court also held: cThe United States presented no evidence suggesting that Windows 98 was not an 8Integrated Product 9 and thus exempt from the prohibitions of Section IV (E) (I). d Page 10 Michael R. Baye THE RELEVANT MARKETS There are two relevant product markets: The market for personal computer operating systems, and the market for Internet browsers. The PC Operating System Market The market for personal computer operating systems consists of operating systems written for the Intel x86/Pentium (or cPC d) class of microprocessors. These microprocessors perform central processing unit ( cCPU d) functions for the vast majority of personal computers, and their operating systems manage the interaction between the CPU and the various pieces of hardware, such as a monitor or printer, attached to such computers. Operating systems also control and direct the interaction between applications, such as word processing or spreadsheet programs, and the CPU. No other product duplicates or fully substitutes for the operating system. The geographic market for PC operating systems is worldwide. Because of the complex interactions among operating system software, applications software, and the hardware attached to the PC, an operating system written for one class of microprocessors typically will not work on another class of microprocessors without significant modification. Thus, OEMs and PC users do not consider an operating system that runs a non-Intel-based personal computer to be an effective substitute for an operating system that runs an Intel-based personal computer. The Internet Browser Market Internet browsers are specialized software programs that allow PC users conveniently to locate, access, display, and manipulate content and applications located on the web. Internet browsers are essential for quick, easy, and efficient use of the web and have been instrumental in building the Internet 9s popularity. No other product duplicates or fully substitutes for the functionality of Internet browsers. The geographic market for Internet browsers is worldwide. Microsoft's Windows Operating System Monopoly Microsoft markets a variety of PC operating systems, including MS-DOS, Windows 3.11, Windows for Workgroups, Windows NT Workstation, and Windows 95. Beginning in or around June 1998, Microsoft will introduce to the market the latest version of its operating system for Intel-based PCs, Windows 98. Microsoft has maintained a monopoly share (in excess of 80%) of the PC operating system market over an extended period of time. The durability of Microsoft 9s market power in part reflects the fact that the PC operating system market is characterized by certain economies of scale in production and by significant cnetwork effects." In other words, the PC operating system for which there are the greatest number, variety, and quality of applications will be selected by the large majority of PC users, and in turn writers of applications will write their programs to work with the most commonly used operating Managerial Economics and Business Strategy, 4e Page 11 system, in order to appeal to as many potential customers as possible. Economies of scale and network effects, which reinforce one another, result in high barriers to entry. The primary channel through which Microsoft distributes its operating systems is pre- installation on new PCs by OEMs. Because a PC can perform virtually no useful tasks without an operating system, OEMs consider it a commercial necessity to preinstall an operating system on nearly all of the PCs they sell. And because there is no viable competitive alternative to the Windows operating system for Intel-based computers, OEMs consider it a commercial necessity to preinstall Windows on nearly all of their PCs. Both OEMs and Microsoft recognize that OEMs have no commercially viable substitute for Windows, and that they cannot preinstall Windows on their PCs without a license from Microsoft. For example: " Packard Bell executive Mal Ransom said that there were no commercially feasible alternative operating systems to Windows 98; " Micron executive Eric Browning asserted: cI am not aware of any other non- Microsoft operating system product to which Micron could or would turn as a substitute for Windows 95 at this time. d " Hewlett Packard executive John Romano said that cabsolutely there 9s no choice d except to install Windows on HP 9s PCs; and " Gateway executive James Von Holle said that Gateway had to install Windows because cWe don 9t have a choice. d Mr. Von Holle has said that if there were competition to Windows he believed such competition cwould drive prices lower d and promote innovation. When Windows 98 is released, it will most likely quickly succeed to Windows 95's monopoly position because, among other things, applications written for Windows 95 will run on Windows 98 and most consumers who purchase PCs want and expect their PCs to have the latest Microsoft operating system. OEMs will begin shipping most