Excerpts

Many applications of technology in the Information Society are subject to network effects: the benefits to a single user are significantly enhanced if there are many other users of the same technology. The value to a user of an e-mail system, for instance, is limited unless the system can be used to send e-mails to many others, and increases enormously with the number of other users. This value, which is over and above the value of a single copy of the technology, is the network externality, i.e. the additional value provided by the network effect.

Network effects can go hand in hand with entry barriers for new technologies. A new technology may be adopted if it provides recognised benefits over a previous technology. However, since the value of a widely used system is, due to network externalities, much higher than the value inherent to a single user's copy of the technology, any new technology is seriously hampered by its lack of an existing user base. A new e-mail system must be far superior to an old system in order for its inherent benefits to outweigh the severe disadvantage caused by the lack of a pre-existing network. In applications highly susceptible to network effects, where the network externalities account for a large share of the total value of the system - such as e-mail - this hurdle may be impossible to cross. Indeed, the e-mail system most widely used today has remained more or less unchanged for over 20 years.

The self-enhancing feedback loop caused by network effects together with the barriers posed to alternative technologies results in the dominance of particular products in their application areas, as natural monopolies. Monopolies are not obviously good for consumers, but the presumption of natural monopolies in many areas has often been thought to provide a better value for overall welfare than, say, having various incompatible systems leading to a Balkanised network of groups of users unable to talk to each other. However, monopolies are in a position to capture (or internalise) the value of network externalities - although this value is by definition not an attribute of an individual user's product or service, a monopoly or dominant player is in a position to raise the price of an individual user's access beyond its inherent value, based on the external value of the network effect. An e-mail system that allowed you to communicate with millions of others may be priced higher than a more sophisticated system that was limited to only a few thousand others. Thus, while monopolies have long been tolerated in the telecoms sector, they are usually subject to regulation to limit their natural tendency to work against consumer welfare.

Another approach to network effects, however, is to try to abstract the network externalities from specific products. This is achieved by identifying the feature of the technology that provides the network effect, and ensuring that its use is not limited to a specific product or service. Rather, products and services from different producers are made interoperable by agreeing on standards for the basic technology components that provide the network externalities. This way, in theory at least, a natural monopoly arises in terms of the technology, but competition can thrive in terms of actual products and services that interoperate.

The problem arises that the natural monopoly on the technology for interoperability may have rights associated with it, and these rights may be owned by one market player (or a consortium). Such rights may be exploited to generate monopoly rents, which may counteract the competition in interoperable products and services that are enabled through the use of the standard. E.g. if the holder of rights to the standard seeks monopoly rents from all use of the standard, it has an anti-competitive advantage over other users of the standard.

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If the holder of rights covering a standard is also a supplier of products and services based on the standard, it has strong incentives to set licensing conditions that disadvantage the strongest potential competing suppliers. Thus, the natural monopoly that the standard creates in terms of technology may come along with competition in the market for products and services, but this competition may be limited by the control by rights-holders of the access to the standard technology.

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Alternatively, standards can be de jure, where a natural monopoly on technology is agreed upon by a body that may be an association (perhaps, but not necessarily, with a public interest mandate) of some combination of technology users and suppliers. Bodies with some level of formal process for defining such standards include ITU, ETSI, IEEE, W3C, IETF. While owners of rights over de facto standards clearly have the interest and ability to exploit their monopoly over the standard technology to control or dominate the market in products and services based on the standard, it is quite possible for owners of rights over de jure standards to do this as well.

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Based on the above discussion, one could define three broad classes of technology frameworks based on the three broad classes of economic effect that they achieve:

1. Proprietary technologies: a natural monopoly in a technology results in a natural monopoly in the market for services and products based on the technology. These often become de facto standards, in which case they are properly referred to as "proprietary standards". This occurs when the rights to the technology are available only to the rights holders, and results in a dominant position for the owner of the technology.

2. ("Semi-open") Standards: a natural monopoly in a technology arises (de facto) or is defined and agreed upon (de jure), but some competition in the market for products and services based on the technology is provided for, although potentially dominated by rights holders of the technology. Unlike most of the literature, we distinguish such standards from the next category and therefore refer to them as "semi-open standards", encompassing most standards set by most industry and international standards bodies. This occurs when the rights to the standard are made available to economic actors other than the rights holders, possibly under terms that provide an advantage to the rights holders over other competing economic actors.

3. Open standards: a natural monopoly arises (de facto) or a monopoly is defined and agreed upon (de jure) in a technology, but the monopoly in the technology is accompanied by full competition in the market for products and services based on the technology, with no a priori advantage based the ownership of the rights for the rights holder. This occurs when access to the technology is available to all (potential) economic actors on equal terms providing no advantages for the rights holders. In particular, rights to the standard are made available to economic actors other than the rights holders under terms that allow all potential competitors using all potential business models to compete with the same degree of access to the technology as the rights holders themselves. When no competitive advantage is held by some players solely by virtue of owning rights over a standard, then a unique economic effect is achieved of separating the natural monopoly of the technology itself from any possible monopoly among suppliers of the technology

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Public procurement and competition

Software buyers' preference for interoperability can conflict with implicit or explicit criteria for software purchasing, in particular whether new software is compatible with previously purchased software. Buyers who use the latter criterion rather than a general requirement for open standards or vendor-independent interoperability in effect remain locked in to their previously purchased software.

