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IN THE UNITED STATES DISTRICT COURT
TABLE OF CONTENTS
Table of Contents
Declaration of David S. Sibley
1. My name is David S. Sibley. I am the John Michael Stuart Centennial Professor of Economics at the University of Texas at Austin. I received the degree of B A. in Economics from Stanford University in 1969 and a Ph.D. in Economics from Yale University in 1973. In addition to my current teaching responsibilities, I have taught graduate level courses in economics at the University of Pennsylvania and Princeton University. Prior to joining the University of Texas. I was Head of the Economics Research Group at Bell Communications Research. I have also served as a Member of the Technical Staff in economics at Bell Laboratories. During the last twenty-five years, I have carried out extensive research in the areas of industrial organization, microeconomic theory, and regulation. My publications have appeared in a number of leading economic journals, including the Journal of Economic Theory, Review of Economic Studies, Rand Journal of Economics, American Economic Review, Economeirica, and the International Economic Review, among others. I am also a co-author (with Steven J, Brown) of a leading textbook on monopoly pricing, THE THEORY OF PUBLIC UTILITY PRICING, which was first published by Cambridge University Press in 1986 and is now in its fourth printing. A copy of my curriculum vitae is attached to this declaration.1
2. I have been asked by the Antitrust Division of the United States Department of Justice to examine the competitive effects of Microsoft Corporation's ("Microsoft's") contractual restrictions (including the bundling of its Internet browser with the Windows 98 operating system) in its agreements with personal computer original equipment manufacturers ("PC manufacturers" or "OEMs"), Internet access providers ("IAPs"), and Internet content providers ("ICPs"), In particular, I examined Microsoft's bundling and other contractual practices to determine whether these actions represent anticompetitive behavior undertaken by Microsoft to maintain a monopoly in the market for operating system software used to run Intel-compatible desktop PCs ("PC operating system market," or "OS market"), I also studied whether Microsoft's actions represent anticompetitive behavior undertaken to establish a monopoly in the market for browsers.
3. In conducting this analysis, I examined: (1) public documents and websites containing relevant information; (2) certain confidential Microsoft and third party documents supplied to me by the Department of Justice; (3) deposition transcripts of personnel from Microsoft and other companies, including OEMs, IAPs, and ICPs; and (4) relevant books and articles from the economic literature in antitrust and industrial organization.
4. In analyzing the competitive affects of Microsoft's conduct, I proceeded in three steps. Each of these steps, and the conclusions drawn from my analysis of relevant data, are summarized as follows. First, I examined whether Microsoft possesses a dominant share of the PC operating system market, and whether it has monopoly power in that market. I found that Microsoft has monopoly power because of entry barriers in a bottleneck input in computing -- the operating system. Second, I examined whether Microsoft's contractual practices affecting browser choice would be profitable on their own, regardless of its monopoly power; or, alternatively, if the profitability of its practices depended on impeding competition in the operating system and browser markets. In particular, Microsoft appears to be concerned about the potential of the browser to serve as a software applications platform that would run on operating systems other than those produced by Microsoft. I conclude that, if Microsoft were not attempting to impede this type of competition, it would encourage the sale of all browsers (including those of its rivals), since greater browser sales would increase the demand for its operating system and increase the profit which could be obtained from users wanting to access the Internet (e.g.,, by increasing the price of the OS). In fact, I found Microsoft's contractual practices constrained consumers' choice of browsers, thus resulting in a diminution of profits that could most plausibly be recouped only because of competitive restraints in the OS market. Importantly, these contractual restrictions have minimal or non-existent offsetting efficiency justifications. Third, I examined whether Microsoft likely can recoup the reduction in profits resulting from its restrictive practices. I found that Microsoft is likely to recover its lost profits by blunting direct and indirect competitive threats to its OS monopoly and by gaining market power in Internet-related markets, Microsoft's restrictive practices add to the natural entry barriers associated with the OS market by inhibiting the use of competing internet browsers as software applications platforms that are independent of any particular underlying operating system. This deters future entry into the OS market and protects Microsoft's current monopoly power.
5. An alternative line of reasoning leads to the same conclusion as that drawn from the three-step analysis described above. Because contractual agreements with OEMs, IAPs, and ICPs impose exclusionary restrictions on the use of a competing browser, Microsoft blunts the threat to its OS monopoly posed by the browser's potential as an alternative platform for software applications. Based on my review of internal Microsoft documents, these exclusionary restrictions were imposed with this threat very much in mind. Furthermore, the analysis presented below demonstrates that these restrictions have few apparent purposes aside from discouraging the use of competing browsers. These findings, as well as the three-step analysis outlined in paragraph four, lead me to conclude that Microsoft's contractual practices constitute anticompetitive behavior.