PCs, particularly for non-corporate users, with the Windows 98 operating system as soon as it is released. For example, Hewlett Packard executive Webb McKinney said that even Windows 95 would be a commercially feasible alternative to Windows 98 c[o]only for a short period of time. d Microsoft 9s Position in the Internet Browser Market The first Internet browser widely used by the general public was Netscape Navigator, which was introduced to the market in 1994. Microsoft responded by introducing its own Internet browser, which it called the Internet Explorer. Microsoft released the initial version of Internet Explorer (version 1.0) in or around July 1995. Microsoft has since released three subsequent versions (2.0, 3.0, 4.0), in each case adding features and functionality to the product. Internet Explorer is, and always has been, viewed by Microsoft and by the market as an Internet cbrowser d 4 a separate software program that allows computer users to efficiently locate, access, display, and manipulate content displayed on the World Wide Web. Microsoft and other industry participants carefully track Internet browser market share, and Microsoft has frequently and unequivocally stated that increasing its Internet browser share is its cnumber one d corporate goal. Internet browsers have product requirements, market Page 12 Michael R. Baye usage, demand, distributors, and suppliers distinct from other products, including PC operating systems. These separate attributes, and Microsoft 9s separate commercial treatment of its Internet browser, all will continue after Microsoft releases Windows 98. Microsoft plans to continue to distribute and upgrade a stand-alone version of its Internet Explorer browser, and it has distributed (and plans to continue to distribute) versions of Internet Explorer for use on the Apple Macintosh, Sun Solaris, and other non-Windows operating systems. Microsoft 9s share of the Internet browser market has grown steadily from less than 5% in early 1996 to approximately 50% or more today. With the growth of the Internet and the World Wide Web, consumer demand for Internet browsers has increased dramatically. Indeed, because of the extraordinary growth and importance of the Internet, the Internet browser market is itself a substantial source of potential profits to any company that might achieve a durable dominant position and be able to charge monopoly prices for the efficient use of the Internet or the web. The importance of the Internet and the significant public benefits resulting from its use, make the potential benefit to a monopolist and the potential economic and social cost of monopolization in this market very high. THE COMPETITIVE THREAT THAT BROWSERS POSE TO THE WINDOWS OPERATING SYSTEM Much of Microsoft 9s present monopoly power reflects the fact that Windows is the cplatform d on which most popular applications software must run. Internet browsers, however, offer the potential to become alternative platforms on which software applications and programs could run instead. In addition, browsers can be an cinterface d -- the primary visual environment in which a user performs most computing tasks -- to which both the operating system and application programs can be connected. The browser thus can be a software clayer d between the operating system and application programs. Application programs can be and are written to the browser instead of the operating system interface. Because competing browsers operate not only on Windows but also on a variety of other operating systems, their widespread adoption and use would create significant potential to reduce the dependence of most PC users on any particular operating system, such as Windows. The development of numerous software applications not specific to Windows that could ultimately result from the widespread use of non-Microsoft Internet browsers would therefore greatly reduce or eliminate a key barrier that maintains Microsoft 9s Windows operating system monopoly (because application programs written to interface to a competing browser could run on any operating system). Competing Internet browsers also threaten Microsoft 9s Windows monopoly because such browsers are a primary distribution vehicle for Java virtual machines ( cJVMs d), the software programs necessary to run programs written in the Java programming language. JVMs that use Java enable any application written in the Java language to run regardless of the operating system on top of which the JVM and application are installed. The widespread distribution of Java virtual machines along with non-Microsoft Internet browsers could provide another avenue by which applications developers could write programs that are not dependent on Windows, thereby weakening the network effects that help entrench Windows 9 monopoly position in the operating system market. Managerial Economics and Business Strategy, 4e Page 13 MICROSOFT 9S ANTICOMPETITIVE CONDUCT Faced with the threat browsers posed