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Business Economics January 2000 47The Lessons from Mi crosoft

he Microsoft antitrust case has generated lotsof attention, and for good reason. 1

Microsoft is one of the largest companiesin the world. Ranked by value of equity, it wasthe largest as of March 2000, but as of

September 2000 was only the fourth largest. Its equity atthat time was worth over 350 billion dollars, down fromabout 550 billion dollars in March. Its growth has beenphenomenal. Its equity was not even publicly traded twen-ty years ago, and just ten years ago its stock was worth lessthan five billion dollars. The actions of Microsoft havehuge effects on other firms in the computer industryanindustry that, like Microsoft, has exploded in size. It isalso an industry responsible for innovation and the recent

booming productivity growth of the U.S. economy. Withthe Internet exploding and reshaping U.S. industry,Microsofts ability to influence the direction of develop-ments in the computer industry raises enormously impor-tant issues of public policy.

Though important on its own, the Microsoft caseshould command our attention because of some very gen-eral economic lessons it provides and because of somehard policy questions that it raises about the appropriaterole of antitrust law and enforcement. I want to describethe key economics lessons that we should learn fromMicrosofts behavior, because its behavior teaches econo-

mists a lot about strategic behavior in a rapidly changingenvironment. Until the Microsoft case, the importance of this type of behavior was neither understood nor appreci-ated, despite the existence of other instances where itseems to have occurred, as for example in some of the IBMcases of about twenty years ago. However, just because we

T he Lessons from

Microsoft MICROSOFTS BEHAVIOR TEACHES ECONOMISTS A LOT ABOUT STRATEGIC BEHAVIOR INA RAPIDLY CHANGING ENVIRONMENT.By Denni s W. Carlton

Dennis W. Carlton i s a professor of economics in the Graduate School

of Business, The Uni versity of Chicago, where his teaching and research center on microeconomics, industrial organization, and antitrust. He is also president of Lexecon, Inc., an economic con- sulting firm special izing in the

application of economics to liti gation. He earned both his Ph.D. i n economics and hi s MS in Operat ions Research from MIT and earned hi s AB in applied math- ematics and economics from Harvard College.

Thi s paper i s based in part on my presentati on to the National Associati on for Business Economics, September 2000, and on my Alexander Brody Disti ngui shed Service Lecture deli vered at Yeshiva Universit y, March 2000.

Thi s paper exami nes the lessons economists can draw from the Mi crosoft li ti gati on. The paper explai ns that the most interesti ng economic lesson i s how strategic behavior involving ti e-i n sales and exclusionary acts can be used in a dynamic network industry to allow an ini- ti al monopoli st to remain the monopoli st even in the face of rapid technological change. The paper goes on to explore the complications for ant itrust poli cy that Mi crosofts conduct and the proposed remedy i n the anti trust case represent.

T

1United States v. Microsoft, Civil Action No. 98-1232. I have servedas a consultant for Sun Microsystems and others in matters adverse toMicrosoft.


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48 Business Economics January 2001 The Lessons from Microsoft

now understand certain strategic behavior does not neces-sarily mean that this behavior should always be attackedas an antitrust violation. I will use this new understandingto briefly discuss some of the antitrust issues that this caseraises.

The major insights fromthe Microsoft case that I dis-cuss are as follows: Microsofts behavior shows how tying of complemen-

tary products and exclusive dealing can be used in adynamic network industry so that a dominant firmcanremain dominant over time, even though the productschange dramatically over time. This is the centraleconomics lesson fromthe Microsoft case.

Some antitrust issues raised by the Microsoft case aresimple; others are more difficult. The case confirmswhy it is appropriate for the antitrust laws to use aRule of Reason (i.e., weighing of benefits vs. costs) toassess whether exclusionary conduct that prevents (orimpairs) rivals from obtaining customers can be an

antitrust violation.2

Tie-in claims of bundling InternetExplorer, Microsofts browser, with Windows,Microsofts operating system, raise complicatedissues; and how those claims are ultimately decidedcould have a huge effect on competition in high techindustries.

