Tenth Circuit Applies Profit Sacrifice Test

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Henry B. McFarland, a Vice President at EI, frequently consults concerning antitrust issues. He previously was an economist in the Antitrust Division of the U.S. Department of Justice.

The Tenth Circuit recently upheld a lower court ruling and rejected Novell’s complaint that Microsoft had engaged in illegal monopolization. Microsoft had withdrawn its offer to share the pre-release version of its Windows 95 operating system and its application programming interfaces with companies, such as Novell, that made applications. That withdrawal allegedly delayed Novell’s release of applications compatible with Windows 95, giving Microsoft’s own applications an advantage. Novell argued that the refusal to deal was anticompetitive and violated Section 2 of the Sherman Act.

Microsoft’s conduct could be argued to affect both the market for operating systems and the markets for applications programs. An applications monopolization claim was barred by the statute of limitations. Novell, however, claimed that Microsoft’s conduct unlawfully monopolized operating systems. Novell argued that because its applications could run on multiple operating systems, the availability of those applications made it easier for consumers to switch operating systems, which threatened Microsoft’s alleged monopoly in that market.

Novell argued that Microsoft’s behavior raised Novell’s costs, but the court rejected raising rivals’ costs as a test of anticompetitive behavior. The court ruled that whether Microsoft’s refusal to deal was anticompetitive should be judged with a profit sacrifice test. This test, which a number of economists have advocated, asks whether a refusal to deal causes a firm to sacrifice short-term profits and would be irrational if it did not tend to reduce future competition.

Novell alleged that Microsoft sacrificed short-term operating system profits to foreclose future competition in operating systems. The court found that the profit sacrifice test must be based on Microsoft’s combined profits from both applications programs and operating systems. Competition from rival applications involved a trade-off for Microsoft. Having more applications that worked with Windows 95 would enhance demand for that operating system, but competition from rival applications would reduce the demand for Microsoft’s own applications. Because of this trade-off, reducing or delaying competition from rival applications could reduce Microsoft’s operating system profits but raise its application profits.

The court did not find evidence that Microsoft’s decision reduced its combined short-term profits on operating systems and applications. Thus, the court ruled that the refusal to deal did not meet its test for anticompetitive behavior. The court also found that the profit sacrifice test would not have reached a different result if applications profits had been ignored. The evidence did not show Microsoft had sacrificed short-term operating system profits.