to its operating system monopoly, and desiring to monopolize the browser market itself, Microsoft undertook steps possibly designed to ensure that it would win what it considers a cbrowser war. d For example: " Microsoft CEO Bill Gates declared on January 5, 1996: "Winning Internet browser share is a very, very important goal for us." On August 20, 1996, Mr. Gates directed: cInternet Explorer will be distributed every way we can. . . . Bundled with Windows 95 upgrade and included by OEMs. d and " In September 1996, Microsoft 9s General Manager for the Windows PC Platform, Carl Stork, noted: cBrowser share is job 1 at this company. d Market and Induce Netscape Not to Compete In May 1995, not long before Microsoft released the first version of Internet Explorer, Microsoft executives visited Netscape and met with its top executives. During this meeting, Microsoft offered Netscape a deal: For Windows 95, Microsoft proposed to draw a hypothetical line between the operating system and the browser. If Netscape agreed not to compete below the line (i.e . , in operating systems) or alternatively, in the production of browsers in the Windows 95 cspace, d Microsoft would agree not to compete above the line (i.e. , in browser applications) or, alternatively, in the production of browsers for platforms other than Windows 95. As one participating Microsoft executive has subsequently admitted, Microsoft cabsolutely d hoped to persuade Netscape not to compete with Microsoft. Microsoft 9s proposal would have divided the browser market between Netscape, the early leader, and Microsoft, which was then on the verge of entering, and would have eliminated the competitive threat potentially posed by Netscape 9s competing browser to Microsoft 9s operating system monopoly. Microsoft 9s proposal was not intended to advance, and would not have advanced, any legitimate pro-competitive interest. Rather, it was a blatant and illegal attempt to monopolize the Internet browser market. Indeed, if accepted, it would readily have enabled Microsoft to monopolize that market. Netscape 9s executives refused Microsoft 9s proposal. They chose instead to continue to compete to serve all computer users, with successive versions of Navigator that work on Windows 95 as well as other PC operating systems. Netscape 9s refusal of Microsoft 9s proposed scheme meant that its competing browser would continue to have the potential to become an alternative platform to Windows; would continue to facilitate the development and distribution of other software with the potential to support applications regardless of the identity of the underlying operating system; and would, thus, continue to threaten to ccommoditize d the operating system and ultimately reduce or eliminate Microsoft's monopoly power. Page 14 Michael R. Baye It seems that Microsoft thereafter embarked on a coordinated course of conduct aimed at eliminating this threat by leveraging its monopoly power to drive competing Internet browsers from the market and to extend its monopoly to the browser market. Exclusionary Agreements with Internet Service Providers and On-Line Services Microsoft unlawfully leverages its Windows operating system to require Online Service Providers (such as America Online and CompuServe) and other major Internet Service Providers (such as AT&T WorldNet, MCI, and Earthlink) to enter into agreements to distribute Internet Explorer to their subscribers, either exclusively or nearly exclusively. ISPs, including OLSs, are sometimes referred to as Internet Access Providers ( cIAPs d). Starting in early 1996, Microsoft began to condition the granting to an ISP of placement in the cInternet Connection Wizard d screens or the Online Services folder in Windows 95 on the service provider 9s agreement to deny most or all of its subscribers a choice of Internet browser. Because nearly all PCs in the United States are shipped with a copy of Windows preinstalled, and because Microsoft prohibits OEMs from replacing or materially modifying the default cdesktop d screen on Windows PCs, nearly all U.S. computer users are guaranteed to see the Windows desktop when they turn on their PCs. Accordingly, placement on the Windows desktop is unique among the numerous ways that software firms, including ISPs and ICPs, promote and distribute their products and services because only this placement offers near ubiquitous distribution and advantageous promotion in exactly the place and context in which users are deciding which software to use. Promotion or distribution of a software product or service through a Windows desktop icon is perhaps unrivaled in its ability to reach the vast majority of PC users in a manner that ensures their attention. No other distribution channel matches the level of convenience, the number of users reached, or the premium placement that Microsoft 9s Windows desktop offers. In return for attractive placement by Microsoft in its Internet Connection Wizard or Online Services Folder, ISPs