Antitrust remedies are hard to fashion in a case likeMicrosoft. The goal is to deter future violations in thisand other industries. One remedy is to impose a largefinancial penalty, a course of action that I understandthe government is not authorized to pursue in its civilaction against Microsoft. Another approach, the one

taken in this case, is to pursue structural relief. Thetrick is to reduce market power at the operating sys-tem level, the target of the government complaint,without creating huge losses by breaking up a suc-cessful firm.

Basic FactsAlthough everyone is probably familiar with several of

the facts in the Microsoft case, let me present some basicfacts in order to illustrate the main economic insights.Because I amless interested in the exact details of theMicrosoft case than in the general lessons that economists

should draw fromthat case, I will consciously oversimpli-fy in order to focus on my main points. A reader interest-ed in only the Microsoft case can find plenty of details in

the public filings, the Department of Justice Websites,and the numerous conferences that have occurred.

To function, a computer needs an operating systemthathandles the internal management of tasks such as file shar-ing and printing. Windows is Microsofts operating system.Application programs such as Word are written to work ona specific operating systemlike Windows. They do notgenerally work on other operating systems like IBMs 0S2or Linux or Apples operating systemunless developersincur the costs of adapting the applications to these otheroperating systems. Figure 1 illustrates these facts by show-

ing that, unless the application program has the correctgrooves, it will not fit into an operating system.

The demand for an operating systemdepends on thenumber and quality of applications written for it. Themore high-quality applications there are, the greater is thedemand for the operating system. There will be moreapplications written for an operating systemwith a largeinstalled base of existing users than for an operating sys-temwith a small base, because switching operating sys-tems in order to use a given application is costly. Hence,a new application will penetrate the user population fasterif it is written to work on the operating systemwith thelargest existing installed base. This linkage makes thecomputer industry a network industry and explains whythe demand for an operating systemwith many applica-tions exceeds that for a rival operating system with fewapplications.

The notion that network industries are somehow newand require a new understanding of economics is mis-leading. Network industries have long existed and been

2Nothing is as simple as it sounds. Microsoft often did not demandexclusivity by the terms of its contract, but instead used various termsto attain such exclusivity. This in itself raises complicated issues thatI have discussed elsewhere. See Carlton (2000) and footnote 4 below, aswell as Paragraph 241 of J udge Jacksons Findings of Fact, U.S. v.Microsoft, Civil Action No. 98-1232, 11/5/99.

Windows-specficApplication

Windows

Windows-specficApplication

CompetingOperating System

W I N D O W S - S P E C I F I C A P P L I C A T I O NW O N T W O R K W I T H A N O T H E RO P E R A T I N G S Y S T E M

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The Lessons from Microsoft Business Economics January 2001 49

important. The railroad industry, which began almost200 years ago, provides a good example; but there aremany others. Indeed, the features of the Microsoft casethat are of particular economic interest include thecomplementarity between two products, operating sys-tems and applications, and the economies of scale thatexist in these products. This particular set of circum-stances is certainly not a new phenomenon. 3 The prin-ciples of microeconomics do not have to be repealed tounderstand these circumstances, just applied appro-priately.

The functions of an operating system haveincreased over time. For example, the development of the graphical user interface (in which a user can picto-rially see and choose functions) illustrates an improve-ment in the usefulness of an operating system. There isno reason to believe that the operating systemwill notcontinue to evolve.

A browser allows one to view Web pages. In the

mid-1990s, the most popular browser was Netscape. The Netscape browser was a formof middleware. Itsat on top of an operating systemand displayed Webpages that were downloaded off the Internet. TheNetscape browser ran on all of the leading operating sys-tems because Netscape had incurred the costs of adaptingits browser to each of these operating systems.

The Netscape browser had its own application pro-gramming interfaces (APIs)the building blocks thatsoftware developers use to write application programs.Because Netscape had its own APIs (and the potential toexpand those APIs) and because Netscape ran on all of

the leading operating systems, Netscapes browser had thepotential to become a substitute for Windows as a platformfor application programs. Software developers might havewritten programs based on Netscape APIs instead of bas-ing their programs on the Windows APIs (the grooves inthe interface between Windows and applications in Figure1). If Netscape (and application programs) had developedin this manner, then the unique link between applicationprograms and the operating systemwould have been bro-ken because application programs written to the Netscapebrowser would have worked on any operating system.