Preferring "compatibility" may even violate public procurement principles, since a preference - explicit or implicit - for "compatibility with previously installed software" favours the single supplier of that software, if it is based on proprietary or semi-open standards. An explicit preference, instead, for interoperability with open standards as defined in this paper does not favour a single supplier of technology and is therefore far more in keeping with public procurement principles. This may also be more in keeping with public procurement law. The European Commission found in 2004 that public procurement requirements to supply hardware based on "Intel or equivalent" microprocessors, or even requiring clock-rates specific to Intel processors without mentioning Intel was not compatible with EU law. [...] What applies to public procurement of hardware could reasonably be thought to apply to software procurement too, especially as the use of tenders with explicit requirements for compatibility with proprietary software standards appears to be quite common.

While this subject clearly needs empirical research beyond the scope of this paper, a quick keyword search for tenders on TED, the EU's public procurement portal identified 149 recent tenders including the term "Microsoft". A brief analysis below, of six calls for tender, identifies the strong anti-competitive effects of public procurement that favours "compatibility" with proprietary standards over "interoperability" with open standards.

1. The anti-competitive effect starts with the procurement process itself, which may require bidders to purchase software from specific vendors. For instance, a tender from Scottish Enterprise, 2005, states that "All expressions of interest shall be provided either on paper or both on paper and in electronic format (via floppy disk using Microsoft Office compatible products)". While not as bad as requiring citizens to purchase software from a single vendor for access to essential government services, such procurement procedure requirements are clearly detrimental to competition in the market for software even among private consumers.

2. A typical case of explicit preference to bidders using technologies from favoured providers is a tender from Fife Council, 2005, which is for additional services to be built around "an interactive site provisioned through the use of Macromedia Cold Fusion and Microsoft SQL". Such anti-competitive preferences are quite common even when they are not explicitly stated - tenders for the provision of websites for the European Commission, for instance, may require compatibility with the europa.eu.int EU portal. As Europa is based on proprietary technologies (including ColdFusion), a specific vendor preference is introduced into the market even without mentioning brand names. This perfectly illustrates vendor lock-in, and how the anti-competitive effect goes beyond the public sector alone when public bodies are locked in. The original procurement of technology for Europa may have indeed been truly competitive in nature. Since it obviously did not require the use of open standards, all future procurement related to Europa is anti-competitive in nature and favours the single vendor owning rights to the original technology chosen, directly (through purchase of the same vendors' software) and indirectly (through the requirement that suppliers of additional websites compatible with Europa purchase these vendors' software).

3. An example of how past purchase of software based on proprietary technology ensures a preference for the same proprietary technology (and thus favouring its sole vendor directly, or bidders who are customers of that sole vendor) is in this tender from Eurojust, 2005, a European international organisation, for a library automation system. In this tender, the preference for compatibility with previously purchased proprietary technology is explicitly stated: "Eurojust employs Intel-based servers running Windows 2003 and workstations running Windows XP . The network protocol in use is TCP/IP. Any proposed software must be able to function efficiently in this environment. Eurojust has a strong preference for Microsoft SQL as the database to minimise the variety of software to be supported in-house. It must be possible to integrate the system with Microsoft's Active Directory for user information and access control." Clearly, Microsoft and its customers are favoured in this tender. If the previously purchased software was based on open standards, the new system could have been required to be interoperable with those open standards, thus giving no preference to individual vendors.

4. Preference for individual vendors can get explicit: a tender from Consip, Ministry of Economy and Finance, Italy, 2005 is representative of the several tenders found for "software licences". It requires "licenze d'uso di programmi software Microsoft Office" (i.e. usage licences for Microsoft Office). It is supposedly a competitive tender, yet the only competition possible is among resellers of Microsoft.

5. Explicit preference for individual vendors can be extreme. In a procurement process that was "negotiated without a call for competition" (i.e. explicitly without competitive bidding but an offer invited from a single vendor), Hessische Zentrale für Datenverarbeitung, 2005, signed a contract with Microsoft Ireland for "software licences" worth Euro 2.69 million over three years. The justification provided for this negotiated procedure is a concise statement of the argument presented previously in this document: "The works/goods/services can be provided only by a particular tenderer for reasons that are: Connected with protection of exclusive rights." Clearly, if proprietary technology is specified as part of the requirements, as explained in section 2 above, only the rights holder can provide the technology, due to the "protection of exclusive rights" around the technology.

According to the European Commission, "Under European law on public procurement, a brand may be specified only if it is otherwise impossible to describe the product sufficiently precisely and intelligibly" (European Commission, 2004). True, the only way to describe proprietary software products such as Microsoft Office or Macromedia ColdFusion is through their brand names. But specifying these products in public procurement, rather than product-independent technical requirements, is surely anti-competitive. Just as the EC argued that microprocessors can be selected on performance criteria rather than specific clock rates (which favour a single vendor), software and software services should be selected on the basis of technology rather than products.

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