Designing to Destroy: Predatory Design, High Technology, and Microsoft

The type of predatory behavior typically illustrative of an antitrust violation involves pricing; however, there are other ways for monopolists to act predatorily towards an anti-competitive end. Using one's monopoly status to act anti-competitively in the design and release of new products to the market is one such method. This method, termed "predatory design," has been a source of growing controversy that has recently been placed in the national and even global spotlight via the recent findings of fact issued by Judge Jackson in the antitrust case brought against the software leviathan Microsoft Corporation.[1] The controversy over predatory design is that on the one hand, the antitrust laws seek to protect competition by preventing the anti-competitive actions of a monopoly; but, on the other hand, such laws should not be used to prevent new innovations demanded by the marketplace.

The argument that the antitrust laws can be used to quash innovation is the basic premise of Microsoft’s defense, which asserts that its innovative spirit is being unfairly crushed by the government. Before any analysis of the Microsoft finding of fact, however, it is first necessary to examine the concept of predatory design and the policy underpinnings that form the basis for the controversy between antitrust enforcement and the promotion of innovation. Such analysis begins with the case of United States v. Aluminum Co. of America ("Alcoa").[2]

In Alcoa, Justice Hand first provided a rationale for recognizing the potential for antitrust laws to adversely affect innovation. Hand wrote: "A single producer may be the survivor out of a group of active competitors, merely by virtue of his superior skill, foresight and industry ... The successful competitor, having been urged to compete, must not be turned upon when he wins." [3] He went on to specify that such a successful company may not have sought, but rather have been unavoidably thrust into a monopoly position as a result of innovation and product superiority. Strangely enough, however, Hand also made the following statement: "[N]o monopolist monopolizes unconscious of what he is doing."[4] How can these two statements be correlated? If a monopolist cannot unconsciously monopolize then how can a company be unavoidably thrust into a monopoly position as a result of successful innovation?

But if intent is really irrelevant in assessing the evils of monopoly, then how can one allow a company to operate as a monopoly, even if such status was achieved through the use of cunning foresight and innovation? On the other hand, however, the legal destruction of a company that achieved its position through the use of innovation and foresight would go against the very policy of promoting innovation that is behind antitrust laws. The answer to this question must not be concerned with the path to becoming a monopoly but rather with what the monopoly plans and does to maintain its monopoly status.

This discussion of intent is perhaps clarified in the case of United States v. Griffith, involving a theater chain and its intent to monopolize the distribution of films.[6] In this case, the Court looked at whether the use of monopoly power to prevent competition, as opposed to destroying competition, was a violation of the Sherman Act. Although the Court found that a specific intent to restrain trade was not always necessary in order for the antitrust laws to be violated, the Court recognized that "the existence of power 'to exclude competition when it is desired to do so' was itself a violation of §2 [of the Sherman Act], provided it was coupled with the purpose or intent to exercise that power." [7] Thus, the Court concluded that "the use of monopoly power, however lawfully acquired, to foreclose competition, to gain a competitive advantage, or to destroy a competitor, is unlawful."[8] It follows from the Court's rationale that each of these acts that negatively affect competition must be planned by the monopolist in order to be a violation of antitrust laws. Hence, the Griffith Court allowed for a lawfully created monopoly but prevented the monopoly from committing anti-competitive acts to further its monopoly position.[9]

But what about the concept of innovation? At what point must a monopolist curtail its innovative effort in the face of using its monopoly power as a competitive advantage? To what extent may that company prevent the abuse of its innovation by free-rider companies who enter the market and reap the rewards of the innovation without any of the investment? The government has provided one answer to these concerns in the form of patents.

Article 1 section 8, clause 8 of the U.S. Constitution grants Congress the power to "promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries."[10] With respect to inventions, this power has been codified in the Patent Code, Title 35 of the United States Code, which grants an inventor, for a limited time, a monopoly against all the world.[11] The inventor or a future assignee has the right to exclude all others from making, using, or selling the invention for a specified period; in the case of a letters patent, the term granted is twenty years from the date of filing the invention with the United States Patent and Trademark Office. In return for this limited monopoly power, an inventor discloses the invention to the world in the form of a published document that allows future inventors to build upon prior knowledge.