Therefore, a large installed base for a particular operatingsystemwould no longer have provided an advantage forthat operating systemover other operating systems whennew applications are written. Figure 2 illustrates how abrowser could theoretically fit into any operating system.

In this schematic, the grooves on its bottomside enableit to work with each operating system, while the commongrooves on the top provide that applications written tothe browser will work on any operating systemon whichthe browser sits.

Java was (and, to some extent, still is) another substi-tute for Windows. Java is part programming language andpart middleware. The middleware portion of Java is the

Java Virtual Machine that sits on top of an operating sys-tem. There is a JVM for each of the leading operating sys-tems. The JVM enables an operating systemto processapplication programs written in Java and that use JavaAPIs. Thus, like Netscape, J ava also had the potential tobecome a substitute for Windows as a platformfor appli-cations programs. Netscape facilitated the distribution of

JVMs and the use of Java. Every time a user put Netscapeon his machine, a JVM was installed.

Thus, Figure 2 also illustrates how Java breaks theunique link between the operating system and applica-tions for any middleware products (such as a browser) thatfits on top of every operating system, yet provides a

common top layer for applications.Rapid technological change and diffusion are familiarstories. Using one common measure of processing speed,chip speed has over the last twelve years increased by afactor of about sixty. The number of PCs shipped annual-ly has risen from19 million in 1990 to about 125 millionin 2000. And, of course, the rise of the Internet has beenphenomenal. Over the last decade, Microsofts share of operating systems on new personal computers based on

3Whether scale directly alters the product characteristic (as in mak-ing it easier to interchange files with users of the same applicationprogramand operating system) or affects the price of a complementa-ry product, the economic effects in a dynamic model are similar. SeeCarlton and Waldman (2000).

Browser/ Middleware

Applicat ion Applicat ion

Browser/ Middleware

WindowsCompeting

Operating System

C O M P E T I N G O S A T N O D I S A D VA N T A G E :B R O W S E R / M I D D L E W A R E P L A T F O R M C A N W O R KW I T H A N O T H E R O S

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Intel-type designed chips has been over ninety percentand is growing. It is in excess of eighty percent (Apple isabout five to ten percent) when one considers all PCs.

What M icrosoft Did: Lessons for BusinessStrategyMicrosofts Conduct

I now want to use these simplified facts to focus on theeconomic lessons fromMicrosofts behavior, focusing ontwo aspects. I emphasize that I am not discussing thelegality of Microsofts actions.

The first aspect of their behavior relates to exclusivedealing. Exclusive dealing occurs when a firmsays to itscustomers or distributors that they are not allowed to dealwith a rivals product. So, for example, if Microsoft said toa distributor (e.g., an original equipment manufacturer[OEM] that makes computers and sells themwith an oper-ating systeminstalled) that it could distribute computersonly with Windows, it would be engaging in exclusive

dealing. As I understand the facts, Microsoft did not typi-cally engage in such explicit exclusive dealing but didoffer pricing structures and other terms to encourageexclusivity. For example, in conduct attacked by theDepartment of J ustice in 1995, Microsoft would chargeOEMs a fee for Windows based on all computers shippedwhether or not Windows was used in those computers.

This means that the marginal cost of Windows was zero,creating an incentive for an OEM to exclusively useWindows. 4

As another example, Microsoft arranged an extra dis-count that Compaq (an OEM of computers) would receive

provided Compaq shipped its computer with MicrosoftsInternet Explorer browser and promoted only IE and notNetscape. Other OEMs also received discounts onWindows provided they favored IE, not Netscape.

There can be good pro-competitive reasons to engagein exclusive-dealing type arrangements. It is well knownthat they can protect property rights and thereby encour-age promotional effort. (See, e.g., Carlton and Perloff [1999], Chapter 12.) So, for example, a manufacturer of cameras might demand exclusivity of camera shops andprevent shops selling its camera fromcarrying competingbrands so that, when the manufacturer engages in promo-

tion or in dealer training, or provides customer leads tostores, other rival manufacturers of cameras will not beable to free ride on those efforts. But, it is also known that

exclusive dealing can harm competition by making itmore difficult for rivals to obtain distribution, especiallywhen distribution is handled by only a handful of distrib-utors. (If there are many distributors and there are noscale economies in distribution, exclusive dealing cantusually harm competition.) Here, Microsofts conductmade it more difficult for a competing operating systemtoWindows to obtain distribution, for Netscape (which mighthave been a rival to the Windows operating system) toobtain distribution, and for JVMs to be installed on com-puters (since Netscape was an important distributionvehicle for JVMs). This use of exclusive-type arrange-ments in these ways can be viewed as a pretty standardapplication of foreclosure in which the foreclosure pre-vents rivals fromcompeting effectively against Microsoftsoperating system.