agreed: " to distribute and promote to their subscribers Internet Explorer exclusively or nearly exclusively; " to eliminate links on their web sites from which their subscribers could download a competing browser over the Internet; " to abstain from expressing or implying to their subscribers that a competing browser is available (and from displaying a logo for a non-Microsoft browser on the service provider 9s home page or elsewhere); " to include Internet Explorer as the only browser they shipped with their access software (i.e. , the software that enables a PC user to subscribe to the service) most or all of the time; and " to limit the percentage of competing browsers they distributed, even in response to specific requests from customers. Microsoft 9s agreements with ISPs also require the ISPs to use Microsoft-specific programming extensions and tools in connection with the ISPs 9 own web sites. Web sites developed with these Microsoft-specific programming extensions and tools will look better when they are viewed with IE than with a non-Microsoft browser. Under Microsoft 9s ISP Managerial Economics and Business Strategy, 4e Page 15 contracts, the penalty for promoting a competing browser, distributing a competing browser more than the maximum permitted percentage, or otherwise failing to provide preferential treatment for Microsoft 9s Internet browser, is deletion from the Windows desktop -- a penalty even the largest ISPs are unwilling to risk. Microsoft recognizes the importance to ISPs of favorable placement on Windows screens. For example: " Brad Silverberg (Microsoft's former Senior Vice-President of its Applications and Internet Client Group) described such placement as "a distribution facility" for service providers that was "a tremendous value to them."; and " In order to induce AOL to prefer IE and disadvantage Netscape's browser, Microsoft agreed to give AOL preferential placement in Windows at the expense of Microsoft's own online service (Microsoft Network, or "MSN") that competed with AOL -- thereby effectively, according to Microsoft's CEO Bill Gates, "putting a bullet through MSN's head." The "browser war" was so critical to Microsoft that it was prepared to retreat in other markets in order to win it. In late April 1998, on the eve of hearings before a committee of the United States Senate and immediately following news reports that the United States had issued civil subpoenas to various ISPs about their agreements with Microsoft, Microsoft announced that it was modifying its contracts with certain ISPs. Significantly, Microsoft has not changed its exclusionary contract requirements with the largest and most important ISPs -- the Online Service Providers, including AOL and CompuServe. Microsoft 9s exclusionary agreements continue in full force and effect for these firms. Even as to the ISPs whose contracts Microsoft has chosen to change, Microsoft 9s belated announcements, made on the eve of Congressional scrutiny and under the threat of litigation, do not correct the anticompetitive effects of the provisions which have been in place for almost two years; nor do the announcements provide any assurance that Microsoft will not reinstitute the exclusionary restrictions in the future. Moreover, they do not eradicate all of the unlawfully restrictive aspects of even the ISP agreements they modify because they leave intact (according to Microsoft 9s Cameron Myhrvold, the executive responsible for dealing with ISPs) requirements that ISPs distribute and promote Internet Explorer at least at parity with any other browser. Finally, and perhaps most significantly, Microsoft 9s modifications, by its own admission, do not apply at all to OLSs, which as a group provide Internet access to more than fifty percent of Internet users in the United States. Thus, the modifications provide no relief from Microsoft 9s anticompetitive restrictions as to most browser distribution through ISPs. Approximately one-third of Internet browser users obtained the browser they use from their service provider, and Microsoft 9s exclusionary agreements with these firms substantially foreclose Microsoft 9s browser competitors from a vital means of distribution. As Microsoft has itself acknowledged, distribution of Internet browsers through the largest online services providers is critical to the competitive success and viability of any browser. Microsoft 9s Cameron Myhrvold testified that for browsers cthe ISP channel and the OEM channel are the two most important channels for distribution. d Microsoft substantially Page 16 Michael R. Baye foreclosed the ISP channel with agreements with ISPs, and (as discussed below) Microsoft substantially foreclosed the OEM channel through agreements with OEMs. The exclusionary restrictions in Microsoft 9s ISP agreements are not reasonably necessary to further any legitimate, pro-competitive purpose. Potentially Exclusionary Agreements with Internet Content Providers Microsoft has also entered