Thus, without this disclosure to the world that releases knowledge that one has with respect to an invention, there can be no legal monopoly surrounding that invention. As a result, the essence of predatory design concerns the ability of a corporation to make design changes or innovations which themselves pose a barrier to the competition without the application of the patent system. This can occur in two primary ways: (1) substitute products having innovations that cannot be easily reproduced, for example, as with trade secrets; or (2) a "tie-in" with other popular products produced by the company such that competitors are unable to market their own independent products. Both of these examples go hand-in-hand in allowing a company to use its monopoly power in one industry as a weapon to achieve dominance in another industry. With respect to trade secrets, a company may conceal important information, such as operating specifications for an application program or an operating system, that force a potential competitor to succumb to the will of the monopoly in order to design any peripheral products. In the case of product tie-ins the control of the monopoly over another industry is more obvious and direct; if a consumer buys product X from market 1 and it comes with Y from market 2, then the producer of Z (a competitive product with Y) is, in fact, facing the monopolistic producer of X from market 1.
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The Chicago School suggests that there are no economic barriers to entry; there is always money available to support an innovative product if the market desires such a product.[12] However, such a theory cannot be supported in the case of predatory design by a monopoly in one industry to dominate another. In such a case, there is a barrier to entry because although a competitive product may be innovative and better than its competition, there is no hope for it to enter the market in the face of a monopoly grip by way of secret information or product tie-ins. This is particularly evident if a firm attempting new entry, or even re-entry, must acquire rights or licenses in order to operate. [13]

In their article, Janusz Ordover and Robert Willig suggest there are five decisions that a monopolist can make with respect to the innovation of a new product: (1) the choice of the product design; (2) the choice of the time to announce the new product; (3) the choice of the price for the new product; (4) the choice of the size and content of research and development and promotional budgets; and (5) the choice of associated adjustments in the prices of existing products of the monopolist.[14] Each of these decisions can be used to further the two main predatory tactics that have been discussed above: (1) releasing products that are substitutes for competitors products and cannot be reproduced easily; or (2) product tie-ins involving the use of monopoly power in one area to promote a product in another area.

While the first of the above-described tactics for predatory behavior attempts to use complexity or trade secrets to garner innovative protection that has not been sanctioned through the use of the patent system, it is the second type that is perhaps the most sinister. The use of a product tie-in as a means of predatorily designing a product to ride on the coat-tails of a previous core competency and success of a monopolist has been the subject of important litigation with two parties in particular, IBM and Kodak. This litigation has attempted to assess the problematic balancing act of using antitrust laws to prevent the use of predatory design to destroy competition while not damaging the promotion of innovative behavior.

Kodak first faced the wrath of the Justice department in its dominance of the color photo finishing in the mid 1950's when it tied-in the purchase of film with its processing. Kodak sold each roll of color film with an advance charge for processing included, making consumers loathe to spend money twice for the services of a non-Kodak processor. The result was a consent decree with the Justice Department preventing such a film/processing tie in. Then, in Berkey Photo v. Kodak, Berkey Photo accused Kodak of wielding its monopoly power in the film industry to further its power in the camera industry.[15] Kodak released a new camera, the 110 Pocket Instamatic, to wild success in the market; people loved the "little camera that takes big pictures". At the same time, Kodak also released an advanced color negative film called Kodacolor II. This 110 camera required the use of Kodacolor II film and thus these two products were advertised jointly as a photographic system.

