DKT/CASE NO.:P951201
TITLE: HEARINGS ON GLOBAL AND INNOVATIONS BASED COMPETITION
PLACE: Washington, D.C.
DATE: December 1, 1995
PAGES: 3725 through 3931
C O R R E C T E D C O P Y
Meeting Before the Commission
Date: December 1, 1995
Docket No.:P951201
FEDERAL TRADE COMMISSION
I N D E X
WITNESS: EXAMINATION
NONE
E X H I B I T S
FOR IDENTIFICATION
Commission's:
NONE
FEDERAL TRADE COMMISSION
In the Matter of: )
)
) Docket No.: P951201
HEARINGS ON GLOBAL AND )
INNOVATION-BASED COMPETITION )
Friday,December 1, 1995
Federal Trade Commission
Sixth and Pennsylvania Avenues
Room 432
Washington, D.C. 20580
The above-entitled matter came on for hearing,
pursuant to notice, at 9:00 a.m.
SPEAKERS:
ROBERT PITOFSKY
Chairman, Federal Trade Commission
JANET D. STEIGER
Commissioner, Federal Trade Commission
CHRISTINE A. VARNEY
Commissioner, Federal Trade Commission
BECKY BURR
Attorney/Advisor to Commissioner Varney
SPEAKERS (Continued):
SUSAN S. DeSANTI
Director, Policy Planning
DEBRA VALENTINE
Deputy Director, Policy Planning
MICHAEL ANTALICS
Assistant Director for Non-Merger
General Litigation I Division,
Bureau of Competition
WILLIARD K. TOM
Director for Policy and Evaluation,
Bureau of Competition
WILLIAM E. COHEN
Project Director for Innovation,
Policy Planning
JONATHAN BAKER
Director, Bureau of Economics
CHRISTINE A. EDWARDS
Executive Vice President,
Dean Witter, Discover & Company
AMY MARASCO
Vice President and General Counsel
American National Standards Institute
JANUSZ ORDOVER
Professor, New York University
ROEL PIEPER
Chief Executive Officer
UB Networks
Senior Vice President
Tandem Computers
THOMAS ROSCH
Latham & Watkins
SPEAKERS (Continued):
RICHARD SCHMALENSEE
Professor, Massachusetts Institute of Technology
DAVID J. TEECE
Professor, University of California, Berkeley
STEVEN SALOP
Professor, Georgetown University
ROBERT WILLIG
Professor, Princeton University
P R O C E E D I N G S
CHAIRMAN PITOFSKY: Good morning, everyone. We meet again in these sets of hearings dealing with global competition and innovation.
I was telling Dick Schmalensee a minute ago that the question that we have been dealing with the last day or two, this issue of how antitrust deals with networks and with bottleneck monopolies and high-tech industries, I believe has been about the most perplexing that we have addressed. We had some fairly sharp disagreements yesterday, everything from open access equals confiscation on the one hand to the claim that open access is the American way on the other hand. And we really look forward to this panel enlightening on us what the issues are and what we ought to do about them.
Our first speaker is Richard Schmalensee the Gordon Billard Professor of Economics and Management at MIT and Director of the MIT Center for Energy and Environmental Policy Research.
He served as a member of the President's Counsel of Economic Advisors from 1989 to 1991. And prior to joining the Council, he served as area head for economics, finance, and accounting at the MIT Sloan School of Management.
His academic work has centered on industrial organization economics, and its application to a wide range of antitrust and regulatory issues. And, of course, he's published numerous articles and co-authored several books.
He has also been a consultant for many private firms as well as government agencies including the Antitrust Division of the Department of Justice.
Dick, it's a pleasure to welcome you here.
MR. SCHMALENSEE: Thank you, Mr. Chairman.
You have my written statement, which is much too long to read. So let me just go through some of the main points.
I'm going to conclude -- this is the sort of testimony when you realize you have become your father. I'm going to conclude that networks are very interesting, networks are very difficult, but that networks really do not justify new rules. Networks raise difficult problems, but they are not fundamentally new difficult problems.
A reason I think for confusion that I want to deal with first -- and it's dealt with first in my written statement -- is the tendency to use the term "network" in a very broad way and then to attach a specific meaning to it.
If you think about the number of things that are commonly called "networks," they range from the telephone system to a new MBA's set of useful friends and acquaintances, to the set of suppliers serving a particular firm connected by long-term business relationships, to the set of users of a particular software product.
These, I contend, are very different animals. Some networks have single sponsors, say the set of individuals connected because they use a particular software product. Some networks have multiple sponsors, say the participants in bank credit card networks. There are a range of differences.
I think the confusion arises, in part, because the economic literature on networks deals with a particular network phenomenon that doesn't characterize everything we describe as a network.
The economic literature focuses on networks marked by a particular kind of externality in which, roughly speaking, the value of the network rises more than proportionally to the size of the network. Networks like the telephone system, in which the value of a telephone to me depends positively on how many people have phones; therefore, the total value of a million-person phone system is more than a million times greater the value of a one-person phone system, for instance.
Networks that have this feature, these network externalities, show a sort of economies of scale on the demand side as distinct from any economies of scale in provision of the networks or its services.
Economies of scale on the demand side, like economies of scale on the supply side, tend to point in the direction of, although it may not carry the system all the way toward, natural monopoly or essential facilities status.
Not all things that we commonly call networks are obviously possessed of that attribute. So simply to say that something is a network is not to say that nature or market forces decree that there should be only one of them or of it. And I think that's important because we tend, when we think network, to think essential facility, to think only one. But as a logical matter, a network is something that has nodes and links. It's not something of which there is logically only one. So let me urge that distinction. And also make the point that simply having networks externalities by itself operating over some range of size of the network doesn't get you natural monopoly either. It may be important in a credit card network, let's us say, to have national coverage or world coverage. It doesn't follow that after that has been obtained there are further externalities that cause economies of scale.
Well, let me talk, then, that general point made, about some issues raised by single-sponsor networks and by multiple-sponsor networks.
The single-sponsor network situation is one -- it would be typified, say, by one that the Commission knows well: The situation involving Microsoft operating system products. That's a situation which one can argue for a network, that there are connections among users.
One can argue there are externalities, that the value of the system grows more than proportionally with the number of users. And that the issue that's raised -- and has been raised by a number of observers -- is whether one needs, in situations like this, unusually strict conduct standards.
The argument, as I understand it, basically builds on the economics literature. The economics literature in situations of this sort says that, by accident of history, by dint of moving a little bit earlier, or as a logical matter, by dint of a small antitrust violation that gives an advantage, an inferior standard, an inferior network, can emerge as the dominant entity.
It follows, then, that because small actions can have large consequences -- it follows in this particular argument -- that one ought to be particularly careful about small actions. That is to say, to avoid losing kingdoms, you have to watch horseshoe nails closely.
Let me point out, first, that this argument hinges on scale economies. It hinges on a situation in which the outcome of an industry will not be perfectly competitive. It might be a monopoly depending on who wins the competition in a situation involving scale economies.
It applies equally as well -- although, I don't think this has been formally done, but it applies equally well to scale economies on the supply side, which are very familiar to us, or to learning economies, which are very familiar to us.
Now, one wouldn't want to say, I think, that because an industry has economies of scale in production that we have to be very, very careful, unusually careful, careful in ways that would otherwise be unjustified, to hold the industry to the a standard of near perfection, because after all, if we don't, then a small antitrust violation can lead to huge social costs.
It seems to me, we tend to apply -- we tend, obviously, to apply different sets of standards -- and appropriately so -- to dominant firms or firms that can be arguably characterized as dominant. But I don't think that it makes sense any more in the case of scale economies than in the case of network effects to be obsessively concerned about the possibility that, if we don't prevent someone getting an illicit advantage, the world will end.
Let me also point out an important qualification. The theoretical models that say that, indeed, an inefficient or undesirable standard or network can emerge as dominant because of accidents, it's unclear how seriously to take those models as an empirical matter. It is hard, as a number of people have pointed out, to find examples. And it's important to recognize that saying that standard X wins when standard Y is better, means there is a profit opportunity for vendors of Y if they can find a way to overcome whatever disadvantage they began with.
In the models in the journals, the vendors of Y have few strategies, typically. In the real world, the vendors of Y have a wide range of strategies that they can seek to employ to demonstrate their superiority to overcome disadvantages.
Given that difference and given the difference in the lack of empirical support for these models, one must be a little careful.
A third point to be made is that, as distinct from situations in which advantages rest on tangible supply side assets, when advantages rest on basically being popular because you're popular -- which is the classic network externalities case -- that's a very precarious position.
As vendors of a number of formerly popular software products like Word Star and Visicalc can attest.
Let me turn, now, to the issue of multi-sponsor networks. And I think the prototype case, from my point of view, would be, say, bank credit cards; although, obviously collective standard setting raises a set of related issues.
Again, it's important to understand that just because a situation is properly characterized as a network does not mean it is inevitably an essential facility, inevitably a natural monopoly, inevitably only one of them.
That said, as a general matter, I think it's useful -- indeed, I think it's important to distinguish between conduct issues related to operations and conduct issues related to membership.
Issues related to the operations of a network seem to me, essentially, indistinguishable from the issues of multi-sponsor network related to how any sort of joint venture carries on its business. And, you know, there are trade-offs between efficiencies from closer cooperation and risks of diminished competition from closer cooperation. There are broad policy issues, the extent to which the joint venture form should be a favored or disfavored form of organization. These are familiar issues and don't seem to me to turn on whether something is a network or has network externalities.
Now, I think much the same is true, despite a lot of recent writing, about membership issues. If you think about what issues are raised by considering a joint venture's membership policy, well, you could reduce competition by excluding firms from a joint venture because they could either be excluded from a market or rendered ineffective as competitors in that market. Of course, excluding a few firms without special advantages from a competitive market, I know, can't have that effect. On the other hand, inclusion of a large fraction of actual or potential competitors may reduce or eliminate competition at the network level, either by effectively merging two networks or by reducing a network below critical size.
The familiar worry -- which we used to hear more about than we do now -- of having a large fraction of competitors in an industry in an industry making collective decisions is, I think, still a valid one. There are dangers from having a joint venture be over-broad.
Finally, I think there are broad policy issues raised by -- of several sorts -- raised by requiring a joint venture to admit members particularly if that joint venture, as is the case in all interesting situations, has actually created something of value.
That raises, first, the question of the appropriate price of membership for a late comer. That, I submit, is fundamentally a regulatory question of the sort that courts have traditionally sought, properly I think, to avoid.
The second broad policy issue is that, given there's always some uncertainty about how access will be priced if it is forced, the prospect of facing that sort of uncertain outcome tends to disfavor the joint venture form and tends to reduce incentives to create property in that way, perhaps either leading to its non-creation or its creation by a merger or a single-firm form.