into exclusionary agreements with Internet Content Providers ( cICPs d) -- firms such as Disney, Hollywood Online, and CBS Sportsline that provide news, entertainment, and other information from sites on the web. One of the new features included in Internet Explorer 4.0 is the provision of "channels" that appear on the right side of the Windows desktop screen after Internet Explorer 4.0 has been installed on a Windows 95 PC. The same channels will appear automatically on the Windows 98 desktop screen if Microsoft is permitted to tie Internet Explorer 4.0 to Windows 98 in license agreements with OEMs and in sales to consumers. Microsoft provides different levels of channel placement, "platinum" being the most prominent. Under Microsoft 9s Internet Explorer 4.0 channel agreements, beginning in mid- 1997, ICPs who desired "platinum" placement (and even some seeking lower-level placement) were required to agree: " not to compensate in any manner the manufacturer of an "Other Browser" (defined as either of the top two non-Microsoft browsers), including by distributing its browser, for the distribution, marketing, or promotion of the ICP 9s content; " not to promote any browser produced by any manufacturer of an cOther Browser d; " not to allow any manufacturer of an cOther Browser d to promote and highlight the ICP 9s cchannel d content on or for its browsers; and " to design its web sites using Microsoft-specific, proprietary programming extensions so that those sites look better when viewed with Internet Explorer than when viewed through a competing browser. These exclusionary restrictions are not reasonably necessary to further any legitimate, pro-competitive purpose. Notwithstanding these restrictions on their dealings with competing browsers, ICPs have entered into Internet Explorer 4.0 channel agreements with Microsoft. ICPs had to agree to these restrictions in order to gain placement on the Windows desktop, which provides a valuable distributional and promotional mechanism for their content. Microsoft 9s exclusionary ICP contracts, expressly targeted at its primary Internet browser competitors, further foreclose these firms from access to customers, and further impede their ability to compete against Internet Explorer on the merits of the respective products. Microsoft has recently announced that it intends to change its agreements with ICPs. However, the changes announced by Microsoft will not remedy the anticompetitive effects the exclusionary provisions of those agreements have had to date, and there is no certainty that Microsoft will not re-impose the same or similar restrictions in the future. Managerial Economics and Business Strategy, 4e Page 17 Microsoft 9s Contractual Restrictions on OEM Modification or Customization of PC Boot-Up Sequence and PC Screens In or around August 1996, Microsoft imposed on OEMs licensing terms that restrict OEMs 9 ability to alter the Windows 95 boot-up sequence. Specifically, among other things, Microsoft 9s license agreements prohibit OEMs from: " modifying or obscuring the sequence or appearance of any screens displayed by Windows from the time the user first begins the boot-up process with a new PC until the cWelcome to Windows d screens have run and the Windows desktop screen first appears; " modifying or obscuring the sequence or appearance of any screens displayed by Windows in all subsequent boot-ups unless the user initiates some action to change the sequence; " displaying any content, including visual displays, sound, welcome or tutorial screens, until after the Windows desktop screen first appears; " modifying or obscuring the appearance of the Windows desktop screen, beyond a narrowly limited set of permitted changes; or " adding a screen that would automatically appear after the initial boot-up sequence or in place of the Windows desktop screen. These contractual restrictions have (and were intended by Microsoft to have) two basic effects on competing browser suppliers. First, they enhance Microsoft's control over the screens presented to users and thus increase Microsoft's ability to require preferential treatment for Internet Explorer from ISPs and ICPs in return for such ISPs 9 and ICPs 9 access to the Windows desktop. Second, these contractual restrictions greatly limit an OEM 9s ability to modify or customize the screens or initial cboot-up d sequence on a new PC either in response to customer demand or in an attempt to differentiate their products, or to substitute or feature a non-Microsoft browser, alternative user interface, or other Internet offerings. The Windows desktop screen is the screen through which most PC users access application programs and the other functionality on their PCs. The desktop screen contains, among other things, icons (i.e. , graphical representations of certain features or functions) that, when selected by cclicking d on the icon with the left button of the cmouse, d provide quick access to other installed software. Microsoft