The second aspect of Microsofts behavior that I wantto focus on is its so-called embrace and extend strategy.

This is really the most interesting part of their economic

behavior. In this strategy, Microsoft recognizes the valueof the browser but is concerned about the spread of abrowser such as Netscape that might become a platformfor applications written for any operating system.Microsoft therefore created IE, which it either physicallybundles with Windows or includes it at no extra chargeand which does not obviate the need for Windows-specif-ic APIs for applications programs written for Windows.Much of the governments case at the antitrust trial was toestablish that there were no efficiency reasons to bundleIE and Windows. Therefore, the consequence of Microsofts strategy was to reduce the demand for

Netscapes browser even though the IE browser was notsuperior. In this way, Microsoft hindered Netscape fromdeveloping into an alternative platformto Windows, andapplications programmers writing a program to run onWindows still had to use Windows-specific APIs, preserv-ing the link between the applications program andWindows (see Figure 3).

Microsofts strategy with respect to Java was similar.Microsoft recognized the advantages of Java as a pro-gramming language and therefore became a Java licensee.Because Microsoft is a Java licensee, the IE browser, likeNetscapes, comes bundled with a JVM. But, afterembracing J ava, Microsoft then extended it. Forexample, it created tool kits for Java software developersthat made it easy for themto mix Windows APIs with JavaAPIs. 5 Figure 3 illustrates this Windows-specific exten-sion of J ava. The consequence of Microsofts actions isthat many application programs written with Microsofts

4Deciding when exclusivity effectively achieved through pricing (orother means) should be treated as the equivalent of explicit exclusivityfor legal purposes is a tricky issue. See Carlton (2000) and Thomet al.(2000). I do not want to analyze here when contractual restrictions turninto exclusionary conduct, a topic analyzed in the just cited papers. Forpurposes of this paper, assume that Microsofts actions can be charac-terized as equivalent to exclusive dealing.

5Microsofts behavior regarding Java is the subject of a breach of con-tract suit by Sun against Microsoft.


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Java will not run on other operating systems, and henceMicrosoft again preserves its application advantage.

Consequences of Microsof ts Acti ons Microsofts actions toward Netscape and Java each

accomplish the same goal. They prevent the applicationadvantage of Windows from slipping away and therebyprevent the source of Microsofts operating systemmonop-oly from eroding. Importantly, Microsofts actions show

how a dominant firmcan use a variety of conducts to pre-serve and maintain its monopoly position in a rapidlychanging environment. That is a new lesson fromMicrosoft, though it is probably one that some of the IBMantitrust cases should have suggested. 6

By preventing new applications from being simulta-neously usable on both Windows and other operating sys-tems, Microsoft preserves its advantage. But it also meansthat, as the operating systems evolve, Microsoft will con-tinue to have an advantage over competing operating sys-tems as long as its operating systems use exisiting appli-cations. Perhaps more importantly, even if operating sys-tems for PCs vanish, Microsoft is well positioned tobecome the monopolist of any new systemas long as thatnew systemcan utilize the stock of Windows-based appli-cations. So, for example, if handheld devices replace PCs,then Microsoft could monopolize operating systems for

themif such systems can use existing Windows-based applications. In this way, Microsoft canswing its monopoly over time fromproduct to prod-uct by using its application advantage at each pointin time to advantage its own products. This behav-ior explains how one firmwith a head start can usetie-in sales and other behavior to prevent genericcomplementary products from being developed.Moreover, at each stage it can use its special linkto the complementary product to become themonopolist of the primary product, even when theprimary product is changing rapidly over time.Indeed, it is the combination of some scaleeconomies (or network economies) and rapid tech-nological change that produces the circumstancesunder which a dominant firmcan remain dominantover time in the face of rapid technologicalchange. 7

