On March 1 the competition division of the European Commission rolled out the heavy artillery against Microsoft. The company’s sin: non-compliance with the Commission’s earlier mandate that it make certain “interoperability information” available to vendors of work group server operating system products, so that they could develop and distribute these products” in competition with Microsoft’s own.

The EU’s decision could lead to it levying fines in hundreds of millions of euros unless Microsoft co-operates.

The current imbroglio begins with the 2004 EU decision that found that Microsoft had violated article 82 of the EU treaty by unfairly exploiting its dominant position in the operating system market. Provision of this interoperability information on “fair and reasonable terms” was, without further elaboration, identified as the appropriate remedy.

On first inspection, the reference to “interoperability” seems to mirror the identical language in the 2002 Consent Decree that ended the long-standing battle between the US Department of Justice and Microsoft. Microsoft had to disclose information that would allow interoperability of its operating system with the products of other vendors.

But clearly there must be a world of division between the two. Microsoft’s critics, such as Herbert Hovenkamp, a professor at the University of Iowa, denounced the DOJ consent decree as a sell out. At the same time, Microsoft has embraced its general principles, by pledging to implement the substantive conditions of the 2002 decree even after its scheduled expiration at the end of 2007. But Microsoft’s pained response to the EU’s current threat suggests that the use of same term “interoperability” conceals a world of difference between the two decrees. And it does.

The entire problem comes down to definitions. In the DOJ decree Microsoft’s disclosure obligation is “for the sole purpose of interoperating with the Windows Operating System product.”

The EU definition is much broader, and wholly misleading. “Interoperability information” means “the complete and accurate specification for all the protocols implemented in Widows Work Group Server Operating Systems and that are used by Windows Work Group Servers to deliver file and print services and group and user administrative services, including the Windows Domain Controller services, Active Directory services, and Group Policy services, to Windows Work Group Networks.”

That large mouthful conceals a world of difference, for the information that has to be provided here covers much more that the interconnection information required under the DOJ decree. It also requires the transfer of information that will allow any EU rival to use Microsoft’s information to replicate Microsoft’s operating systems for its own benefit.

Under the EU decree both software patents and trade secrets that were used to put together the Microsoft system have to be handed over to its competitors on a silver platter, for prices that the EU deems fair and reasonable, which as it turns out, means very little money.

The EC’s approach to Microsoft thus introduces a major system of transfer price set not by market forces, or even arbitration, but through government fiat. The information needed to make this work is not trivial, but ties up the efforts of hundreds of key Microsoft employees who have to deal with millions of line of code.

I am in no position to comment on the reasonableness of Microsoft’s proposed prices, or even the methodology that was used to generate them. But it is clear that the EU’s grand enterprise is doomed from the start because it introduces a massive system of administered prices in areas that could be subject to an intelligent form of competition.

The key point to note here is that the potential buyers of Microsoft technology do not have any viable alternatives to the protocols for interconnecting with Microsoft. But they have oodles of alternatives for acquiring various protocols to construct their own rival systems.

It was for that reason that the June 2005 pricing principles that Microsoft and the EU agreed to stipulate that the prices for each element should take into account not only the value conferred upon the licensee (without regard to “any strategic value that stems from Microsoft’s market power”) but also the “market valuation of comparable technologies”.

But once these technologies are available, then there seems to be no reason at all to use administered pricing that would allow, for example, the EU’s experts to conclude that many of Microsoft’s patents and trade secrets contain no real innovations or are of little or no commercial value.

There is an instructive parallel here within the American system that augers ill for the EU’s recent broadside. The ill-fated Telecommunications Act of 1996 was also adopted with much hoopla that it would bring a much needed measure of competition to the telephone industry by allowing the entry of competitive local exchange carriers to compete with the established Regional Bell Operating Systems. But far from ushering in a golden age of competition, the 1996 act unleashed a regulatory rate-making binge unmatched in recent times.

And why? Because the act and the Federal Communications Commission did not stop with imposing obligations on established carriers to allow interconnection with their new rivals. Rather, it insisted that the RBOCs offer for sale, at administratively set prices, “unbundled network elements” that allowed the new entrants to put together their own systems with pieces of the incumbents.

That system gave the outsiders free options on millions of individual components at administered prices, which produced major distortions at high administrative costs, for no social gain at all.

The EU stands poised to replicate that error by converting an ill-conceived antitrust action in to a programme that gives immense subsidies to EU countries at the expense of outside firms.

The cynics, who have often denounced competition policy as a covert weapon for undermining market competition, are the only ones who should rejoice at this ham-handed protectionist manoeuvre of the EU.

Richard A. Epstein is the James Parker Hall Distinguished Service Professor of Law, at the University of Chicago, and the Peter and Kirsten Bedford Senior Fellow at the Hoover Institution. He has extensive ties with Microsoft and with their financial support has written: “Antitrust Consent Decrees in Theory and Practice: Why More is Less”, forthcoming from the American Enterprise Institute.

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