This photographic system was a success for Kodak. People wanted the 110 Instamatic and the "remarkable" Kodacolor II film and to get this package, consumers had to buy both; for 18 months after its introduction, Kodacolor II was only produced in the 110 format. The question that arose over this film, however, concerned its quality. Although advertised as "remarkable" film, its quality was undisputedly worse than Kodak had hoped, and even inferior to its predecessor film in a few respects, including degeneration time. Was this film really an innovation immune to antitrust violations? Or was it an advertising ploy by Kodak who intended to increase demand for its new 110 cameras through the harnessing of its position in the film industry?
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Berkey asserted that Kodak was involved in a mere advertising ploy and also complained that Kodak had not given notice to its competitors of the release of the new products that would constitute its advanced photographic system. The court definitely stated, however, that such predisclosure was not required of a monopolist. The core concept was that predisclosure is not a power unique to a monopolist; any firm can produce an innovative product without releasing notice to its rivals. The court found no circumstances where nondisclosure of its own innovations would violate the Sherman Act. The court then concluded that it is up to consumers, rather than courts, to determine product quality. If the market believes the product possess improved quality, then it may act as it sees fit without the influence of the courts. [16]

In the 1970's and early 1980's, IBM was attacked in a series of litigation for violating section 2 of the Sherman Act through its design and release of new central processing unit (CPU) technologies. In these cases, IBM was accused of predatorily designing CPUs that combined the functions of peripheral units and would no longer operate with peripheral components designed by other companies.[17] In all of these cases, the court upheld the legality of the design changes. Interestingly, however, the courts did not focus their assessment on the market opinion of the innovative aspects of the redesigned CPUs. Instead, the courts look more to the intent of IBM in making the design changes. In particular, the court in Transamerica listed "specific intent to ... destroy competition with respect to a part of commerce" as one element in establishing an attempt to monopolize through predatory conduct.[18]

Philip Areeda and Herbert Hovenkamp have addressed the issue of predatory behavior behind implicit and non-implicit product tying. Areeda and Hovenkamp make the assertion that a "product improvement is protected and beyond antitrust challenge"[19] and product superiority is "one of the objects of competition and cannot be wrongful, even for a monopolist."[20] This is a valid assumption that is backed by common sense and was previously recognized by Judge Hand in Alcoa. Areeda and Hovenkamp submit that it is not the position of judges to second-guess the judgment of consumers in deciding upon the improvement of a new technology. If consumer demand increases for a new technology over an older technology, whether it is the inclusion of peripherals in a central computer system or a camera and film combined photographic system, then that is evidence of an improved product in the marketplace regardless of the intent of the monopolist.

An argument that is then raised by Areeda and Hovenkamp is the concept of superficial superiority, that is, advertising-created perception that a product is superior when, in fact, is it is not better or only marginally improved. In this case, consumer preference creates the appearance of product innovation when what actually has occurred is a predatory wool-pulling over the consumer's eyes. It is here where the concept of intent surfaces: Did the monopolist improve a product or intend to deceive? The trial court in Berkey allowed the decision of anti-competitive intent versus genuine product improvement to go to the jury. The 2nd Circuit, however, rejected this decision, preferring to let the consumers rather than the jury decide. The premise of this decision was the belief that the market cannot be fooled for long, and unconstrained consumer acceptance of a product is a far better means for assessing product superiority than a jury's decision of intent after-the-fact.[21]

What happens, however, when a monopoly resorts to a process of "excessive" product variation, namely, making small improvements in a continuous product line versus a large number of improvements in a single product generation? Clearly, such a strategy could provide significant difficulties for a smaller rival who must struggle to compete with each product improvement or style variation. This difficulty for smaller rivals could result in decreased competition, an extended outcome of which consumers may be unaware as they make their purchasing decisions. Areeda and D. Turner[22] and later Areeda and Hovenkamp[23] all arrive at the same conclusion in regards to this type of product innovation: the market is the supreme controller. Areeda, Hovenkamp and Turner all place great importance on the power of the market and the choices of consumers to decide such issues. They suggest that consumers are making informed choices if they sacrifice the number of competitive suppliers in exchange for the product diversity that results from many smaller improvements and style variations. The authors stress that they "cannot condemn a monopolist who succeeds in varying his product in ways that buyers, whether well-advised or not, find desirable."[24] Such a condemnation would serve to reduce research and development (R&D), which can often be speculative, for fear of antitrust retribution. Making small improvements through a trial and error process is often the path for a successful R&D strategy, particularly when facing a volatile and swiftly advancing market, such as the fast-paced computer industry.