6. The development of the high-tech, computer industry has had a profound positive effect on the nation's economy and the economic welfare of all consumers. The growth of software and computer companies has accounted for almost thirty percent of the increase in gross domestic product since 1994, and it is estimated that commerce conducted over the rapidly expanding Internet will surpass $180 billion dollars annually in the beginning of the next millennium.2 The absence of effective competition in two important segments of the software industry (PC operating systems and browsers) will not only affect the price that consumers pay for these products but, perhaps more importantly, it will also change the pattern of innovation that has characterized this dynamic industry. Innovation is a driving force in economic progress because it affects the quality of existing products in the marketplace and the development of new and better products. Actions taken to increase competition in this industry may well be among the most critical economic policy decisions facing the nation today. The artificial entry barriers erected by Microsoft (through its restrictive practices, including bundling) will have the effect of slowing or halting the natural tendency of the marketplace to provide alternative technologies, reducing the welfare of many consumers. If current trends in market share continue, the browser market is likely to tip to a Microsoft monopoly soon, eliminating the competitive threat Microsoft faces from Internet browsers that have the ability to run software applications independent of any particular operating system. If this happens, the Microsoft browser may well become the bottleneck input for Internet-related markets.
7. For the purposes of antitrust analysis, the relevant operating system market is the market for personal computer operating systems that are compatible with Intel x86/Pentium (or Intel-compatible) microprocessors. This definition is motivated by the product market definition given in the U.S. Department of Justice and Federal Trade Commission Horizontal Merger Guidelines, and is, in my view, consistent with accepted economic theory.3 A proposed product market defined under the Merger Guidelines is accepted as corret if a price increase in the proposed market would not cause demand to shift to products outside the proposed market to such an extent as to dissuade a hypothetical profit maximizing monopolist from imposing a "small but significant and nontransitory" price increase.4 Because I am evaluating here an allegation of maintaining monopoly power as opposed to evaluating a merger, I adopt this definition with the clarification that the initial price level prior to the price increase be a competitive price level.
8. In order to implement this methodology, I begin by noting that the licensing fee for the vast majority of the operating systems currently licensed by Microsoft to OEMs is approximately $65.5 If a hypothetical monopolist were to increase price by ten percent above this level6, this would represent an increase of no more than four-tenths of one percent in the price of a $1,500 computer, (For a $1,000 computer, the additional $6.50 represents an increase in price of no more than seven-tenths of one percent.) It seems implausible that a price increase of less than one percent would cause a significant number of buyers of PCs with Intel (or Intel-compatible) microprocessors to switch to Apple or UNIX PCs not using an x86 or Pentium chip, let alone forego the purchase of a PC entirely. Industry experts corroborate this conclusion.7 Therefore, a hypothetical monopolist that was the only supplier of operating systems for Intel and Intel-compatible PCs would find it profitable to increase price by ten percent over a competitive level The reasoning is that for an end user to switch from the Intel-based PC to an Apple computer, for example, usually requires the end user to incur substantial switching costs, in both time and money, to learn to use the different system. Moreover, as discussed below, even if the product market were more broadly defined to Include desktop operating systems for all PCs, such as those offered by Apple and UNIX that do not use Intel (or Intel-compatible) microprocessors, Microsoft's market share would fall only slightly (see discussion below) and its monopoly power would remain.8
9. Internet browsers are in a separate relevant product market. An Internet browser is a specialized software program that allows computer users to locate, access, display and use applications located on the Internet's World Wide Web or on internal corporate computer networks known as intranets.9 Today, a browser is the predominant conduit to the Internet and allows computer users to access and view "pages" on the World Wide Web. Browsers constitute a separate product market because a distinct consumer demand exists for browsers, apart from operating systems, as evidenced, for example, by the many PC users who obtain the Internet browsers they use as a stand-alone product apart from the OS.10 In fact, many corporate users purchase only an operating system and do not want a browser at all.11 Moreover, OEMs have a separate demand for a particular browser apart from the Microsoft operating system, as evidenced by CEM's desire to remove the version of Internet Explorer ("IE") packaged with Windows 95 (with the option of replacing IE with another browser).12
10. The view that Internet browsers constitute a separate product market is further supported by the fact that browsers are marketed and distributed independently from PC operating systems. Significantly, Microsoft independently markets, distributes, and monitors the distribution of its Internet Explorer browser software even though it is also bundled with its Windows 95 operating system. In addition, Microsoft intends to offer a version of IE (referred to as IE 5.0} after Windows 98 is released.13 Microsoft's marketing and distribution channels for IE provided apart from its operating system are numerous: IE is available on the Microsoft website for consumers to "download" directly to their PCs; Microsoft has agreements with IAPs that allow them to distribute IE to their subscribers; and Microsoft sells IE as a stand-alone product at retail software outlets. Microsoft has even developed and distributed versions of the IE browser for Apple Computer's Macintosh and the Sun Solaris operating system, both non-Microsoft operating systems. Finally, Netscape, Microsoft's principal browser competitor, also distributes its browser product apart from an operating system.
