Microsoft's Licensing Agreements: Theory and Evidence on the Sale of MS-DOS and Windows

I. INTRODUCTION In 1990 the Federal Trade Commission (FTC) began a three-year investigation of Microsoft Corporation for allegedly anticompetitive business practices related to its licensing of personal computer (PC) operating systems. After failing to break a two-two vote among the Commissioners as to whether the practices were indeed anticompetitive, the FTC suspended the investigation. The Department of Justice (DOJ) subsequently took over the investigation, which lead to a proposed consent decree on July 7, 1994. Judge Sporkin originally rejected the decree on February 14, 1995, arguing that it did not constitute an effective antitrust remedy and that it failed to serve the public interest.I However, both parties appealed the ruling, and it was eventually overturned.2 According to the DOJ complaint, Microsoft used exclusionary and anticompetitive contracts to market its personal computer operating system software and unlawfully maintained its monopoly of personal computer operating systems and has unreasonably restrained trade.3 The key focus of the investigation was on the competitive impact of Microsoft's licensing agreements with computer hardware manufacturers for the sale of MS-DOS and Windows. The agreements included three characteristics that were of concern to the DOJ: metering devices, minimum purchase commitment clauses, and lengths.4 A per-processor license is a contractual arrangement which requires an Original Equipment Manufacturer (OEM) to pay a royalty for the use of an operating system (OS) based on the number of computers the OEM ships that contain a particular microprocessor.5 According to the complaint these arrangements impose a penalty or 'tax' . . . upon OEMs' use of competing PC operating systems.6 In addition to the perprocessor meter, Microsoft employed per-system and per-copy licenses.7 Under a persystem license, royalty payments are based on the number of units of a particular system or model shipped by the OEM. Under a per-copy license, royalty payments are based on the number of units actually installed on any system produced by the OEM. Minimum purchase commitments require an OEM to purchase at least a prespecified, minimum number of copies of the OS over the contract period. Because OEMs did not always meet their commitments, Microsoft would sometimes credit unused balances to future agreements if the OEMs were willing to sign new licensing agreements.8 In addition, multi-year contracts were sometimes explicitly structured with separate minimum commitments in each year, and unused copies from early years could be carried forward into subsequent years of the contract. Microsoft's practice of allowing unused copies to be carried forward into subsequent periods is related to the third key component of the complaint, the allegedly excessive length of the contracts. The typical contract length was two years, and in some cases they lasted as long as five years from the original negotiation date.9 Given the rapid pace of technological change for both operating systems and microprocessors, it is likely that the contracts covered most or all of the relevant shelf life of the products. The DOJ alleged that the per-processor licensing agreements constituted de facto exclusive dealing arrangements, which served to unfairly exclude or foreclose rival operating systems producers from the OS market by denying them access to a critical input (the OEM distribution channel). The DOJ concluded that the licensing agreements served as anticompetitive vertical restraints that erected entry barriers and foreclosed entry into the OS market. The purpose of this Article is to examine Microsoft's OS licensing practices and to discern their likely economic impact. Three primary conclusions arise from the analysis of these licensing practices. First, the focus of existing explanations on the per-processor meter as the key economic element of the contracts is misplaced. …