The mantra in high technology, particularly the computer industry, is faster, better, cheaper. Companies strive to reduce costs through the advent of new technology that allows for one company to underprice another. The ability to make such price cuts rests solidly on the innovation of the company. There's nothing wrong with that; it is the essence of such innovation that the antitrust laws seek to protect. Competition fosters innovation, which in turn fosters more competition through a desire to make a mouse-trap better and cheaper than anyone else. However, although beautiful in theory, this process can potentially be perverted with respect to predatorily designing in order to price-cut and force out competition.

Areeda and Turner were the first to develop cost based tests for predatory pricing.[25] The principle behind a cost-based test for predatory pricing through innovation is whether a monopolist will recover its R&D investment to lower a product's price only with the exit of a rival. Thus, the question is whether the R&D investment should be included in calculating the threshold for predatory pricing on the part of the monopolist. Take the following example: A monopolist produces a product with a profit maximizing price of $100. The firm's cost for the product is $90 including long term capital costs which is the same cost for a current rival who has just entered the market. With a significant R&D investment, the monopolist can reduce the cost for the product to $88 excluding the significant cost of the R&D investment. The monopolist makes the investment and prices at $89. At some point the rival is forced to exit, the monopolist can increase price to $100 and recover the R&D investment for the period before any other rival can gather the necessary funds to cover the capital costs to enter the market. Thus, although the monopolist didn't price below its actual cost to produce the improved product, the cost did not include the R&D development expenditure which was to be recouped after the rival's exit from the market.

Ordover and Willig suggest that a significant element in determining the predatory behavior of such a scenario depends to a large extent on the nature of the market. Clearly, if the market has few barriers to entry, then the monopolist could never recover the R&D investment before another rival enters the market. Timing is also critical in determining predatory behavior. Did the monopolist make the R&D development before the entry of a rival or after? Such a determination affects whether the R&D investment should be included in or excluded from the cost-based price floor.[26]

R. Bork explained that successful predation is impossible based on the unstated assumption that reentry barriers are small.[30] However, in the world of computer technology, such an explanation must fail because of the "applications barrier to entry." The vicious cycle influencing this barrier appears quite real due to the public and developer mindset behind applications development.

With the advent of browser technology and the ability of Internet browsers to run applications over the Internet regardless of the type of operating system used, the DOJ submitted that Microsoft is fearful of losing the monopolistic applications barrier to entry. Thus, in order for Microsoft to preserve its monopoly power and prolong the applications barrier to entry, Microsoft has used its monopoly power in the operating system and applications industry to promote its browser Internet Explorer and engage in a "jihad" browser war to crush the opposition, namely Netscape.

The similarities between this case and the IBM peripheral cases are immediately obvious. The same questions that arose in the IBM cases are posed to assess Microsoft's actions: To what extent is Microsoft promoting innovation by giving consumers a product they want, namely a seamless connection between an operating system and an Internet browser? The DOJ made the following statement: "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."[31] Can such a statement really be supported? What is the basis for such a statement? The DOJ pointed to Microsoft's separate marketing of its Internet browser for non-Windows operating systems as evidence of the separate product market for Internet browsers. Yet, is it really so clear that the bundling of a browser and operating system is inefficient and not an innovative step? To what evidence should the DOJ look in making this statement?

The answers to these questions have previously been addressed. The 2nd Circuit in Berkey and Areeda, Hovenkamp and Turner all suggest that the market place controls such that the will and preference of the consumer is the ultimate indication of the innovation of a new product. It is the choice of consumers to sacrifice the number of competitors in return for a line of seamlessly connected products. Thus, although the DOJ complaint sought to prevent the acts of Microsoft that "deter innovation, exclude competition, and rob customers of their right to choose among competing alternatives,"<[32] it is unclear to what extent the DOJ recognized the right of the consumer to choose not to support competing alternatives in the face of a product that appears innovative and has fostered consumer preference.

Microsoft has fought the charges that it is anti-competitive and acting to deter innovation with a vengeance. In its answer to the DOJ complaint, Microsoft suggested that the market for computer software is itself one of the fastest moving, most innovative and most competitive businesses in history.[33] Microsoft asserted that it has engaged in a continuous process of creation, improvement and marketing of computer software that has "fueled the growth of one of the most important sectors of the economy ..."[34] Microsoft expands upon this assertion in its White Paper entitled Integration, Innovation and the PC.[35]
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In this White Paper, Microsoft claimed that the integration of new functionality into PC operating systems has marked a continuous improvement and invigoration of computing in the American high-technology industry. Microsoft stressed that Windows has provided a common platform for software developers and that Internet Explorer is one example of the "building blocks that are integrated into the operating system and thus can be called upon by software developers to create new and useful applications." Furthermore, the White Paper suggested that each improvement and variation that Microsoft incorporates into its operating system is simply a response to consumer and developer demand for seamlessness and a standardization of Internet technologies. This argument seems clearly drawn from the assertions by Areeda, Hovenkamp, Turner and the 2nd Circuit that the marketplace is making decisions as to what it wants for improvements, and so be it if the cost of such improvements is the sacrifice of smaller rivals in the browser and applications industries.[36]

But is Microsoft doing more than simply rapidly improving products such that smaller rivals cannot keep up? The answer, given as a resounding "yes," can be seen in the findings of fact issued by Judge Jackson on November 5, 1999.[37] In this lengthy written finding, Judge Jackson cast a serious shadow on the activities of Microsoft, and all but accused the company of committing serious anti-competitive acts in recent years to protect its own monopoly power and deter innovation.

With regard to Original Equipment Manufacturers (OEMs) such as Compaq and IBM, Microsoft's licenses for Windows contained extremely restrictive provisions. OEMs were not allowed to modify desktops icons nor programming code in any way. Thus, OEMs could not respond to customer demand with regard to the type of Internet browser, nor even remove the browser for those customers who did not wish one. The prohibition of browser removal extended further than just the OEMs. Microsoft intentionally made the disabling of the browser technically difficult and even set some operations to automatically run Internet Explorer, even if Netscape Navigator had been installed by the user and set as the default browser. The restrictions imposed upon the OEMs prevented them from tailoring their products to the will of the consumer.[38]

If an OEM at any point violated the restrictions imposed upon it by Microsoft, the retribution was swift and severe. While compliance resulted in reductions in royalty prices for the use of Windows, as well as contributions to co-marketing funds, violations meant the elimination of royalty reductions, and the suspension of any marketing or sales campaigns with the offending firm. A comparison of the effects upon a company in compliance and a company in violation was clearly seen in comparing Compaq and Gateway during the 1996-97 period. Compaq capitulated in all respects to the demands of Microsoft in supporting Microsoft's Internet strategy. In response, Compaq consistently paid the lowest licensing fees of any of the OEMs in business with Microsoft. In comparison, Gateway refused to replace Netscape with Internet Explorer as its internal corporate network browser and as a result paid one of the higher licensing fees to Microsoft during that period.[39]

IBM also suffered the wrath of Microsoft. In late March of 1995, IBM was negotiating for a license for Windows 95. IBM then announced the intended acquisition of Lotus Development Corporation, a software company that competes with Microsoft in the office software market. After this announcement, Microsoft terminated negotiations with IBM for a Windows 95 license and refused to provide IBM with the "golden master code" that is needed for product planning and development for Windows. Despite further attempts at negotiations, IBM did not renounce its acquisition of Lotus and was only granted a license to Windows 95 fifteen minutes before Microsoft officially launched it on August 24, 1995. The delay prevented IBM from providing computers having Windows 95 for the back-to-school market, resulting in significant loss of revenue.[40]
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Microsoft contends that the contractual and technical restrictions of its browser with Windows improves the efficiency of the operating system and application interaction as well as provides for a standardization across the industry that helps consumers, OEMs, and independent software vendors (ISVs) alike. Microsoft has also begun harnessing the patent system to further its competitive edge through the use of legal monopolies. The following two tables shows the level of patenting for Microsoft and other companies in high technology areas for the last decade:[41]