places a number of icons on the Windows desktop screen, prohibits OEMs from removing any of them, and permits OEMs to add others only subject to strict limitations. Although Microsoft allows some customization of the cActive Desktop d in Windows 98 and Internet Explorer 4.0, an OEM may not delete icons or folders. Furthermore, an OEM that does not preinstall the Active Desktop may not add to Windows desktop screens new icons or folders that are of a size or appearance different from those already placed on the desktop by Microsoft. Through these restrictions, Microsoft leverages its Windows monopoly to ensure that Microsoft-designated applications or other software reach all new Windows users, and that no software not designated by Microsoft receives preferential placement, no matter which OEM has built the computer or what options the OEM would like to have in presenting Page 18 Michael R. Baye software products to its customers. Moreover, these restrictions ensure that users of Windows continue to see the Microsoft-specified Windows desktop unless and until they take affirmative steps to change the screens presented. The restrictions preserve the advantageous desktop positioning that Microsoft secures for Internet Explorer and other Microsoft or Microsoft-designated software, foreclose competing Internet browsers from securing preferential placement, and foreclose OEMs from choosing among competing browsers on the merits. Microsoft 9s refusal to permit OEMs to alter the initial boot-up sequence and screens, or to install an alternative user interface, precludes OEMs from developing such alternative interfaces on their own or with competing browser suppliers. The effect of these restrictions is to significantly restrict the access of competing browsers to the important OEM channel and further perpetuate Microsoft 9s operating system monopoly by making the successful introduction of a new platform more difficult. OEMs (including Micron, Hewlett Packard, and Gateway) have requested that Microsoft allow them to provide new PC purchasers with an alternative user interface, boot- up sequence, or initial or default screens, but Microsoft has refused. Microsoft recognizes and intends that these restrictions consolidate its strategic power over the valuable real estate that the desktop screen represents for the provision of software, advertising and promotion. Indeed, Microsoft 9s Vice President of Marketing and Developer Relations made clear in an internal document that the underlying purpose of the restrictions was to prevent OEMs or others from ultimately gaining control over the desktop: "In order to protect our position on the desktop and increase the likelihood that IE gets the prominent position with the end user we should move the [Internet] Sign Up Wizard into the boot- sequence some where, before we give control over to the OEM. . . ." In Windows 98, Microsoft has done exactly as its Vice President of Marketing and Developer Relations urged, moving the Internet Connection Wizard feature of Internet Explorer, which presents new users with the ability to sign up (at the time of the initial boot and before the Windows desktop appears) with any of a number of ISPs, none of which (according to Microsoft 9s Cameron Myhrvold) is permitted to distribute or promote any other browser more favorably than Internet Explorer. Microsoft 9s boot-up and first-screen restrictions make it more difficult for competing browsers to attract users and have resulted in fewer choices for OEMs and PC end users. These restrictions are not reasonably necessary to serve any legitimate, pro-competitive purpose. The Tying of Microsoft 9s Internet Browser Software to Windows 95 Internet Explorer is recognized by both Microsoft and the industry as a product separate and apart from Windows. For example: " Microsoft has always sold Internet Explorer separately at retail, distributed it separately through the Internet, and paid for it to be distributed separately; Managerial Economics and Business Strategy, 4e Page 19 " Microsoft has distributed Internet Explorer as a separate product through ISPs and other channels and has tied and conditioned the access of numerous companies (e.g. , ICPs and ISPs) to Windows facilities on such companies 9 distribution of Internet Explorer as a separate product; " Microsoft and the industry separately track browser market share and operating system market share; " Microsoft bundles, and plans to continue to bundle, the stand-alone version of IE 4.0 with other application programs (e.g. , Word, Works, Encarta) in a package that will be the successor to the Microsoft Works and Microsoft Home Essentials packages; " Microsoft promotes, and enlists others to promote, the distribution and use of Internet Explorer as a separate product; " ISPs consider IE to be a separate product from Windows, and, recognizing the demand for a browser separate from the operating system, Microsoft deliberately markets it as such to ISPs; " Internet browsers and operating systems perform different functions; and " Microsoft markets Internet Explorer for non-Windows operating systems, including operating systems produced by Apple Computer and Sun Microsystems. Indeed, Microsoft devoted a substantial effort towards developing these versions of its Internet Explorer -- a counter-intuitive step (i.e. , enhancing the capabilities and functionality of non-Windows, non- Microsoft operating systems) that is in Microsoft's interest because it is part of Microsoft's effort to foreclose opportunities for non-Microsoft browsers to establish themselves. Microsoft 9s Paul Maritz believed in June 1996 that in order to accomplish its browser share objectives: cIn addition to shipping IE 3 on W95/NT, we need to get AOL & CompuServe shipping IE3. We need to ship IE3 on Win 3.1 & Mac. d There is separate demand for Internet browsers from the demand for operating systems. For example: " many PC users (who, of course, require an operating system) do not need or want a browser; " for a significant number of customers, the forced inclusion of a browser with the operating system is a significant negative -- including corporate customers who do not want their employees connected to the Internet and customers that would prefer only a different browser. Microsoft has acknowledged that some OEMs and PC users want to be able to delete Internet Explorer from Windows 95 and has provided the ability, through the Add/Remove utility, for them to do so; " many customers who want a browser do not need another operating system -- a majority of all browsers distributed to date have been distributed to users who already had a PC with an operating system installed; and " other PC customers want an up-to-date Windows operating system together with non-Microsoft browsers. Page 20 Michael R. Baye Microsoft has consistently treated and referred to its browser software as a separate product, and not merely as a component of the operating system, both internally and in agreements with other companies. However, over "the last couple of years" Microsoft was told by its counsel to be ccareful d not to refer to its browser software in such a way that it appeared that the software was a separate product. Microsoft executives became cvery concerned d that statements in the ordinary course of business made IE cappear separate d and concluded it was ccritical d that there be ca thorough walk-through looking for places in the UI that can be corrected" and that there be a csweep d of the IE web site to remove references inconsistent with Microsoft's present legal position. It was agreed that there would be ca review of win 98" by Microsoft executives and csomeone from legal staff d to censure IE is properly presented. d Microsoft recognized that there was a potential danger that a competing Internet browser could eventually cobsolete Windows. d Microsoft also recognized that Netscape was initially the leading browser supplier and that Netscape 9s csurvival depends on their ability to upgrade a significant chunk of their installed base. d Microsoft 9s top executives internally declared that gaining browser market share for Internet Explorer and depriving Netscape of market share was a top priority. Microsoft recognized, however, that it could not win what it described as the cbrowser war d on the merits alone, even if it gave its browser away for free 4 indeed, even if it paid bounties for its distribution. Microsoft concluded that to win the browser war and preserve its Windows monopoly it would have to tie its Internet browser to the Windows 95 operating system that was being preinstalled on most new PCs. For example, Microsoft 9s Megan Bliss and Rob Bennett recognized that designing Windows 95 cto win the browser battle d required ca very substantial set of trade-offs. d Nevertheless, they concluded the ckey factors to keep in mind d were, first, the need to increase browser share and, second, that the way to do that was: cLeveraging our strong share on the desktop will make switching costs high (if they get our technology by default on every desk then they'll be less inclined to purchase a competitive solution. . . .). d Accordingly, Microsoft tied Internet Explorer to Windows 95 and continued to do so until January of this year, when it came into compliance with an Order of the Court prohibiting it from distributing its Internet Explorer browser as a condition of licensing Windows 95. Microsoft effectuated this tie, among other things, by requiring, as a condition of licensing Windows 95, that OEMs also license, install and distribute Microsoft 9s Internet browser software, including software that provides the Internet Explorer icon and the other means by which users may readily use IE to browse the web. It is this software that establishes Internet Explorer 9s identity for commercial purposes as a separate product. Microsoft's internal docume

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