Figure 4 illustrates these points. Initially, there

is a monopolist of A (operating system), which uti-lizes complementary products B (applications thatwork only with A) and B (applications that work

with A or a future rival A). By preventing B fromsuc-ceeding, the competition between A and a rival A in laterperiods is avoided, and the initial monopolist of Aremains the monopolist in later periods. An importantpoint is that product A in the later period could be a dif-ferent product than A in the initial period, as long as A inthe initial period and A in the later period both utilize Bas a complementary product.

Lessons for Antit rustLet me now turn to the economic issues related to theantitrust challenge of Microsofts behavior. First, it is per-fectly legal to be a monopolist. U.S. antitrust laws (andpatent laws) recognize that firms that innovate will havemarket power and that the associated profits provide theincentive to firms to develop new products that consumerswant. And our antitrust laws recognize that tough compe-tition helps consumers but harms rivals. Just because arival complains does not mean that a firmis doing some-thing wrong. Our antitrust laws do, however, prevent thecreation or maintenance of market dominance through

certain types of conduct deemed bad acts.Although the Microsoft case raises some hard ques-

tions about antitrust law, some of the issues are relativelyroutine. 8 This is the case for the claims regarding exclu-sionary conduct aimed at preventing OEMs fromdistrib-

6 The IBM cases (e.g., the private cases as well as the government case)often focused on peripherals. Once one realizes that intelligence andprocessing capability can reside in peripherals, some of the issues inthe IBM cases become similar to those in the Microsoft cases.

7If the technological change is so rapid that the value of the comple-mentary product vanishes, then the advantage of the incumbent iseroded.8With the important caveat of footnotes 2 and 4.

Many Windows-specificApplications

Middleware

Windows

Few Applicat ions

Competing OS

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uting Netscape and Java (or competing operating systemsfromobtaining distribution). The relevant issue is whetherthe harmto competition fromexclusion exceeds the effi-ciency benefits presumably associated with the exclusion.

This is a standard type of claimin which the dominanceof Microsoft would play a key role. In the 1990s,Microsofts share of the operating systemmarket has beenover ninety percent and growing. In such a setting, an eco-nomic analysis under the Rule of Reason would requirethat the efficiency benefits fromexclusion would be verylarge in order to offset the possible harmto competition.

The claims regarding the embrace and extend con-duct aimed at Netscape and Java are more complicated toevaluate. Let me focus solely on the tie-in claimregardingIE. Tie-in law is muddled froman economic viewpoint.

The standard tie-in case is that a monopolist of product Arequires that you also buy product B. Why? Why not justcharge more for A? The case law provides feeble answers.

The most common explanation is that such a tie enables

price discrimination to occurwhich has ambiguous con-sequences on social welfare. The bottomline is that thereis little economic justification for traditional antitrust hos-tility toward tie-ins. (This insight, due to Aaron Directorand Edward Levi, still applies today [with some modifica-tions]. 9)

But the tie here creates true competitive harm, by dis-advantaging rival operating systems by preserving theMicrosoft advantage in applications. So the economicunderpinnings of tie-in law can finally be made sensibleonce one understands the rationale for Microsofts behav-ior. This should be one of the key economic insights of the

Microsoft case applied to antitrust.A difficult issue is whether product design should be

subject to antitrust attack. Recall that Microsoft was chal-lenged for making the code of Windows and IE insepara-ble (a physical tie-in). There are some plausible benefitsof expanding the functions of the operating system. Do we

want courts weighing the efficiency benefits vs. the com-petitive harmissue, as a general matter? Do we want thegovernment telling Ford how to design a car in terms of what components have to be removable? The costs of impeding technological change could be enormous. I f onegoes down this route, one should give significant weight toefficiencies, which are likely to be too difficult for courtsto evaluate. 10

One unique feature of the Microsoft case may be theunusual amount of internal e-mails that could allow one tofigure out the real reason that IE was tied and what the costsof untying it would be. But it would be foolish to believe thatsuch e-mails will exist in the next antitrust case. So, if thetie-in claimagainst Microsoft stands, I would hope that itwould be interpreted as a reflection of the rather unique cir-cumstances of this case and not as a general attack on tie-in sales achieved through product design.

RemedyWhat remedy makes sense in this complicated case?

The purpose of a remedy is to deter future bad acts in thisand other industries and to restore competition. There areat least three possible remediesa fine, conduct restric-tions, and structural relief.

First, a large fine (e.g., many billions) would be appro-priate so that the threat of future large fines should serveas a deterrent to future bad conduct in both this and otherindustries. The beauty of a fine is that one does not haveto get involved in figuring out the costs of structural relief in which a successful firmis torn apart. The fine shouldbe large enough to make this firm(and other potential vio-

lators) take notice and must specify the types of undesir-able conduct with enough specificity so that the firmknows what to avoid in the future. The major difficulty isthat the government (though not private plaintiffs) has nolegal basis to request monetary damages in a civilantitrust suit. This represents a serious impediment forthe government to fashion an effective remedy quickly,

9See Carlton (2000) for a discussion of tie-in doctrine and, in particu-lar, the discussion of Whinston (1990).

10 There is a distinction between a physical tie and a contractual tie. Ina physical tie, the product comes bundled so that a requirement thatthe components of the bundle be sold separately requires analyzinghow production costs within the firmwill be affected when the physi-

cal nature of the product is altered. In contrast, a contractual tierequires that a user consume, say, two separate components fromonefirm. A requirement that the components cannot be tied will not entaila change in the physical nature of each of the components produced.Courts have been reluctant to intervene within a firmand tell firms howto operate. In contrast, courts have frequently intervened in markettransactions achieved through contract. So, for example, it would beunusual for a court to order GM to allow Ford to use its spare produc-tion capacity, but would not be unusual for courts to prevent GM fromcontractually monopolizing independent dealers (if it had the ability todo so) to prevent distribution of Ford cars.

P R E S E R V I N G T H E M A R K E T P O W E R I ND Y N A M I C I N D U S T R Y

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Now Later

PRODUCT A B PRODUCT A B

B' A' B'

If the presence of B' will erode As power later, then attackB' now.

Product A in later period could even be a different productthan A now.


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and this impediment could be removed only through leg-islation.

The second possible remedy involves conduct restric-tions. Basically, Microsoft is told: Dont do it again. Dontengage in conduct that places significant restrictions onthird parties (e.g., OEMs) fromdealing with your potentialrivals. There are two difficulties with conduct remedies.First, they are hard to enforce because the third partiesmay be reluctant to complain about Microsoft if their suc-cess depends on Microsoft. Because of the constant ongo-ing assistance that Microsoft must provide an OEM, someOEMs could be fearful to complain about Microsofts con-duct to enforcement officials. Second, the conduct thatwill work tomorrow in harming rivals may be difficult topredict today. Hence, specific conduct remedies may turnout to be obsolete quickly.

The third remedy, the structural dismembering of Microsoft, is the most radical. Any structural remedyimposes costs by destroying the internal knowledge that asuccessful firm has developed that has allowed its con-stituent parts to work together successfully. The advantage

is that, unlike a conduct remedy that requires enforce-ment, a structural remedy relies on the forces of competi-tion to remedy the complained-about behavior. There area variety of possible structural remedies that could restorecompetition in operating systems, which was the focus of the governments case. One is to create several operatingcompanies. The Justice Department specifically chose notto do this, fearing that the costs of doing so were too highwith one of the costs being different versions of Windows.Instead, the Justice Department chose to create one oper-ating systemcompany and one applications company. Theidea is that soon, there would be an incentive for the

operating company to develop its own applications and forthe applications company to develop its own operatingsystems. That remains to be seen.

Conclusion The Microsoft case illustrates how an

initially dominant firmcan use contractu-al and physical ties to remain a dominantfirmin a rapidly changing industry. It rais-es some antitrust issues that defy easysolutions. One can perhaps argue that theMicrosoft violations were so egregiousand the reported e-mail evidence seemsoverwhelmingthat a dramatic remedy is

needed and justified. Maybe so. However, the harmfroma general interventionist antitrust policy could dwarf anybenefits. If the drastic remedy of structural relief isimposed in this case, it should best be regarded as anexceptional remedy for an exceptional case.