Now, I think none of these points have much to do with whether the joint venture being considered is a network.
Certainly changes in technology have made networks that use electronics -- have sort of increased the scope for productive networks of that sort -- and that's been a important development -- but the points I just went through don't have anything to do with networks. They have to do with joint ventures, competition between joint ventures and other entities, competition within joint ventures, nature of markets, and so forth.
I think the fact that the Mountain West case involved a network is, in one sense, coincidental and in one sense not. It's coincidental because those issues could have been raised by other joint ventures. It's not coincidental because the technology means that a lot more joint ventures or related forms will be networks in the future.
I come down in these questions to something close to an essential facilities position; that is to say, I think the balance of policy considerations means that a joint venture should be required to admit a new member only when it can be shown that doing so is essential for effective competition or close to essential for effective competition in some market.
That is to say, I think the presumption is that refusal to admit a new member ought to be legal, just like that's the presumption -- rebuttable, of course -- just like a refusal to agree to a merger proposal is presumptively legal.
Now, that's not a per se rule despite things friends of mine have written. And various friends of mine would take another view, would apparently condemn any decision to exclude an applicant for membership in a joint venture if exclusion would reduce the applicant's effectiveness as a competitor, unless that exclusion could be shown to be reasonably necessary to achieve efficiencies.
Well, the contrast between the two approaches is what's to be proven and sort of what's the presumption.
My sense is that a harmless exclusion should be treated as harmless, even if you can't provide an efficiency defense for it. That is to say, one could conclude -- I'm not offering this is a conclusion. One could conclude that the main reason that VISA declined do admit competitors, to admit Dean Witter was a visceral reaction that says -- the standard, typical business person's reactions -- these folks have been our competitors, and now they want to join our venture; no way.
Now, if that was the case, it's real hard to find an efficiency defense. But in my view, that ought to be a legitimate decision if it does not reduce, does not appreciably reduce market competition.
I think to go the other way, to put the presumption in favor of admission, makes sense only really if you think that, as a general matter, refusal to admit a new member tends to reduce competition. In light of the importance of competition at the network level or among joint ventures or between joint ventures and other firms, I don't see how that presumption is justified.
In addition, I think it's not justified because there are costs, potential competitive costs to having over-broad joint ventures. I think to ignore that, that traditional and proper concern, and to do that by saying, it's a network, is unjustified.
To circle back to the point with which I began, if you start with the presumption that because something's a network, network economies are important; because network economies are important, you're in a natural monopoly, essential facilities situation. If you begin with that, then, of course, there's no loss to admission because you're dealing with essential facilities by assumption; and why would you ever want the owners of an essential facility to be permitted to exclude?
But it doesn't follow that anything that is properly labeled a network is a natural monopoly without proof.
If there is proof, then admission should be required and the difficult task of what is the price should be faced.
Now, as I said at the outset, this is the sort of testimony, when you have prepared it, you realize you have become your father. So I want to be clear that I'm not suggesting that antitrust industries should receive less vigorous -- or network industries should receive less vigorous scrutiny.
It seems to me, however, that existing -- that the issues raised in these industries are not intrinsically novel. They are issues that we have encountered in the antitrust area in other settings. They have been difficult in other settings. They are difficult here.
The recent work in economics -- it would be nice if the recent economic literature on networks were of the following character: I don't know about these other situations, but in a network context, here's how you deal with them. But the literature isn't of that character.
The literature is of the: Here are some interesting and difficult things that can happen in networks. That, I submit, does not really provide new analytical tools to be used to deal with these old issues in a network context. So I am forced to conservative conclusions.
Thank you.
CHAIRMAN PITOFSKY: Well, thank you for an exceptionally clear presentation on this.
What we have been doing the last couple of days is maybe ask a clarifying question or two but save discussion, including discussion among the panelists, for a little later in the morning or the afternoon.
Dick, let me make sure -- I believe I understand that you're drawing a distinction between an essential facility that's essential to the competitor. That's not enough. It's got to be essential to competition. If it's only essential to the competitor, that's your notion of a harmless error.
But let's assume it's essential to competition, even in that situation, would you allow the joint venture or the monopolist to say, yeah, but letting more people in is highly inefficient and will diminish the efficiency of the total operation?
MR. SCHMALENSEE: No. I think -- I was about to say I follow the traditional essential facilities doctrine, but that's not a clear statement.
In principle, there's a balance called for, of course. In practice, I think that's not likely to be feasible unless it can be shown that competition is simply not feasible.
Then it seems to me -- and that's a difficult showing in this day and age, and I think it's very difficult in these industries. I think to the extent there is a traditional essential facilities doctrine that says, if competition is feasible, if access to this facility is essential for competition to occur, then, reluctantly, painfully, awkwardly, we must compel access.
So I would go that far. I think essential for a competitor is not far enough.
CHAIRMAN PITOFSKY: Right.
Thank you.
Other questions?
Our next speaker is Roel Pieper, President and Chief Executive Officer of UB Networks and a Senior Vice President of UB Networks' parent company Tandem Computers.
UB Networks is one of the largest network communications vendors worldwide and provides enterprise organizations with ATM, Ethernet, and others.
Prior to joining UB, Mr. Pieper served as President and CEO of UNIX Systems Laboratories. Before that he spent 10 years at Software AG, both in Germany and the U.S. There he served as Chief Technical Officer and Senior Vice President of the Technology Division.
Mr. Pieper.
MR. PIEPER: I would like to make an attempt to comment on the subject of networks probably more in a, what has been called a "real network sense."
Having had the experience of the leadership of the UNIX community, or the UNIX Operating System environment for a number of years 1990 to 1993, I would say I have been whipped into shape as to what real standards were and what real standards weren't and, even more importantly, what real processes were and what real processes weren't.
In that experience I detected that standards is not about technology. It's actually about attitude, and I want to explain that in the following way:
The opposite of "open" -- a lot of people make the mistake that when you talk about open standards, a lot of people make the mistake that they think that the opposite of "open" is "proprietary"; and actually the opposite of "open" is "closed."
Whereas the opposite of "proprietary" is "public." So if you would draw a quadrant between the opposites of those determinations -- i.e., "open" and "closed" and "public" and "private" -- you come to the conclusion that the winning quadrant is "open" and "proprietary."
Now what does that mean?
That means that there must be some process by which standards evolve and proprietary value continues to be added. It must be a coexistence of proprietary evolution, you know, fostered by competition or fostered by invention, whatever that may be, off of the basis and process of at least a base of common, open standards that are moving ahead.
I concluded after those years leading the UNIX community that to be successful creating a valid standard, at the heart of the success lies the attitude of the providers, not the technology itself.
Now I'll come back to that particular point with regard to a number of activities that I'm currently trying to sponsor outside of my business activities in Silicon Valley and other places, partially also for the Dutch Government. I'm a Dutch citizen, and I'm advising to a certain extent on somewhat sort of similar issues.
There are, you know, again, a whole bunch of battles in the industry today which are not visible yet. The ATM forum is one other, let's say, new community on the horizon trying to come to grips with a new set of standards, derivatives of ISBN, to try to foster, within the network sense, collaboration, competitiveness, interoperability, and, obviously, effective products, effective in the sense of functionality, price, et cetera.
We can debate if that process is going to be successful or not, given the experience that we have had, in the operating system wars that have mostly, you know, subsided.
I believe that the risk of convergence, again around monopolistic standards that are driven through economies of scale, vendor dominance, in the sense of network functionalities, network capabilities, will, again, be derived off of what I would say are "undocumented features" and "capabilities" similar as that has happened in the operating system types of environment.
Again, there is no real difference -- and I agree with you -- there is no real difference with a lot of these issues coming at it from a more technical point view, I understand. There are really not a real lot of differences between what has happened more from the single computer point of view than from the, let's say, networked computer point of view.
I would like to try to make a stab and explain some of the things we are trying to do out of an organization that is called "Smart Valley," not that there are no other smart valleys in the world; but there is a group in Silicon Valley that is called Smart Valley, which is a composite of academia, business, and administration-type of, let me say, managers, leaders, and executives.
And this group has made a statement towards each other and to the Valley that their mission is going to be to try to foster sharing of technologies, sharing of ideas, but way ahead of actual product delivery to the market.
And around that concept, which I have been part of the founding of, the very specific new project has been founded; and I would like to maybe start with some foils to try to come to that conclusion and then fold in some other points that I believe are very relevant to how an administration in general -- this is my personal opinion -- should behave with regard to the participation in this whole standards process.
It might be a little controversial, and that's okay.
Okay. So the main points that I would like to talk about are these four -- talk about what I believe are the various choices of government positions and, again, the word attitude, because I think that's the central point; talk a little bit about standards, definition, and evolution of that -- I already started to position it a little bit by talking about these open, closed, public, proprietary types of dimensions -- and then try to position some of that all in the sense of the first mover effects and second mover effects and how one could address some of these issues, again, just bringing forward some suggestions.
Let me first try to put into perspective some of the things that have happened in the industry and that continue to happen in the industry.
The conclusion that I make is that paper standards will continue to fail if they are not tied to real-world evolution and are not in sync largely because of the lack of timing.
We've seen that with OSI. We have probably seen that with things around the UNIX Operating System. And we run the risk, again, of seeing that around the ATM standards.
There is a continuous risk that the more formal processes will be run over by the, let's say, exclusion of other technologies in that environment and, you know, typically short cuts by vendors of a particular nature could be made.
There are clearly de facto standards that are very, very important. I mentioned here in the network sense TCP/IP. I mean if TCP/IP is not a pure example of how an unnoticed technology can suddenly appear as a real market standard and actually work and actually be a real collaborative-type of technology, interesting risks though that these kinds of standards might actually be subsumed by economic volume leaders as their ownership going forward. That's actually another risk that could happen, even after a certain technology standard has been established.
There have been attempts of what I would call blended standards, blended standards where there is both a reality test as well as a paper compatibility test. And I mentioned just a few, X/Open, in the early 80's. And OSF in the mid 80's, and today, things like the ATM forum that you might be familiar with.
I absolutely am convinced that the early movers must be identified more by an organization like this Smart Valley that I mentioned or others around the world or in the U.S. By trying to bring these early movers, these early innovators to an environment that you could call a "collaboratory," a "reference lab," environments in which these early moving parts are identified and exposed to the fundamental question: Would sharing be better or not?
Sometimes sharing is not necessarily good for that single vendor; but after some, let's say, social pressure, public pressure there is the possibility -- and I've seen that work -- that some of these moving technologies could actually reach a much broader market with much more capabilities for a number of companies to be, you know, competitively and economically able to take advantage of a broader set of standards that have been made available through sharing of technology.
