Antitrust For The Digital Age

Prices still matter, but Justice's focus is increasingly on fostering innovation

When the government sued Microsoft Corp. two years ago, trustbusters had a simple goal: to prove that the rusty old Sherman Antitrust Act of 1890 still applied to the world of high technology. So far, they've succeeded beyond their wildest dreams.

Now, prosecutors are aiming even higher. With the submission of their proposed remedy on Apr. 28, the Justice Dept. and 17 state attorneys general have made it clear that they want to use the Microsoft case as a vehicle to set out the competitive ground rules for the New Economy. The government has proposed dividing Microsoft into an applications company and an operating-system company--and the primary justification for this radical step is the desire to boost future innovation rather than simply encourage price competition in operating systems or applications. "The Microsoft case is about innovation," says Daniel L. Rubinfeld, an economist at the University of California at Berkeley who was Justice's chief antitrust economist from June, 1997, to December, 1998.

The government's focus on promoting innovation, if the remedy stands up on appeal, is likely to form the basis for antitrust policy in the New Economy. "The Microsoft case has to have precedent-setting value because so much more of the economy is made up of industries where innovation is important," says Robert E. Litan, a Brookings Institution antitrust expert who, with three other leading economists, has filed a brief supporting a Microsoft breakup.

By contrast, traditional Old Economy antitrust policy concentrated to a large extent on protecting consumers by keeping prices down and stimulating choice in a relatively static market. That was an appropriate focus for antitrust policy during the 1970s and 1980s, a period when the underlying technology of the economy changed slowly.

But as the economy started to evolve at an accelerating rate in recent years, antitrust policy started to shift toward a new emphasis on innovation. In 1998, Justice filed an action against Visa International and MasterCard International Inc., alleging that overlapping ownership of the two credit-card networks restrained the adoption of innovations such as "smart cards." Justice also challenged Lockheed Martin Corp.'s proposed acquisition of Northrop Grumman Corp. alleging that it would choke off innovation in critical defense technologies, including stealth technology. "Innovation is more and more the central arena in which competition plays out," says Robert Pitofsky, chairman of the Federal Trade Commission. "I think it is the hot issue for the foreseeable future."

The government's arguments in favor of breaking up Microsoft are the clearest sign yet that trustbusters are trying to turn it into the central issue in contemporary antitrust. The choice of Paul M. Romer, the economics profession's leading advocate of the importance of innovation, to write one of the three supporting briefs in favor of the breakup is particularly striking. The Stanford University economist is best known as the founder of New Growth Theory, which is based on two main ideas: first, that innovation--be it better software, more effective drugs, or even more reliable cars--is the most important factor determining the well-being of consumers; second, that innovation, like any other economic activity, responds to incentives.

In his brief, Romer argues strongly that competition is more likely to create innovation than a monopoly. Even if the application company and operating-systems company start out in separate markets, over time, writes Romer, they "will each have an incentive to compete with the other, or at least to encourage other firms to do so."

Indeed, the effect of the breakup on independent software developers is very important in Romer's analysis. Without fear of being squished by a dominant company, he argues, developers of new software would anticipate higher rewards for successful innovations. They would thus be more likely to devote more resources to developing rivals to either Office or Windows, or to supplying software for non-Windows platforms, such as handheld devices. The result: Consumers would receive new types of software more quickly.

Fundamentally, Romer's argument in favor of breakup rests less on detailed empirical studies than on his belief in the power of competitive markets, which are more likely to produce better outcomes than ones controlled by a single company. As Romer's brief says: "Competitive markets are, on balance, the best mechanism for guiding technology down a path that benefits consumers."

How does a focus on innovation change antitrust policy? In a rapidly innovating market, the traditional belief that conduct remedies are less intrusive may not hold. Government regulators cannot keep up with the changes in an economy moving at Internet speed, and any attempt to set rules for conduct may actually impede innovation. Instead, it may be more important to create the right structural conditions for future innovations and then step aside.

Second, the new focus on innovation argues for keeping a closer watch on how market structure affects small startups, which historically have been the source of much of the innovation in technology industries. Cisco Systems, for example, is thought to have about 40% of the data-networking-equipment business, but Lucent Technologies and Nortel Networks have major pieces as well. As a result, a small company with a hot new networking product can be sure of getting a good price for it, or even for the whole company, which boosts its incentive to innovate. By contrast, small companies face a tougher time in markets that are dominated by a single large competitor that has an incentive to either squeeze them out of the market or buy them up at a low price.

Moreover, antitrust regulators need to pay special attention to those industries where the technology is changing rapidly and unpredictably. Those are the businesses where existing companies, especially those with market power, have the most incentive to try to slow or distort innovation that could erode their momentary dominance.

The government's emphasis on innovation faces several problems, though. Because the issue was not emphasized in the government's original presentation in the trial, it could be vulnerable on appeal. "The case law in innovation is not very well formed," notes Rubinfeld. Moreover, if George W. Bush is elected President in November, a Republican Administration might well pull back from any aggressive remedies.

The economics of innovation are relatively fuzzy as well. The time scale for innovation can be as long as 10 or 15 years out. That means that antitrust enforcers need to worry about markets, technologies, and competitors that don't exist yet--a very difficult task. Moreover, there are situations under which collaboration between companies is a boon to innovation. Indeed, just-published collaboration guidelines from the FTC and the Justice Dept. can be best read, in Pitofsky's words, as "lean over backwards to facilitate arrangements that produce innovation."

The trend is clear. "We want a world in which people are really innovative and creative," says Rubinfeld, "and where they will be rewarded and not thwarted." In the New Economy, that may be the best antitrust policy.

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