A C K N O W L E D G E M E N T SI thank Gregory Pelnar and Robert Stillman for help-

ful comments.

R E F E R E N C E SCarlton, Dennis W. and Jeffrey Perloff. 1999. Modern I ndustri al

Organization. Addison, Wesley, Longman, third edition, Ch 12.Carlton, Dennis W. 2000 forthcoming. A General Analysis of

Refusal to DealWhy Aspen and Kodak are Misguided. Antitrust Law Journal .

Carlton, Dennis W. and Michael Waldman. 1998, revised March2000. The Strategic Use of Tying to Preserve and Create MarketPower in Evolving Industries. Working Paper No. 145. George J.Stigler Center for the Study of the Economy and the State, Universityof Chicago.

Thom, Willard, David Balto, and Neil Averitt. 2000.Anticompetitive Aspects of Market-Share Discounts and Other

Incentives to Exclusive Dealing. Antit rust Law Journal. 67, pp. 615-639.Whinston, Michael. 1990. Tying, Foreclosure and Exclusion.

Ameri can Economic Review. 80, pp. 837-859.

So the economic underpinnings of t ie- in l aw can fi nal ly be made sensibl e once one under stands the r ati onale for Micr osofts behavior. T his should be one of the key economi c insights of the

Micr osoft case applied to anti tr ust.


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54 Business Economics January 2001 Tomorrows Electri c Distri bution Companies

The issues surrounding electric industryrestructuring, merger and acquisition activi-ties, changing regulations, and ever-acceler-ating technology enhancements are dauntingto electric utility distribution companies and

poorly understood by their customers. The regulatorysafety net providing a guaranteed double-digit earningsstream is not what it once was. Even the apparently safeoption of a pure poles and wires strategy is potentiallythreatened by load (sales) losses from distributed genera-tion resources (such as large customers generating theirown power), energy conservation measures and services,and distribution bypass (sales direct from generators toultimate customers).

The electricity industry value chain depicted inFigure 1 illustrates the vital position of distribution sys-tems and services in the provision of electricity. Whiletodays customers refer to their utility when they thinkabout electricity, their attitudes about the company arelargely determined by their interaction with the distribu-tion part of the company. Metering, billing, customerservice, outages, and power quality are all functions thatcurrently reside in distribution services.

Tomorrows Electric

Distribution Companies CRUCIAL STRATEGIC DECISIONS WILL AFFECT THE ENTIRE U.S. ECONOMY.By Ahmad Faruqui and Ken Seiden

Ahmad Faruqui i s Area Manager,Retai l & Power Markets, at EPRI (the Electric Power Research

Insti tute). Dr. Faruqui has held senior consulti ng positi ons with Barakat & Chamberl in, EDS,Hagler Bail ly, and Battelle. He has BA and MA degrees in economics from the University of Karachi and a Ph.D. in economics from the University of Cali fornia, Davis. Ken Seiden i s Vice President of Quantec, a con- sulting fi rm dedicated to quanti- tati ve economic research for the uti lity industry. Dr. Seiden has worked for Essential Economics,

Barakat & Chamberl in, Pacif ic Bell Telephone, and Bonnevil le Power. He holds a Ph.D. Economics from the University of Oregon.

The electri c industry has been dominated by verticall y integrated uti l iti es for most of its history. These uti li ti es are being restructured as the electric industry i s being deregulated and moves toward competi ti on. Some vert i-

call y integrated uti li ti es have sold off their generat ion assets and are becoming distr ibuti on companies that deli ver electricity. Some observers contend that such companies wil l simply provide physical delivery service,that is, they will become poles and wi res companies that wil l perform a few basic functions, such as l ine maintenance and tree trimming. This art icle shows that

such a de minimus view of the future electri c distribution company i s myopic. Several al ternati ve futures await the creati ve distr ibution company of tomorrow. The key to success is choosing that future, which best matches the companys core competencies. Since electricity supply affects every aspect of the U.S. economy, these choices are l ikely to have ramifi cati ons far beyond the uti li ti es and should be understood by al l businesses for whi ch electric- i ty i s important i n their operati ons and planning.

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