It is not entirely justified to make a direct comparison between the numbers of patents in different high technology industries. For example, a hardware and software manufacturer such as IBM is bound to have more patents than a pure software developer due to the variety of patentable features the are created with hardware. However, it is clear that throughout the 1990's high technology companies like IBM, Kodak and Du Pont maintained a certain commitment to innovation via the patent system that was lacking in Microsoft's development in the early 1990s. During this period, Microsoft was already a presence in the software industry, reaping the rewards from the release of Windows 3.1. However, its level of patenting was only commensurate with newly developing and significantly smaller software companies such as Adobe and Lotus. It is clearly evident from the above tables that Microsoft was initially reluctant to share its knowledge and obtain legal monopolies through the use of the patent system.

Judge Jackson also asserted that Microsoft's level of investment in innovation reflects its desire to "thwart some and delay others by improving its own products to the greater satisfaction of the consumer."[42] In view of this aggressive innovation and marketing of its browser technology, Judge Jackson believes that Microsoft can stave off emerging competition through the preservation of the "applications barrier to entry." Although, Microsoft initially considered charging for Internet Explorer as part of a "frosting" upgrade package to Windows, Microsoft ended up offering Internet Explorer for free; forcing Netscape to offer its browser for free as well. In addition, Microsoft even offered special pricing incentives to OEMs in exchange for inclusion of their browser as has been described above. This innovation of Microsoft's Internet Explorer has cost the company hundreds of millions of dollars and is currently a non-profitable industry.[43]

The concept of designing and innovating to gain advantage over one's rivals is an appealing aspect of competition and one that the antitrust laws should encourage and foster. It is where innovation becomes a means of destroying competition from new entrants seeking to add their innovative contributions to the market that the idea of predatory design surfaces as an evil to which the antitrust laws should apply.

Beginning with Judge Hand, courts have cautioned against the use of antitrust laws to prohibit the rise of a company to monopoly status through the success of a superior product resulting from competition and innovation. However, once a monopolist has achieved its status in the market, it is the purpose of antitrust laws to ensure that such monopoly power is not used to illegally destroy other competitors attempting to contribute their own innovations. Such illegal uses of monopoly power can include "tying" products together from different markets to gain a boost in other industries, or investing in R&D to reduce the cost of a product where recovery of that investment necessarily requires the exit of rivals. Monopolies, however, are not required to cease innovation; in fact, a monopolist must innovate to survive. The patent system provides the protection from potential competitors and the market place judges the results.

Although the future of Microsoft is yet to be decided in an official judicial opinion, Judge Jackson believes that in light of the evidence presented, Microsoft has abused its position as monopolist and harmed innovation in the market place through its desire to maintain its own monopoly status. Microsoft's actions have been focused on prolonging the barriers to entry that exist in the software development industry through coercion, threats and penalties to those who break from its rules. In the end, however, the deciding factor for Microsoft's fate rests not with the judiciary but with the public, who daily weighs the benefits and frustrations of Microsoft's products and whose consumer dollars will have the last word.

Year	1998-99	1997	1996	1995	1994	1993	1992	1991	1990
Patents	654	206	103	53	26	18	8	2	3

	1998-99	1997	1996	1995	1994	1993	1992	1991	1990
Kodak	2093	801	795	784	901	1008	790	878	736
IBM	5136	1786	1914	1466	1355	1138	869	715	639
Xerox	1872	808	880	741	775	700	589	426	314
Du Pont	715	329	412	477	532	612	656	629	474
Apple	428	230	185	124	66	69	48	34	26
Sun Micro-systems	972	162	113	69	72	70	57	23	16
Lotus	7	11	6	11	16	4	3	1	3
Adobe	59	8	13	1	4	10	4	4	0
Netscape	12	2	0	0	0	0	0	0	0