11. In many software markets, including the OS market, there are fundamental forces which may lead to one firm being dominant at a given time and which tend to create barriers to entry. These forces have been widely discussed in the economics and computing literature. Very briefly, they are as follows:
Economies of Scale. For complex software such as an OS. the initial, or first-copy, costs to writing software are often very large, whereas the incremental cost of producing additional copies is small. Hence, average cost declines as the scale of output rises.
Both economies of scale and increasing returns in consumption, when combined with the lock-in effect created by consumer switching costs discussed below, create natural barriers to entry,
12. Increasing returns to consumption and economies of scale give rise to a phenomenon which lies at the heart of antitrust analysis of network industries: monopoly tipping.15 If a large set of users adopts a new network technology, then that technology becomes more attractive to everyone else due to increasing returns in consumption. As more users join, the technology becomes still more attractive until it becomes dominant; in economic terminology, the market has "tipped" to the new technology. Once tipping has taken place, there are forces that tend to keep the victorious technology dominant until a new, much improved product is developed; incremental improvements are unlikely to be successful. Users invest time and money in learning to use a given technology proficiently. If at some future date a still "newer" technology were to become available, potential users of the newer technology would have already incurred those learning costs on the older one. Therefore, in considering whether or not to adopt the newer technology, potential users would weigh the possible benefits of the newer technology against the switching costs of learning that technology, given that they already know the old technology. Thus, for the newer technology to succeed, it would have to offer a substantial improvement in performance, i.e., enough of an improvement at least to overcome the switching costs associated with the change. In the normal course of markets and competition, such improvements do, in fact, occur. An example is the displacement of slide rules with pocket calculators.
13. The economic theory of network effects describes well the performance of the OS market. As Microsoft itself has stated: "The availability of a rich variety of quality applications software that will ran on a particular operating system is fundamental to its success. This fact has been recognized by publishers of operating systems for years."16 In the computer industry, the theory of network effects is known as "positive feedback." The concept of positive feedback recognizes that as an operating system gains popularity, the incentive to develop software for that operating system grows since the number of potential customers for the application developer is larger. This, in turn, increases the value of the operating system (and likely its market share) which is determined by the quality and variety of software applications written for it. As the OS gains market share, software developers find it even more advantageous to produce additional applications for that system, and so on. As noted by Dr. Nathan Myhrvold, a Senior Vice President of Microsoft, the positive feedback effect has been responsible for the phenomenal strength of leading software products in both applications and operating systems,"17 Dr, Myhrvold also notes that the exchange of data between computer users is facilitated by computer and computer software compatibility. He observes "the laws of positive feedback govern any system where compatibility with other users is either directly or indirectly a key factor in the utility of a product or service."18 Positive feedback explains the importance of the number of complementary software applications and the installed base of these applications as a natural barrier to entry, and also why alternative operating systems already in the market at a small scale (such as Unix) are not effective competitors,
14. A predictable consequence of the installed base of applications is evidenced by Table One, which presents market share information for operating systems that rely on Intel x86/Penttum (or Intel-compatible) microprocessors, Microsoft's market share in each period from 1991 to 1997 holds consistently at about ninety percent.19 Microsoft's OS dominance is stable; has hardly fluctuated in the face of determined attempts at entry by rival operating systems; and is forecast to remain stable in the future.20
15. To illustrate the importance of the installed base as an entry barrier, it is instructive to review the experience of IBM's OS/2 operating system. This operating system, first released in 1987, was designed to compete with Microsoft Windows. In 1994 and I995} IBM installed OS/2 on its own Aptiva line of computers, but retailers and consumers routinely demanded software applications that were not available on OS/221 In response, IBM abandoned its practice of installing OS/2 on the Aptiva computer, choosing instead to license Windows from Microsoft.22 Similarly* Packard Bell negotiated with IBM in 1994 to license OS/2 for preinstallation on the Packard Bell PC because Packard Bell was interested in the possible price advantage that OS/2 might offer. But, when IBM stated "in addition to our operating system you need Windows"23 to ensure software compatibility, Packard Bell decided to license Windows from Microsoft directly and not install OS/2,