I think users, in general, have become much smarter and much more active in qualifying and disqualifying vendors through their behavior, not through their ability or willingness to apply standards in their products that they deliver but actually by their attitude. You see much more vendors making buying decisions blended by both their opinion of the attitude of the vendor as well as the, of course, technical and pricing proficiency of the products that are being offered.
At the same time, vendors have become much smarter as well. The way that proprietary values and undocumented capabilities are being hidden are getting substantially more sophisticated.
So there is a real question as to who is moving faster and smarter in the right direction.
I believe we can talk a lot about these standards in trying to come up with the right processes to write these things down to share them on paper, but my conclusion has been that the only way to really expose the issues of real working and collaboratory-type technologies, if it's a database application, a multi-media application, a telephony-based application, a set-top application, it is through exposure in live collaboratory.
So my conclusion in the sense of standard definition and evolution is that the only place where standards and evolution can happen is in the real world, but we must find a way that this collaboratory-type of environment is fostered by a number of different organizations. And one I believe clearly has to be the administration or government. So let me switch to that point.
As I have done for the Dutch Government, maybe contrary to some belief in the U.S., I believe that there is almost a black and white decision only for an administration to decide to engage or not.
When you engage -- and what I mean by that I'll explain a little bit later -- but when you engage as an administration to participate in the evolution of the market process, you have no choice but to go all the way. There is no middle ground. You must try to be on top of the issues. You try to have the best technical people, the best business people, the best economic people on board to try to understand what's going on in the industry.
The other side, which you could call black or white, is to not do anything at all; and you basically let it go the way it goes, a market free for all.
A governing body -- and I'm just mentioning a few of them. Obviously in the U.S., NIST, in Germany, Deutsche Industry Norm, you know, there are different types of examples of norming bodies and norming organizations that could exist if they are powerful and knowledgeable and active in the sense of participation, not controlling.
I believe that there is a possibility -- and we are experimenting in Holland with that -- that there is a possibility by having both government guidelines, academic guidelines, and business guidelines to create an environment in which sponsoring tax incentives, public, academic and business frameworks are created that are, in a way, coexisting with the real-world market dynamics but within which these newer technologies, the early mover technologies, as well, let's say, as the second mover types of technologies, are continuously brought together, are continuously tested, are continuously validated; and key areas of misnomers are identified.
They are not identified by laws or fines or whatever. But that are identified by different types of attitudes of different vendors coming together in a fairly public place.
So what needs to happen, my opinion is, that this decision to engage or not must happen. I believe the decision to engage is better than the decision not to engage. If the decision is to engage, it might be a difficult one and a costly one; but it is definitely one that could lead to more powerful interoperability standards in the network sense that would allow better economies of scale between different companies. I suggest, for example, that the early notions of EDI, "electronic data interchange," could evolve much more broadly and much more efficiently if the business-to-business communication procedures and processes could be done on the basis of much more capable technologies that would be derived off of network functionality, inventory matching, order processing, customer administration -- I could go on and on and on -- a lot of very valuable applications that can become very effective through the usage of a network, let alone the distribution of goods in general as another discussion of value that a network could bring.
Let me talk about first mover and second mover subjects for just a little bit. Again, I'm identifying here some organizations. I'm labelling it NIST, but for me that is not so relevant. It has to be some kind of organization or some group of organizations that I believe need to be put into light that really drives the definition, behavior of these various reference laboratories and applications.
We are, in the sense of networking, at a very early stage. There is a lot of opportunity, I believe, to identify the key types of technologies, applications, and companies that should be brought together by public pressure, social pressure, technical pressure, economic pressure, whatever might apply.
The example that I would like to point to of some of these concepts that is happening in the U.S. -- a similar project is happening in Holland -- is called BAMTA. BAMTA is the "Bay Area Multi-media Technology Alliance." It was started by Smart Valley. There are about 50 organizations that are participating in that, both from academic, administrative, as well as from business entities.
It is also sponsored, to a large degree by NASA, AMES, in which the role of NASA, in this particular case, is both the, let's say, monitoring of attitude as well as the pursuing of certain objectives with regard to standards and evolution in the network sense, in this particular case for the health care education subject.
This organization has been surprisingly successful in trying to bring together technologies and ideas that I had originally thought would be really kept close to the vest by a whole bunch of different companies. And I'm talking about companies such as Oracle, Kodak, Intel, Hewlett Packard, Sun Microsystems, UB, Bay Networks, et cetera, where I would believe that early technologies, in the sense of trying to create a better cooperating network set of capabilities, both at the physical level as well as at the application level, surprisingly, by simply trying to establish this kind of different collaborative type of environment, these things did happen; and there was no formal process for it other than this type of a, I would call it, somewhat of a social economic pressure model.
Obviously these kinds of organizations cannot be a singular one. There must be a whole number of these, and it cannot clearly happen just from a nation point of view. There must be very strong international coordination and verification.
I believe that these things will happen within the European Community. I believe the European Community has another, let's say, organization forum that will try to drive and foster examples of these kinds of collaboratory or projects that would have that common theme of sharing or collaborative technology of the early mover category.
Now, obviously, for second mover technologies, the situation is a little different. Let me use the example of TCP/IP. There is a substantial risk that TCP/IP will be taken over by some organization that simply subsumes it and makes it economically inclusive in other capabilities. And so that's just one example. There are probably other technologies that could be subsumed by economic leaders.
There must be, again, an environment in which some of these evolutionary steps of new technologies that have to be added to an existing environment, similar to some of the joint venture ideas, that when a new party with some value-added ideas is coming to the same place, the real market, the real application, or the real business-to-business communication environments, then we should find a process by which these technologies can be added. If that is not possible by normal collaboration between the business entities, there should be adjacent procedures in place, such as these collaboratories that I talked about, where that kind of a problem or opportunity could be identified.
So this is very similar to the first mover effect; although, the second mover types of environments could be a little more hard to establish and to validate.
Again, I'm trying to stay away very far from formal processes. I'm trying to focus really on the idea of public exposure, public pressure between the various organizations either from an engineering point of view or simply from a social point of view.
For the sake of time, let me try to conclude here. I think that, you know, from my point of view, if an administration in general decides to be passive, it will have to give up a lot of its ability to judge what is really happening and what is not, simply because of the speed by which some of these technologies are developing and because of the proficiency that is being exposed by the vendors. And I'm talking as a vendor as well.
The smartness, if you want to call it that, by hiding proprietary capabilities and closing them is getting pretty special.
I think by engaged behavior, not controlled behavior, by engaged behavior, one could sponsor, through tax incentives, project incentives, according to specific guidelines. I want to mention here some ideas that I have derived from having been both in Finland and Singapore. I mention Finland and Singapore as some countries that have taken a very rigorous step along these lines of what I would call engaged behavior.
Let me take Singapore as one example. In Singapore there are a whole range of tax incentives, of model suggestions that are being put forward by the administration of Singapore but are derived of a very clear project and model that they call "IT 2000," which is their model to create an infrastructure, a society infrastructure, a business infrastructure in that, let's say, physical territory called Singapore, where companies that follow those guidelines, or at least stay within, you know, a reasonable definition of those guidelines, are given substantial incentives to stay within those rather than to disregard them.
We can debate that that's good or bad behavior, but it's at least a stab ahead by an administration to try to create more commonality in the public services, in the infrastructure services that are being offered indirectly or directly through an administration in the country or region that they are operating in.
I believe a norm, an effective norm -- maybe not a standard -- can be set and can be evolved by this collaborative process by academia, business, and administration. And somebody will have to step up to a leadership role in the form of not controlling but actively guiding that collaborative process forward.
And, you know, as a final statement, I know that this is not the easiest solution, and maybe it is one of very, very few.
CHAIRMAN PITOFSKY: Thank you very much for some very provocative and interesting ideas.
Our next speaker is someone who --
COMMISSIONER VARNEY: Could I clarify?
CHAIRMAN PITOFSKY: Yes. Yes.
COMMISSIONER VARNEY: Is it fair to say, then, that your belief that the collaboratories are pro-competitive is only true where there is government involvement?
MR. PIEPER: No, that is not true. I think collaboratories could be pro-competitive even without government involvement.
But I believe, especially if we start thinking about the usage of networks both by administration as well as by public entities, you know, going forward, there is going to be more and more interaction, I believe, through networks either for, you know, personal, citizen-type of administration activities or business-to-business or business-to-government communication activities through networks. There would be a lot of advantages and economies of scale achieved if government would evolve as an organization themselves the same way.
COMMISSIONER VARNEY: I'll hold my other questions for later.
CHAIRMAN PITOFSKY: I'm sorry to say our next speaker has lived in the real world in this question of access, joint ventures, and so forth.
Christine Edwards is Executive Vice President, General Counsel and Secretary of Dean Witter, Discover, the parent company of Dean Witter Reynolds and NOVUS Credit Services, Inc.
As General Counsel at Dean Witter Reynolds, Ms. Edwards has responsibility for the legal and compliance functions of the broker/dealer, mutual fund, and investment banking businesses.
As general counsel for NOVUS, she has responsibility for the legal function of the three NOVUS businesses: Discover Card, Lending Services Division, and SPS Transactions.
Welcome to the FTC.
Am I right in assuming that you have paid some attention to the Discover/VISA-MasterCard controversy?
MS. EDWARDS: I have paid a little attention to it, yes, Mr. Chairman.
Thank you and good morning.
First of all, I would like to start out by taking note of the tremendous antitrust expertise resident on this panel this morning and promptly exclude myself from that description. Instead, I'm going to testify today from the perspective of having been involved in the credit and charge card industry for about 25 years now, which, of course, means that I started, obviously, well before any child labor laws existed; at least that's how I like to think about it.
I did submit written testimony, but I'm going to streamline my presentation for this morning. And my observations begin from the premise that various horizontal issues are presented by networks that operate in this industry, which this morning I'm going to refer to as the charge card industry.
Networks play a vital role in that industry. VISA and MasterCard, joint venture networks which include nearly every issuer of general purpose charge cards have achieved a position of dominance and collective market power.
The policy issues I'm going to pose this morning arise from the fact that changes in marketing and processing technology have created, for the first time, the opportunity for non-association proprietary networks to provide the same kinds of services as the two associations and to do so equally, if not more, efficiently than the bankcard associations.
But at a time when there is a real opportunity to encourage efficient proprietary networks, at a time when there's a real question whether there is a need any longer for the associations, the associations are aggressively using their substantial incumbency advantages to impede competition from proprietary networks. They are also working to extend those advantages into new financial products and services like the electronic delivery of home banking services.
These developments, I believe, raise important policy issues which I think can be summarized in a question: How should antitrust enforcement respond when two industry-wide charge card networks use their market power to impede the entry and the growth of efficient, competing proprietary networks?
How these issues are resolved will determine the structure and competitiveness of the charge card industry; but perhaps more important is whether the bankcard associations are going to be allowed to use their market power to impede competitors in other emerging payment system markets, affecting other areas of electronic commerce.
Similar issues will, no doubt, come up in other industries. We've heard about them this morning. The policy decisions you make regarding these issues, whether by affirmative decisions or by inaction, will have a significant impact elsewhere in the economy.
For these reasons, I applaud the Commission, and you, Mr. Chairman, for holding these far-ranging hearings and taking seriously the observations of business people and their counsel, along with academicians and other antitrust professionals.
In the United States today, there are only two models for charge card networks. One is represented by the networks operated by the VISA and MasterCard. They were formed about 25 years ago. Both are extremely broad joint ventures with virtually identical memberships that include almost every issuer of general purpose charge cards in the United States.
And I use the term "bankcard" to refer to the charge cards that are supported by the two association networks.
Now the competitive dynamics between the two associations are curious. Since almost all card issuers belong to both associations, their members gain no competitive advantages against other charge card issuers if either association tries to make its brand more desirable to consumers than the other's. And any innovations that result in differences in operational requirements between VISA and MasterCard actually can cause substantial additional expenses for their memberships, and their members don't appreciate that. As a result, the associations don't compete with one another.
The other network model which is represented at the bottom of the chart is the proprietary network. Three proprietary networks exist in the United States today, and they are operated by my company, which is NOVUS, by American Express, and by the largest issuer of bankcards in the United States, Citicorp.
In contrast with the association networks, substantial incentives exist for a proprietary to compete against other proprietary networks as well as against association networks.
The evolution of our network, which we call the "NOVUS Network," demonstrates how proprietary networks operate.
Back in 1985, Sears, which was then the parent company of Dean Witter, decided to enter into the general purpose credit card market. Our strategy was to pursue a model like Citicorp, which at the time participated not only in the VISA and MasterCard networks but also operated several proprietary networks of its own, including Diners Club and Carte Blanche.
We decided to enter the charge card market by first launching a proprietary charge, which we did by rolling out the Discover Card in late 1985. We faced enormous barriers to entry of our new network.
We had to deal with the classic chicken-and-egg problem. We sent eager, young salespeople, who probably didn't know any better, out with the assignment of persuading hundreds of thousands of merchants to accept a card that not one cardholder held.
At the same time, we had to persuade millions of consumers to accept a card that they didn't know whether they could use it with any merchant.
It was a high-risk strategy. And it is very likely that without the substantial business credibility that Sears and Dean Witter had built over the years, that both merchants and consumers would not have accepted the card.
But we were successful. But to achieve our success, we had to overcome not only fair competitive responses from existing competitors but also a variety of efforts by the bankcard associations to prevent Discover Card from having a chance to compete in the market at all.
For example, VISA orchestrated an elaborate disinformation campaign to try to persuade merchants not to accept the Discover Card on the basis of a false claim that Sears somehow was going to use Discover Card information to steal their merchant customer base.
Another association-led program was designed to prevent our card from being processed over the bankcard authorization terminals. We did, however, succeed in making the Discover Card a viable competitor in the charge card market.
Then, about three years ago, we made a decision. Now this was after the trial court antitrust decision that did give us some comfort that the law would provide practical protection against the associations' collective interference in our competitive efforts.
Our decision was to enhance our proprietary network. We invested tens of millions of dollars in converting the network that we had built for Discover Card into one that could be used not only for that card but for other cards as well. The result was the NOVUS Network.
Dean Witter offers three cards on the network presently: the Discover Card, Private Issue, and the new Bravo card. Other cards are in the works. The system that we are building also has the capacity of supporting NOVUS-marked cards that are issued by other firms.
But there are some very significant differences between the association networks and proprietary networks.
First, the association networks enjoy huge incumbency advantages. Thousands of banks promote VISA and MasterCard brands. And most merchants feel that they must, as a practical matter, accept those cards.
Second, proprietary networks are simpler to operate. And changes in marketing and processing technology are making it possible for proprietary networks to compete with increasing efficiency against the association networks. Now that wasn't always true.
The industry has dramatically changed since when the associations were formed. Banks have been permitted to expand geographically. They have become more willing to compete nationally. Credit cards are marketed across the country by banks with no local presence. Transaction processing is almost entirely electronic with no local presence required. And firms with enormous resources, such as General Motors and AT&T have entered the charge card market either individually or in combination with other firms.
If the industry were first coming into existence today, there would probably be no need for networks operated by giant industry-wide ventures like VISA and MasterCard. A series of interlinked proprietary networks and processors could perform the same services equally, if not more efficiently.
You don't have to look farther than the Internet for an example of how unnecessary a huge central clearing house is today for the operation of an efficient, electronically based network.
Third, in studying these industry changes, you would expect to see a decline in the dominance of the bankcard networks. Yet the market share of the bankcard networks has been rising steadily. In fact, in just the last three years it has risen from an already-lopsided 72 percent of the market to 76 percent of the market.
The market share trend is not accidental. It is the direct result of the bankcard associations' using their market power.
But the associations' goals are not a matter of speculation. A few years ago, we obtained a videotape of one of the closed-door meetings that VISA held with its members in connection with the launch of the orchestrated anti-Discover campaign.
On the tape, which I'm going to show you this morning, is Fran Schall, who is VISA's Vice President of marketing, who summarized VISA's goal in dealing with proprietary networks like ours.
At the beginning of the tape, she refers to a tape which was just shown to all of their bank members featuring Claude Aikens who was an actor. He is now deceased.
The video was shown to all association members during the course of that year and was basically indicating to banks that they should go to their merchants and tell them not to accept Discover Card.
Let me show you the video.
(Whereupon a videotape provided by Ms. Edwards was played.)
"Meeting the challenge of Discover"
"Copyright, August 1982"
"Presented by VISA S.A., Inc."
"John Bennett, Senior Vice President, Consumer Products"
"Brian Ruder, Vice President VisaNet Marking"
"Fran Schall, Vice President Member Relations"
"Phil Skarston, Market Research and Planning""MS. SCHALL: If you weren't convinced before that there was a threat, I hope that Claude got the message across.
"By working together, which was really his close, we can be effective. And not only can we slow down Sear's effort, but we can prosper from the investment which has been made over the years in the VISA program.
"It's important for all of us to keep in mind that Discover has not succeeded to date and that we're in the position of strength. We have 150 million cardholders worldwide; we have five million merchants on a worldwide basis.
"And by working together and by being proactive, rather than reactive, I think we can thwart the efforts not only of Sears but of other outside competitors. And we can develop a very effective means to compete.
"It's important that we not do anything in the process to give away or dilute our market advantage.
"If we're successful in responding to Sears, then other non-bank competitors, who are likely sitting on the sidelines, will think again when they try to follow Sears' lead.
"If we aren't successful, then there are going to be many more "Discovers" that we're going to be hearing about in coming years. And all of them are going to be looking for a share of your business and your profits.
"Remember, it's not likely that Discover is going to create new business. They're out to take away your business, your business in the bankcard industry and your bank's business."MS. EDWARDS: Well, the associations have stated that proprietary alternatives like the NOVUS Network are a potential competitive threat to their dominance that must be suppressed.
And they have taken a variety of actions, first, to impede the growth and development of networks that already exist and, second, to deter the formation of new ones.
Let me give you a few examples.
VISA bylaw 2.10(e), which is not the bylaw that we challenged several years ago, automatically terminates the membership of any VISA issuer that begins to issue a card, quote, "deemed to be competitive" with VISA cards.
VISA applies this rule only to Dean Witter and American Express networks and not to VISA membership participation in MasterCard or to Citicorp's Diner Club and Carte Blanche program.
The punitive effect of this rule is clear: No VISA member is likely to even consider signing onto a proprietary network at the cost of automatic loss of its ability to issue VISA cards.
The impact was very deliberate. When VISA's board adopted the first version of this rule, the board asked VISA's management to draw up a list of all of the non-bank firms that had the capacity to introduce a competing network.
The resulting list named more than 100 non-bank firms, including General Motors, Ford, Chrysler, Shell Oil, Amoco, and AT&T. The VISA board then instructed VISA's management to monitor all of these firms, many of which were then VISA members, and to expel or exclude them from VISA if they actually began issuing proprietary cards.
Many of those firms were not, then, issuing cards; but they have since entered the market. And not unsurprising, in light of VISA's bylaw, not a single one of them has come forward whith a proprietary card program.
Another example relates to processing charge card transactions for merchants. In order to build a merchant base for the NOVUS Network, it's been extremely important that we offer merchants, particularly smaller ones, cost-effective processing for their charge card transactions. But merchants have no interest in a processor who can't also process their VISA and MasterCard transactions.
VISA has adopted rules that are designed to prevent Dean Witter and American Express from efficiently offering bankcard transaction processing. This has limited our ability to achieve maximum efficiency and limited the growth of our network.
Bankcard associations which account for 76 percent of all transaction volume engage in standard setting. Because of the associations' overwhelming market dominance, these standards drive the market.
Our technology and our ability to change must be nimble enough to comply with the standards that they have set. We don't even have a seat at the table on the discussions on standards. The recent VISA-Microsoft discussions about setting security standards for transactions over the Internet are a good example of that.
A final example is one that I find particularly troubling. I start from the perspective that VISA has been quite careful over the years to describe itself as a joint venture association, only engaging in activities on behalf and for the direct benefit of its members.
But VISA recently announced a for-profit merchant processing joint venture with Total System Services Inc.
The significance of that announcement is that VISA will be directly competing in a for-profit corporation with its members in the marketplace at the same level as others who do business with its network.
Now, with VISA's simultaneous role in setting industry rules and standards, this is a development I think that deserves careful attention in a part of this market that Commissioner Varney recently described as "increasingly concentrated."
Bankcard associations are also working to capture other payment system markets, including on- and off-line debit cards, stored value cards, Internet commerce, and the new and potentially huge market for electronic delivery of retail banking services to the home.
In some cases they are clearly leveraging their market power with respect to charge cards in these new markets.
Now, the facts that I have described this morning raise several important antitrust enforcement policy issues, I believe.
The goal of antitrust enforcement, I think, should be to foster increased efficiency and innovation through unfettered competition.
This kind of competition will occur only if the activities of the two bankcard joint ventures that dominate the industry are actively monitored.
This is the opposite, I think, of the hands-off antitrust treatment that VISA advocates, but I believe it's justified by the competitive landscape of this industry.
Antitrust enforcement should monitor association practices like those that I have described this morning that are designed to disadvantage proprietary network competitors.
Antitrust enforcement should also be prepared to challenge each new area of association activity. The bankcard associations are antitrust anomalies. They are extraordinarily large joint ventures of competitors, cutting across virtually an entire industry.
Antitrust policy, I thought has always strongly disfavored collective competitor activity of this magnitude unless it can be justified by compelling efficiencies. At the dawn of the general purpose charge card industry, legitimate efficiency justifications probably existed for the scale and scope of the bankcard associations. But should historical fact also dictate the appropriateness of the associations moving into new activities today?
We believe expansion of the activities of these joint ventures should receive precisely the same searching scrutiny as would the formation of a new joint venture to engage in the same activities.
I believe it would be prudent antitrust policy for the enforcement agencies to actively discourage the VISA and MasterCard associations from engaging in any new activities.
If there are efficiencies that necessitate joint activity in order, for example, for the debit card market to develop or for home banking to take off or for health care provider reimbursement processings to succeed, let appropriately scaled new joint ventures be formed. If not and if individual companies can compete efficiently, then let them do so. But bankcard association joint ventures should not be permitted to quietly take the market power that they have achieved in the charge card industry and parlay it into similar power in entirely new areas.
Only one significant, proprietary network has entered the charge card market in over 35 thanks largely to the bankcard associations. Antitrust review should not permit them to have the same stifling effect in other markets.
I also think that bankcard associations should be prohibited from engaging directly in for-profit activities. Their central rulemaking and standard setting role, coupled with their market power, creates far too much risk of the associations' leveraging their not-for-profit activities into an unfair competitive advantage in their related for-profit businesses.
The approach that antitrust takes to the bankcard associations and their networks will have a critical impact on the industry's competitive landscape.
The business people who I advise will make decisions about where they take the NOVUS Network based on their assessment of the legal ground rules under which they and the bankcard networks will be operating.
But the same will be true for anyone else who considers a business challenge to the bankcard networks. This is an industry in which antitrust policy will influence real investment decisions, decisions that will determine the intensity and the innovation of the competition in the future competitive structure of the charge card market.
That structure today is clearly far from optimal. We do not ask you to prejudge the outcome of free competition between bankcard associations and their competitors. We only ask for the opportunity to have the market, not the associations, decide that outcome.
Let me close by relating what I have said this morning to the specific questions that you posed on the agenda for this morning's session.
Networks, particularly ones operated by joint ventures that encompass virtually an entire industry, as the bankcard associations do, very definitely can give rise to an opportunity for strategic anti-competitive conduct.
Jointly owned networks can amass a substantial market power and can use it to prevent the entry and growth of new competitors who want to offer more efficient network processing by taking advantage of technological innovation.
As for the criterion assessing whether strategic conduct and industry standard setting are pro-competitive or anti-competitive, I believe it continues to be the traditional fact-specific inquiry: Does the conduct in question increase the efficiency of the parties that engage in it? Or is its primary purpose and effect to reduce the intensity of competition among themselves and from others?
The bankcard association conduct that I've described this morning I think clearly fails that test. That's why I think it deserves your attention.
I thank you for the opportunity to testify this morning, and I appreciate the efforts of the Commission to examine these issues.
CHAIRMAN PITOFSKY: Well, thank you very much for directing our attention so forcefully to a real-world controversy that relates to these theoretical issues.
Let me just ask one question to make sure we set the stage for our later discussion and to make sure we understand that there is a real difference of view here.
Let me recall Professor Schmalensee's earlier comments. His thought was that where there is a successful joint venture, access is only mandated where it's essential for competition.
Discover was already in the market and competing rather successfully in that market. So without trying to decide which is right or wrong or what the policy issues are, you would be urging a broader view of mandatory access than one that says it only is required where essential to competition?
MS. EDWARDS: Actually, first of all let me start out by answering that question by observing that, to begin with, we did not use an essential facility argument in our case against VISA.
Second, I think that although the bankcard associations do exhibit many of the qualities of an essential facility, we were very careful this morning in putting together our testimony in not dealing with issues of membership.
Instead, I think what we attempted to do is look at competition from the network's perspective and look at future issues that we think the enforcement agencies should be focusing on there in terms of competition between networks of the bankcards versus proprietary networks.
If what you're addressing by the essential facilities doctrine is actual membership, those are issues I think we tried to effectively battle before and have lost; and those are previous battles.
CHAIRMAN PITOFSKY: I see. All right. Good. Good.
Any other comments or questions?
All right. Let's have one more presentation, and then we can take a break and open it up for a broader discussion.
Amy Marasco is Vice President and General Counsel of American National Standards Institute, ANSI. She is primarily responsible for overseeing ANSI's Procedures and Standards Administration Department which provides support to the Board of Standards Review, the Executive Standards Council, and the Appeals Board.
Ms. Marasco also assists those bodies in formulating and implementing policies and procedures regarding the accreditation of standards developers and standards development process.
Before joining ANSI in July 1994, Ms. Marasco was an attorney with a law firm in New York for 11 years.
Ms. Marasco.
MS. MARASCO: Thank you, Mr. Chairman. Good morning.
My name is Amy Marasco, and I am the Vice President and General Counsel of the American National Standards Institute, which is usually referred to by its acronym ANSI.
ANSI is a federation of industry, professional, technical, trade, labor, consumer, and academic organizations and some 40 government agencies.
I will focus my comments today on two more general issues than those relating to networks.
The first being: How should enforcement agencies and the courts approach the voluntary consensus standards development process to determine whether impermissible anti-competitive conduct is present?
And, second: What is or should be the process by which patented technology is incorporated into standards?
And this will lead me to some brief comments on the proposed consent decree in FTC v. Dell Computer Corporation.
The benefits and pro-competitive effects of voluntary standards are not in dispute. Standards do everything from solving issues of product compatibility to addressing consumer safety and health concerns.
The standards also allow for the systemic elimination of non-value added product differences, reduce costs, and often simplify product development. They also are a fundamental building block in international trade.
That is why the rule of reason, typically, is applied to standards activities. Weighing positive effects against anti-competitive ones, however, is not always easy to do.
One of the principal difficulties confronted by enforcement agencies and the courts when applying the rule of reason to standardization activities is that any cost benefit analysis or consideration of possible alternative standards often requires a technical expertise that these bodies normally admittedly lack.
ANSI's view is that the best alternative is to leave the resolution of technical issues to the experts who participate in the standards development process and focus, instead, on the process itself.
Focusing on the process also has the benefit of being easier for courts and enforcement agencies to analyze; providing clearer guidance to the business community; and the process can be designed and, if necessary, modified to reduce if not eliminate, the possibility of anti-competitive activity.
This has been ANSI's approach, and we believe it has been effective. In its role as the accreditor of U.S. standards developing organizations, ANSI seeks to further the integrity of the standards development process and to determine whether candidate standards meet the necessary criteria to become American National Standards.
ANSI approval of these standards is intended to verify that the principles of openness and due process have been followed and that a consensus of all interested parties has been reached. These requirements ensure that the playing field for standards development is a level one.
Standards are market driven. If a standard is developed according to ANSI requirements, there should be sufficient evidence that the standard has the substantive reasonable basis for its existence and that it meets the needs of producers, users, and other interest groups.
Is the ANSI system absolutely foolproof? The answer is no. But it offers several advantages to other methods when evaluating whether anti-competitive activity is present in the standards development process.
First, it only requires a procedural and process-based review and not a dissection of the technical merits of the standard. We agree that due process in and of itself is and never can be a complete defense to an antitrust claim. However, the value of an open system and due process-based procedures derives from the fact that they are designed, in large measure, to cause antitrust-related issues to surface as early in the process as possible.
In addition, we realize that proper procedures are of little value if they are not followed in practice. As a result, in addition to the review ANSI undertakes when a standard is submitted to it for approval as an American National Standard, ANSI also has implemented a mandatory standards developer audit program.
The ANSI system has a long-standing history of effective self-policing. As a result, there are very few examples of enforcement or private action decisions relating to anti-competitive conduct in the standards development process.
I also want to say that ANSI would welcome any input or comments from the FTC regarding ANSI's procedures or requirements.
The second issue I want to address is what is or should be the process by which patented technology is incorporated into a standard?
The issue is this seemingly incongruous marriage between what is essentially a government-granted monopoly and a standard which is often viewed as a public good.
In place of wedding vows, ANSI has developed and implemented a patent policy. The ANSI patent policy encourages early disclosure of patent rights that may be implicated by a proposed standard. And it requires that the patent holder supply to ANSI a written assurance that either it will license the technology to would-be users for free or that it would license the technology on reasonable and non-discriminatory terms.
Very often this occurs before the standard is completed. Otherwise, it is requested as soon as the patent right at issue is discovered.
ISO and IEC, the two principal, non-treaty international standards organizations, of which ANSI is the U.S. member body, have a similar patent policy that applies to international standards.
This brings me to the FTC's proposed consent order with Dell Computer Corporation. By way of the background, for those not familiar with this matter, the FTC filed a complaint against Dell because a Dell engineer participated on a VESA, which stands for Video Electronics Standards Association, Standards Development Committee, which, by the way, is not ANSI accredited.
When asked, the engineer stated that he had no knowledge of any Dell patents that would be implicated by the standard under development. After the standard was finalized and in widespread use, Dell began asserting patent rights against users of the standard.
In paragraph 4 of the proposed consent order between the FTC and Dell, Dell would have to license its technology for free if it, quote: "Intentionally failed to disclose," its patent rights in response to an inquiry from a standards setting body.
I would like to emphasis the word "intentionally." ANSI absolutely agrees with the Dell consent agreement to the extent it applies to situations when a participant in the standards development process intentionally and deliberately fails to disclose that his or her organization holds a patent relating to the standard in question in an attempt to gain an unfair competitive advantage. This would violate ANSI's and ISO's and IEC 's patent policies as well.
What is possibly of more concern to us is paragraph 5 of the consent order. That paragraph appears to impose some sort of duty on Dell to set up a mechanism to check whether or not it has any patents implicated by a standard under development in order to disclose those interests prior to the standard's completion.
In essence, the consent agreement could set a precedent to the effect that the corporate representatives participating in the development of a standard are under an affirmative duty to exhaustively review their patent portfolio and disclose their company's patent rights before the standard is finalized or be required to license their technology for free.
Unintentional failure to disclose a patent right would be treated the same as an intentional one.
First, as a practical, matter, some companies would find this affirmative duty to identify all possibly applicable patents virtually impossible to fulfill. Many U.S. participants, at any given moment, have literally hundreds of employees, participating in as many standards development activities and in excess of 10,000 patents in their intellectual property portfolio. Often the implication of a specific patent in connection with the portion of a very complicated standard is not easy to determine or to evaluate.
These companies often have invested billions of dollars in research and development in order to develop this portfolio. By requiring them to assume an enormous research burden each time they participate in a standards development process, these companies may effectively be denied the opportunity to participate in that process for fear of making their intellectual property a public good.
This would be unfortunate in that we all benefit when what the experts decide is the best technology is incorporated into standards and what was once available exclusively to one company becomes available to all on reasonable terms.
Without incorporating this technology into standards, we would have standards and products that may be free and clear of licensing issues, but then standardized products would be that much less relevant and effective. It also could slow the process down as well by not taking advantage of what already took years to develop.
Second, in addition to the practical concerns, there are incentives built into the ANSI system to prevent the snake-in-the-grass problem. The risks that these snakes face are that: First of all, approval of the standard is subject to withdrawal, which can often render the company's innovation relatively useless, it's self-policing; often the best police are a company's competitors who, among others things, can avail themselves of their legal rights in court; and in the case of deliberate misconduct, enforcement agencies such as the FTC can intervene.
Moreover, the burden that an overextended view of the consent order would impose on U.S. businesses is reminiscent of similar burdens that other countries have pursued and which have been repeatedly and successfully prevented from becoming a requirement in the international standards arena.
For example, a few years ago, the European Telecommunications Standards Institute, or ETSI, proposed an intellectual property policy that many U.S. businesses believed to be coercive; and it became the subject of a trade dispute between the European Community and the United States.
The plan was that ETSI would announce a one-page work program when it undertook a new standards development project; and if a member did not quickly disclose any possible patent rights, then the patent would be deemed automatically licensed on terms that were, in effect, acceptable to ETSI.
The U.S. Government, working with ANSI and the U.S. industry, was successful in preventing the ETSI policy from becoming a reality.
In the global marketplace, there have been and continue to be efforts such as ETSI's to establish a process to facilitate what some would call a technology grab of U.S. intellectual property in an effort to reduce or eliminate any competitive advantage the U.S. enjoys as a result of its collective intellectual property portfolio.
ANSI would caution the FTC from enunciating any "disclose it or loose it" policy that competitors in other nations could then point to as a reason why the U.S. should accept a similar condition for participating in the global marketplace.
Thank you very much. I appreciate this opportunity to comment on these issues, and I am very willing to provide additional information upon request and/or receive any input from the FTC on what we at ANSI can do to address anti-competitive concerns or issues as they relate to the voluntary consensus standards development process.
CHAIRMAN PITOFSKY: Thank you very much for participating here.
Let's take about a 10-minutes break; and then we can begin by opening things up to questions, comments, exchanges among panelists. And then we will go on with other presentations.
(Whereupon, a brief recess was taken.)
COMMISSIONER VARNEY: Why don't we take a little bit of time just to talk about what we've heard this morning before we do some further presentations.
I would like to start by asking Professor Schmalensee what you thought of a couple of the presentations, particularly what we heard from Merrill Lynch and from Roel Pieper.
MS. EDWARDS: Dean Witter.
COMMISSIONER VARNEY: Dean Witter. I'm sorry. I'm not feeling too well today, Christine. I really apologize.
MS. EDWARDS: It happens all the time.
COMMISSIONER VARNEY: Dean Witter.
MR. SCHMALENSEE: Mr. Pieper raised a number of issues that I confess I haven't thought a lot about. I understand both the utility and the frequency of relatively informal discussions among actual or potential competitors about evolving standards in high-tech industries. It happens in a variety of settings. It clearly has values. There are clearly risks posed by it. And I don't have any particular constructive thoughts to add.
MS. VALENTINE: Actually, maybe to focus that a little more, one thing we did hear yesterday in a telecom and computer context was that, if a firm or a competitor is required to disclose relatively early on in the process standards or technology or interfaces -- they're not standards yet, technology or interfaces -- that this leads to a real dulling of incentives for innovation --
MR. SCHMALENSEE: Well, I think that's right.
MS. VALENTINE: -- and that's, I suppose, one issue.
MR. SCHMALENSEE: It's the question of what does "require" mean?
And if I understood Mr. Pieper correctly, he's dealing with a situation in part in which you have standards and technologies that need to interoperate; and so I have a reason to disclose the way I'm thinking because I'd like you to be thinking in a way that will work with what I'm thinking.
That's a little different from a situation in which you have a set of competitors that are all, as it were, head to head and you're requiring early disclosure.
I don't have any particular informed thoughts to offer. But I do think that distinction is worth keeping in mind. If I have to interoperate, then preventing people from talking has high costs.
I mean, despite the fact that there are difficulties between them from time to time, Microsoft and Novell have a variety of technical communications and have had over the years and have noted this publicly and privately, because their systems need to operate. And to prohibit that has high cost. To have too much of it also has potential risks.
I disagree with less of Ms. Edwards' presentation than one might think. She said relatively little about membership, and I don't have a whole lot to say, except I would remind us all that the lack of competition between VISA and MasterCard, to which she pointed, is a result of an antitrust-induced shotgun wedding between the members of the two associations.
And it, I think, illustrates perfectly the notion that exclusion isn't always anti-competitive. If VISA had been able to exclude MasterCard issuers, arguably, we would have today two competing bankcard associations instead of two associations that do compete to some extent but are surely not independent competitive entities.
On the whole question on the kinds of conduct that she described, I don't have anything particular to say about the joint marketing. There are issues involved in, is it appropriate to market collectively since they have marketed -- done marketing collectively, the notion that you would have a meeting of members of an association faced with an entrant that wouldn't discuss the entrant and competing against it I find a little far-fetched.
But I think the issue of principle on which she and I do agree and that potentially looks at the new activities, there are two.
First is that a joint venture, association, whatever, that has such wide coverage in an industry that its operations are properly subject to closely antitrust scrutiny. I don't think there's any plausible grounds for a claim of immunity. It's collective action by a large fraction of an industry that is properly a subject of concern.
And the second is -- and I hadn't thought of it until she mentioned it, but on first blush it strikes me as an appropriate notion -- that a significant change in the scope of a joint venture ought to be thought of like a new joint venture.
As to the particular incidents involving terminals and standards and new enterprises, I'm simply don't -- I'm not familiar with them. I'm not here to defend VISA. And I don't have any thoughts on those factual matters. But on the principles, I don't think we -- at least as to operations, we don't differ dramatically.
COMMISSIONER VARNEY: Okay. Before I turn to my colleagues, do any of the panelists have questions of each other at this point or comments on the presentations they heard this morning?
MR. ORDOVER: Let me just make one point on the issue that Mr. Pieper raised about the extent to which discussions and commonality of interest should play themselves out in the software area.
It strikes me that -- I would agree with the fact that extensive communications may be desirable in some circumstances.
What I am troubled by is reliance on European or East Asian models that seem to have extensive government involvement, and I find that troubling partly because I have yet to see any effective software or advancements coming out of these models and, therefore, to use them as guides for what we should be doing in the United States is somewhat nerve-racking to me.
I think that obviously there are circumstances in which government participation is desirable when we are talking about substantial market failure. But even there, after the initial seeding of the ground, it strikes me, again, that it's much more desirable to rely on private incentives, whether cooperatively or individually, to promote future development.
I think that there are dangers through government participation leading to uniformity, leading to the use of federal government funds for projects that may or may not be wise; and, in the end, I think we would end up with less competition, less progress, and less development than we would if we had simply relied, to the maximum extent possible, on private incentives.
I must say that I found his four-part topology of the standards to be extremely useful in thinking about developments. And there are very few boxes that I would think that "public" and "open" is the right box. I think most of the boxes that contain anything that is really on people's agendas are probably in the three other ones.
So the dangers that I think arise are when there is a decision to move either horizontally or vertically amongst these boxes because that changes the playing field and creates the kind of competitive concerns that we have heard expressed in many other forums. I will probably talk about it a little bit more later on.
But the idea of the box is really superb and I think that it will help a lot of people organize their thinking about standard-setting processes and how to structure antitrust and public policy around them.
COMMISSIONER VARNEY: Yes.
MR. PIEPER: Maybe I could just quickly answer that. Obviously, my statement with regard to how much and how government interaction and participation should happen is not an easy subject, and I'm fully aware of that.
I believe that by participation and engagement, as I described it, of both business, academia, and government administrative, local, federal or state, I believe one will arrive at capabilities both within the business environment as well as in the administration environment, because in the end administrative functions and organizations are as much a company in the sense of procedures and activities as a normal company in its administrative processes.
So I believe there is a lot of value if there is active participation. As to how much the government should be engaged in setting more harness-like or dulling effect-like guidelines, I mean obviously that should work its way out by having enough of a balance between both academia and business participation in this collaborative-type of environment that I described.
The examples that I used the -- and I can make them a little bit more specific. For example the administration in Finland made a very strong suggestion both to business and academia that they wanted to be the leading country by providing the best ATM network infrastructure to business in general. And they provided tax incentives. They provided funding projects, examples, et cetera, et cetera. They did not necessarily influence the standard. They did not necessarily influence what was being built.
But they did force a particular, let's say, momentum that I think is going to be -- in that particular case is going to be very beneficial for that country. And I'm just using it as one example where active government engagement -- maybe not control and maybe not direction -- did create a much higher momentum in that particular example of ATM connectivity for businesses that is not found anywhere in the world.
COMMISSIONER VARNEY: Okay. Let me start down on this end of the table, and we'll work our way up
Becky.
MS. BURR: Mr. Pieper, one of the things that we heard in a slightly different context over the last few weeks is that the capital formation industry is increasingly requiring a strong, well-protected, proprietary system. And one of the questions I had for you is: How is the capital formation industry responding to the kind of collaboration, early collaboration that you're talking about?
Is there participation from the venture capitalists, for example? And is the desire to have a locked-out, protected technology interfering with the collaboration process?
MR. PIEPER: Well, being in Silicon Valley, I would say that almost anything that you do, either overtly or not, will be shared by venture capitalists in some form anyway. There is not a lot you can hide in Silicon Valley.
But I would say that, given the role of the size and dominance of the companies like Microsoft and Intel, that most of the activities today, both with regard to computing and networking, get a lot of support of those organizations in the sense that people are trying to, one, find new ways to create a more level playing field. The Internet clearly is a space where there is a wide open door at the moment to escape some of the current monopolies in place of Microsoft and Intel. And there's an enormous amount of money rushing into that space.
At the same time, there's a big concern that effective applications, networked applications, multi-media applications -- and what I mean by "effective" actually working together, actually, you know, usefully communicating and transmitting data, images, voice and text -- if they are not created, that will also die. You know, it will peak up and then it will come down again because it simply will not work together.
So that's why this collaborative perspective is really focused on making that networked application environment, for whatever business, work. And there's a lot of investment going into that space by private and public financial institutions.
MR. COHEN: I have a question for Professor Schmalensee and perhaps anybody else on the panel who would like to join in.
I understand you made the point that existing economic theory of narrow sense networks doesn't provide much in the way of general rules for antitrust policy.
But at the same time, I would ask you to try to shift your point of view a little bit and suppose that you are controlling or allocating antitrust enforcement resources and you do find an industry in which there's a presence of very strong network effects. Does that suggest to you any particular practices at which you would want to take a particularly close look?
MR. SCHMALENSEE: One of the ways you might come to the conclusion that there were such strong effects would be the emergence of a highly concentrated structure, particularly the emergence of what might be characterized as a dominant seller.
It seems to me -- if one has an industry that has a fragmented structure, then one is reaching to conclude that there are strong -- one is reaching to conclude that there are strong network effects.
So if you have an industry with a dominant firm, let us say, that can be properly characterized, worry about the usual things you worry about in a dominant firm industry. You worry about exclusionary strategies. Now, it may be that because the network -- because the industry has network characteristics that there are particular strategies that are attractive because of the nature of the business.
But it seems to me the basic question, what do I worry about when I see a dominant firm, doesn't depend on there being a network. You can worry about a dominant vendor of sand, or you can worry about a dominant vendor of operating systems. In both cases, your initial worry is exclusion. The strategies you look at depend on the nature of the network, what's available. They may have to do with standards. They have to do with pricing. They may have to do with whatever.
And I don't think there is an answer that goes across all networks. I think it depends on the facts of the business. When somebody charges that Strategy X is exclusionary, yo've got to ask: Does that make sense?
MS. VALENTINE: Let's try to tease out just one last part, because I do think I keep hearing the same thing.
What were you getting at at the very end of your testimony when you suggested that, in industries in which innovation is an important form of rivalry, that, perhaps, should be viewed through a different lens than in more technologically stagnant industries?
COMMISSIONER VARNEY: Clearly, Debra, he was advocating an innovative market theory.
MR. SCHMALENSEE: No, I just realized I hadn't said anything about innovation and thought, oops, I ought to make the point that industries where innovation is an important form of rivalry tend to look different. Like they tend to have shorter life times of products. They tend to have shorter life times of leading entities. Depending, again, on the industry.
So that was not intended as a button which, when clicked on in the Internet sense, will produce a nice outline because I don't have one in my head. But I think it is an important way in which markets differ. It is an important way in which some network industries differ from some non-network industries. And you have to think about it.
But, again, I don't think that -- some industries that have a high degree of innovation also are marked by the importance of patents. Some industries that have a high degree of innovation, patents don't play an important role. How you think about those two industries and a variety of issues would be different.
So, again, I don't think there is a simple, single answer that covers innovation. But where it's there, its implications have to be addressed.
COMMISSIONER VARNEY: Professor Teece, do you have a comment on that, or do you want to wait for your presentation?
MR. TEECE: I'll wait.
COMMISSIONER VARNEY: Okay.
You had a question, didn't you?
MR. ANTALICS: Yeah. I had a question for Amy Marasco.
COMMISSIONER VARNEY: Okay. Go ahead.
MR. ANTALICS: Relating to the negligence aspects of your comments with respect to standard setting, would your opinion on the burden change if the company simply had the option of not making the certification on behalf of the corporation as to a patent right?
And also, I guess, would your opinion change if that standard ultimately became the dominant standard in the industry so that the choice, then, is between the company that made the mistake and consumers that are ultimately going to have to pay the price?
MS. MARASCO: Well, I do believe that most companies want to disclose their patent rights. There's a lot of peer pressure that they do do it. I think there are a lot of incentives for them to do so. And in our experience, we've seen that that typically happens, that they tend to disclose as soon as possible.
I think our concern is that there's a potential affirmative burden of making them search would just be too great; and I think, then, you would lose some of your key players in the standards process.
Did that answer your question? Or did you --
MR. ANTALICS: Well, suppose they had the option of not making it, it's clear that they didn't have to affirmatively make the certification, would there be a role for the Commission in a case like that if there was a perception that there was going to be some harm?
MS. MARASCO: I think there is a role. And I think, though, that because the system, to some extent, is self-policing that you'd find out about it because some competitors would say, this is unfair, for these various reasons, or there is some severe anti-competitive effect.
So I would agree with that.
COMMISSIONER VARNEY: Okay. Jonathan.
MR. BAKER: My question is for Professor Schmalensee and anyone else who might be interested in it.
Suppose we went down the road of identifying, in an industry with big network externalities and sort of natural monopoly properties, a problem that, where access to the natural monopoly facility somehow seemed essential for competition and we decided that -- we decided that we would seek mandatory access or interconnection of some sort.
Should we worry, in that sort of case, that the -- about the possibility that the market which had chosen the standard or whatever, which had given them the natural monopoly in the first place, that the market had tipped to the wrong standard and that we might be further entrenching a less than perfect standard and making it more difficult for the succeeding generation of products or standards or approaches to supplant it in the future?
Is this something that's just too distant and too hard to get at or it should be a serious concern?
How do you respond?
MR. SCHMALENSEE: Well, I mean, I think the enforcement agencies should be constantly worried about a range of things.
But I guess that one strikes me, in the situation you described, as not something at least that it's productive to lose sleep over. You hypothesized a situation in which access in one form or another to the network is important for there to be effective competition.
And the situation -- that is one in which you want to compel access perhaps by standards and open architecture or something like that or perhaps by forced membership or depending on what's happening.
There will still be an incentive for someone to supplant the network. We always tend to think of natural monopoly or network-based monopolies or near monopolies as things that endure. Henry Ford's Model T lasted a lot longer than Word Star.
Should the antitrust agencies have been worried that the economy had tipped to the wrong cheap black car? Well, I suppose; but what are you going to do about it, productively?
The last thing, it seems to me, you want to do is say, well, we have an apparent winner; it could be the wrong winner, so we'll handicap it. It seems to me that the only option you've got is to say: We want to handicap this to make possible the emergence of something else. Well, there may not be anything else. There will be no shortage of people who will come forward and say: We are actually better if only you would handicap these guys. That's certainly true.
But it seems to me, as an enforcement matter, you can't make that call.
MR. BAKER: My question -- let me rephrase it in terms of the Henry Ford example.
Suppose we had decided that, in the ancient past, that all car manufacturers ought to have access to Henry Ford's design, for the reason you suppose, does that dampen the incentive of the other manufacturers to come up with a new design of their own that would seek to supplant Henry Ford's design? And should we care?
MR. SCHMALENSEE: It does to some extent, just as a mathematical model, because you now have an asset, which is access to that design, which, if you supplant the design will be rendered less valuable.
But if you're not a major player in the use of that design, then that asset isn't worth a lot to you. So you're not -- you know, if you overturn the design, that term, the "sacrifice," is relatively small.
And particularly in that example, the rewards to being the next generation, to being the closed body car and so forth, were huge.
So, I mean, I think in principle there is a diminution of incentive. It operates most strongly against those who are most vested, the big players in the old design.
But if it's a situation in which tipping is possible, the rewards to being the tipper are sufficiently large, again, that if you have more than a couple of players, I don't think you need to worry about the diminution of incentives.
And, in any case, as in all membership issues, there is a problem, of course; but I guess my inclination would be to choose competition in the present, if you really think it's an essential facility, over the possible slight increase in the incentives for the emergence for the next design.
MR. BAKER: Thank you.
MR. ORDOVER: Let me just make one point. I think that there was an incomplete hypothetical from Baker. And that is that, he did not specify the terms of access.
I always get nervous when people talk about "access" as if it were enough to say that. I guess it's important to specify all the dimensions on which access can take place, the price, the terms. Other than the price, the obligations and the duties that come along with having access. For example, to the Ford Model T design, I might also be compelled to therefore defray the additional R&D cost that Ford may decide to embark upon to modify the design; or I'm just going to be allowed to take part of the old version of it.
So if I have anything to say -- which is not much today, somehow -- I have never done that; I always say something -- and that is when we talk about access and access rules and we don't talk about it in the abstract, but really we are talking about it in a very concrete sense, specifying all the key dimensions and all the rules that would govern access along these key dimensions, such as price and contribution to costs, all those things will matter to incentives, both to stimulate current competition but also to overcome the preexisting standard or to supplant Model T because these things will interplay in firms' decisionmaking processes.
And the big gap that we have I think now in our learning so far, still is in my perspective, is that we don't know how to specify these rules of access. We can only talk about granting access but not specifying the rule. And that's the -- a big danger, relying on access while not really being clear on the next step.
COMMISSIONER VARNEY: Before we continue this discussion further, let's turn to Professor Teece for your presentation, and then I think part of that will fold into this; and we will continue with the questions.
Please go ahead.
MR. TEECE: My presentation will be rather short and crisp, in part because my colleagues have already helped me out by covering important issues about standards and antitrust policy.
What I thought I would do is focus somewhat more narrowly on the question of standard setting and intellectual property, because, increasingly, as intellectual property gets more value and as standards become more important, there are an increasing number of circumstances -- and Amy has already reminded us of one -- where these two issues become joined.
Now, as an opening statement, I think it's important to recognize that standards are important for markets to form. So in some sense, standards and getting standards set are really almost a precondition for competition in many circumstances. I think about multi-media, for instance, and why isn't much going on there?
Well, in part it's because of the absence of standards and there isn't this sort of coalescence around a major standard. And on a general philosophical level, that should lead us to want to see efforts, including cooperative efforts, to get standards formed. Because in some sense, that is an enabling factor for competition.
So in a Schumpeterian sense where really what's important to competition is new products and new innovations, standard setting is an early, upfront step that's necessary to kick off a new round of competition.
Having said that, I also recognize that there is, in sort of antitrust, almost an implicit bias that sort of open standards are better than closed and public is better than proprietary. But having said all of that, I think we have to recognize that very often standards increasingly involve proprietary elements; and that, indeed, one has to recognize that if, in fact, technology that's proprietary becomes anointed as a standard, it necessarily increases the value of that technology.
Now, some standards bodies -- and ANSI is one of them, SEMI is another -- attempt to minimize the advantages that flow from intellectual property.
But it is important -- and I did look at the SEMI constitution. It is important to recognize that most of these bodies do recognize that in some cases it's desirable to have a standard that is -- or that it's okay for intellectual property to be wound up in a standard. And, indeed, there's normally some requirement for non-discriminatory licensing, reasonable royalties, and the like.
And I guess I'm saying this because, in some part, there's a lot of natural protection already out there in the standard setting process for the kinds of concerns that the Federal Trade Commission and other antitrust agencies might have.
So let me turn and address specifically the very narrow point about the Federal Trade Commission and what, for want of a better term, I'll call the rule of Dell. This is -- I think Dick Schmalensee started off talking by saying, you know, in the area of standards at a conceptual level, one of the properties is, you know, that there aren't any clear rules so the government is trying to craft clear rules in an environment where it's not clear from the conceptual level what's right and what's wrong.
But also, here there are enormous practical problems. And the practical problems are almost deeper than the conceptual ones.
And remember here the circumstance was Dell had some intellectual property that was wound up in a standard for, I think it was called the VO Bus, and it didn't disclose this ahead of time; and the Federal Trade Commission, in a proposed settlement, has said, okay, you must give this technology away, basically, to get out of our hair.
And this, I think, is a very problematic rule. Amy pointed to one aspect of it, namely -- and it was a very obvious one -- large companies don't know what their intellectual property is. And it's not just a question of patents. One of the virtues of patents is at least, you know, they get filed and you can look them up. There are many other elements of intellectual property: copyright, copyrightable material, maybe even trade secrets, where it's not so apparent.
So the notion of a mechanical intellectual property audit that will expose everything so whoever's sitting there on the standard committee knows what the company's portfolio of intellectual property is, I mean, that's a myth. I mean it's theoretically a valid concept, but as a practical matter, it's a myth.
A second issue that you didn't point out but I think is an even larger one is that -- and it's not really revealed so much by the Dell facts -- but in the Dell case, you know, there was a patent that read on a standard and vice versa. But there may be other circumstances where someone has a very broad-based patent that may be implicated in a standard.
So quite unknowingly, a standard may touch on some broad-based patent of enormous scope. So what you could find under this sort of rule is that a firm that had a very valuable patent that wasn't sort of directly implicated in a standard but indirectly was implicated because a standard may, in fact -- or conceivably could read on many different patents and many different pieces of intellectual property that the Dell-type rule could end up torpedoing the value of a broad-based patent.
And if that is the case or if there's any significant danger of that, I think what most prudent firms should do, given that they can't accurately audit their intellectual property is stay out of the standard-setting process. And that's the fundamental problem with the sort of the Dell-type rule is that, given the uncertainties that occur because of the difficulty of auditing intellectual property, the prudent thing to do, in many cases, may be to stay out of the process. And that, in turn, slows down standard setting and slows down competition. So what on its face may look like a pro-competitive rule could, in some more fundamental sense, be anti-competitive.
And, likewise, the notion of compulsory licensing takes away the value or the possibility of an injunction. And this is something that goes to other aspects of your charter and other people's charter that's I suppose already there; and I wouldn't argue with it too much, but only simply to point out that if there is a compulsory licensing requirement, you know, any potential infringer might just as well say: Well, look let me risk infringement and we'll pay up in the courts because we won't pay more than a reasonable royalty there. In other words, taking away the power to bring about an injunction grossly diminishes the value of much intellectual property and orders the Dell rule deal, with the whole question of what do you do with pending patents and intellectual property that's incipient. The deeper you look into these questions, the messier they get, I suppose, is a basic message.
And I think Commissioner Azcuenaga's instinct that there wasn't something quite right here -- at least she didn't see a section 5 issue, that may be true; I'm not a lawyer -- but I certainly see the creation of a tremendous amount of uncertainty. And uncertainty is the bane of new investment.
So all of this simply comes down to the fact that, indeed, I don't think networks justify new rules, to echo another speaker; and that, if this be the type of rule that we are creating to deal with these problems, I think it has strong practical problems as well as fundamental conceptual weaknesses as well.
So that's enough for an opening statement about some of the new emerging issues in standard setting.
COMMISSIONER VARNEY: Well, Professor Teece, let's postulate the Dell rule slightly differently and get your reaction to it.
MR. TEECE: All right.
COMMISSIONER VARNEY: Suppose the Dell rule says, only when the official that's participating in the standard setting has knowledge of an existing patent that could be exerted against those who eventually adopt the standard should the company be held liable, is that reasonable?
MR. TEECE: Yeah. I think, you know, there's sort of a deliberate sort of opportunism here. But my understanding is that's already -- isn't there strong case law that already provides support for that? In which case, you know, it's not clear the FTC has a role.
But, yeah, I mean, clearly one doesn't want to support deliberate opportunism in the standard setting processes. But sorting out deliberate opportunism and strategic opportunism from the absence of omniscience is the task at hand.
And I would be much more comfortable with something along those lines.
COMMISSIONER VARNEY: Other comments.
MR. ANTALICS: Yeah, I have a question. This was actually raised by somebody in the audience.
Isn't the patent holder the person who has the best -- the most efficient person to do the search and the person put in the best position to identify whether or not they have a conflict in the technology with what's going to be incorporated in the standard and together they have the option of either certifying or not certifying? Shouldn't they be the ones who make the decision of, if they are going to certify, they do the search?
MR. TEECE: Well, that presumes that a search ought to be the done and a search, when completed, will, in fact, display whether or not there's infringing technology.
I don't disagree that the owners of the intellectual property are in the best position to determine whether there is the prospective infringement. But I'm not sure that's the right question to ask.
MR. ANTALICS: Janusz?
MR. ORDOVER: I have a comment. I think that it's easier to take the view as David has taken of the owner of the intellectual property rights, and I'm very sympathetic to that viewpoint because I think that owners of intellectual property rights do greatly contribute to the welfare of the economy.
But there is also another angle to that, and that is the viewpoint of those who actually do participate in the standard setting process as well.
And somehow we have not heard about the incentives or the effects of the rule or the absence of the rule on how willing they are going to be to participate in such a process.
And the point being that at a time that a particular standard is being developed, there are many different routes along which one can proceed. And, therefore, the outcome of the standard setting process may be to -- I guess the right word from the Silicon Valley -- is evangelize a particular standard and, therefore, to create value where, potentially, initially there was very little value to begin with. It was one of many particular ways to proceed; and once the road is chosen, the value is created.
And the question to my mind is: While having been a part of that process, who should be allowed to extract the additional value that was created as a result of the standard setting procedure?
And I think that if that value is fully allocated to the one whose particular patent or piece of intellectual property right was actually evangelized through the process -- that one is allowed to capture all of it without disclosing the initial interest, I think that the wrong incentive is potentially being created. And also it creates a disincentive, potentially, for other players to engage in the standard setting process that creates values for others.
So the rule, perhaps, may be too strong. I have not studied the rule at any great length. But I would suggest that if there is a problem of resolving the conflict, that the way to approach it would be to grant -- not to expropriate the intellectual property right. But, again, to come back to what I have been harping upon, which is to say that the benefits of the standard setting value creation should be somehow divided amongst the owner as well as those who participate in the process of enhancing the value.
In other words, the value should not all rest with the original owner who, at some point, realizes whether by mistake that he or she failed to inform or obviously if it was a strategic withholding that the matter is quite different.
But I believe that there are trade-offs going both ways; and, therefore, to take only the viewpoint of the owner distracts from the fact that the other players have a stake in resolution of the conflict in a way that does not expropriate all the value from them and does not transfer all of it onto the owner of the intellectual property right.
And that viewpoint also has to be respected in some way. I don't have the solution to it, but I would not want it to become completely disregarded.
MR. TEECE: No. Let me just say, nor would I. But the Dell rule, is you'll give it up for zero royalty, if I understand it correctly. Right? The Dell settlement did not allow Dell to take a reasonable royalty.
Am I right about that?
MR. ANTALICS: The Dell settlement would say, with respect to the standard, you know.
MR. TEECE: Okay. So zero royalty, which presumes -- so you and I agree
MR. ANTALICS: It would also presume you have to look at other facts as to whether or not the patent itself had any value apart from --
MR. TEECE: As a standard, right
MR. ANTALICS: Right. And certainly that's part of the analysis.
MR. TEECE: Well, the standard setting bodies, basically, are consistent in their approach to what Janusz just advanced.
Because if there isn't -- you know, the usual approach is we prefer not to have a standard that's proprietary; if there's a close substitute, we'll move to that; and if there's not a close substitute, then a reasonable royalty over the intellectual property that's involved is acceptable.
And in this case, the thing that I think both of us would find troubling is the zero royalty.
CHAIRMAN PITOFSKY: All right.
It's a pleasure to welcome back Professor Janusz Ordover, who has participated in these hearings before and also has worked with us and has been instrumental in organizing these hearings from their very beginning.
He's a Professor of Economics at New York University and Advisor to the World Bank on privatization and regulation of infrastructure industries and is affiliated with the Law and Economics Consulting Group in Berkeley, California.
In the past, Professor Ordover served as Deputy Assistant Attorney General for Economics at the Antitrust Division of the Department of Justice.
Professor Ordover.
MR. ORDOVER: Thank you, Mr. Chairman. Again it's a great pleasure to be back. I will be very brief because I think it's more fun to listen to other people than to myself.
I would like to make a few points, somewhat in disagreement with my friend Dick Schmalensee, who advises that the network industry does not create new problems. I think that, in fact, to some extent they do, primarily because the problems of supplanting a dominant sand or gravel vendor may be quite distinct in terms of their magnitude and the technological prowess, the expertise, the access to intellectual property and to the consumer base that might be present when network effects are particularly strong, both on the cost side and the demand side, not only for any particular time slots but also inter-temporally.
In other words, the networks effects can, indeed, cause dominant firms to unravel very quickly, maybe perhaps more quickly than a sand or gravel monopoly would unravel. On the other hand, the time that it takes to cause the tipping may be much longer than we would find desirable or socially desirable.
Now, nevertheless, I would agree with Dick to the extent that one should be very careful in crafting rules designed to supplant the network dominant firm before its time.
Who said they will not serve Gallo before it's ready, I don't think Gallo is ever ready to be drunk.
Sorry about that. I just like wine.
It seems to me there are great dangers to coming to a viewpoint that somehow the particular technology has run its course and it should be supplanted by a newer and better technology with the assistance, especially of those who have a vested interest in supplanting the preexisting one, which is the new brand of competitors.
I believe strongly that network industries require the very careful application of economic theory, which, unfortunately, has not developed to the point of offering clear enough guidance what we ought to do.
So we are now in a very difficult position, I think, because we need to address these issues; they come up in front of the Commission on a daily basis and in front of the courts. Yet very little guidance can be gleaned from the literature that has emerged thus far. I think the literature is superbly summarized in Bill Cohen's background paper. And I think we all should be grateful, yet again, for his efforts.
The fact of the matter is that the results that we have on these theoretical results are very specific to the assumptions that people have made about the nature of the problem they are modeling. And, as such, they are not robust, to changes in these assumptions.
Nevertheless, I think that there are some things perhaps we can learn. And I tried to summarize a few of them that, at