16. The importance of an installed base of applications software as an entry barrier is further demonstrated in the analysis of Mr. Joachim Kempin, Senior Vice President of OEM Sales for Microsoft. In discussing what could "derail" Microsoft's OS pricing strategy, Mr. Kempin stated:
Our high prices could get a single OEM (Compaq might pay us 750M$ next year) or a coalition to fond a competing effort (say in India). While this possibility exists I consider it doubtful even if they could get a product out that they can market it successfully, leapfrog us and would not deviate from their own standard to differentiate. Could they convince customer [sic] to change their computing platform is the real questions [sic]. The existing investments in training, infrastructure and applications in windows computing are huge and will create a lot of inertia. No kindling of OS on low end systems would be the easiest way to hurt us - but who would want to start with this and loose [sic] business.24
17. Based on the above discussion, it should be clear that in markets such as OS software, certain economic forces can lead naturally to dominance by a single firm, even apart from exclusionary restrictions. (There are, of course, other countervailing factors that tend to perpetuate competition, such as product differentiation,) ff a single firm does achieve dominance, these forces lead to entry barriers which protect that dominance. In themselves these facts do not warrant competitive concern. Preeminence in a market is the market's own way of rewarding excellence. Indeed, there is no reason to think that the market, left to itself, will not generate alternatives to Microsoft's operating system that will be sufficiently superior to overcome the entry barrier advantage that Microsoft enjoys. For example, in an insightful article, Evans and Schmalensee25 point out how tipping was reversed in the case of stereo long playing record players, a technology with a huge installed base of recordings, by the CD technology, which started with no recordings at all.
18. The bundling and other contractual browser restrictions that Microsoft insists upon in its agreements with OEMs, IAPs, and ICPs add artificial entry barriers to those that occur naturally, and are therefore a source of competitive concern. These artificial entry barriers have the effect of slowing or halting the natural tendency of the marketplace to provide alternative technologies that compete with Microsoft. Specifically, these restrictions are currently threatening the potential of competing Internet browsers that can run software applications independently of the Windows operating system and that therefore challenge the dominance of the Windows OS. Bill Gates recognized this threat when he stated: "They (Netscape] are pursuing a multi-platform strategy where they move the key API into the client [browser] to commoditize the underlying operating system." 26 This is the subject of the next section.
19. In this section, I carry out the second step of the three-stage analysis outlined in paragraph four above. After describing the browser restrictions contained in the Microsoft agreements with OEMs, IAPs, and ICPs, I analyze their competitive effects and conclude that they are likely to enable Microsoft to monopolize the browser market, thereby removing the Internet browser as a software platform that can exert competitive pressure on the OS market where Microsoft has monopoly power. I also examine possible legitimate business justifications for the browser restrictions and conclude they are likely to be minimal or non-existent,, so that the main effects of the restrictions are to reduce profit to Microsoft from browsers and the Internet. Such practices therefore appear to make sense only in their entry-deterring effects in the OS market. Finally, I address the issue of Microsoft's distributing its browser without charge,
20. Table Two presents a summary of the restrictions in Microsoft agreements with OEMs, IAPs (including online service providers and Internet service providers ("ISPs")), and ICPs which have anticompetitive effects. Taken together, these constitute a powerful force against the use of non-Microsoft browsers in four main distribution channels. (Whether or not these restrictions have countervailing benefits will be discussed in Section IZI.B.)
21. Consider first the OEM agreements. To obtain licenses to preinstall Windows on the PC, OEMs have agreed to restrictions designed to deter them from preinstalling and promoting a competing browser. The requirement that the OEM not modify the OS software has been used to prevent OEMs from offering the OS without the IE browser. It also prevents OEMs from removing the IE icon or replacing it with the
Original Equipment Manufacturer Agreements:
Online Service Folder Agreements: