Last month the Justice Department hired veteran antitrust attorney Sanford Litvack to help assess the evidence gathered by its lawyers in what many see as the clearest indication that the Justice Department could be planning to mount a legal challenge to the deal which allows Google to sell ads alongside some Yahoo search results on some of its Web sites. Google dominates the search advertising market. It is feared that the deal will reduce competition in the search advertising market and lead to higher prices. The real concern of antitrust law is to protect consumers–-the advertisers. Investigators trying to build a lawsuit to block the deal worried are that it could give Google too much power.

The two companies have maintained that the deal does not violate antitrust law and recently agreed to delay implementing the deal until at least October 22 to give the investigators–-federal and state–time to scrutinize the deal and complete their investigations. According to them, the deal would serve advertisers and users more effectively.

Both companies are in talks with the Justice Department in an effort to prevent any challenge to the deal. The negotiations are at an early stage and both companies have discussed concessions including capping the volume of Google ads Yahoo would use, assurances that Yahoo would continue to compete in search ads, and a reporting mechanism to ensure compliance. A reporting mechanism could require the companies to disclose details about their closely guarded search advertising technology. The disclosure requirement could require disclosing more than what they really want to disclose. The Justice Department will try to impose measures to ensure that advertisers won’t have to pay prices that are significantly higher.

Any settlement reached would likely be laid out in a consent decree that would be filed in court allowing the deal to go ahead. If the deal does go ahead, many feel it will be a formal recognition of Google’s market powers constraining its future conduct. It could draw private antitrust suits–opponents of the deal including Microsoft have been provided with documents and depositions for use in possible litigation.

Some experts are looking at the appointment of Mr. Litvack as an effort by the Justice Department, which in the past has been criticized by some in Congress for its approach to antitrust enforcement, to deflect any political fallout from its ultimate decision.

It’s easier than you might think. A company that has amazing technological and financial resources at its command should actually find it quite a trivial matter to simply enforce over the Internet the policy of a unique copy of Windows being installed on just one computer. I believe it can certainly be done. Why then has it not happened?

To answer this, we need to understand the facts about something called “network externalities.” In game theory, the term “network externalities” relates to the phenomenon of something becoming more valuable simply because more people use it. Since it’s more valuable, even more people use it, and it is, therefore, a self-propagating mechanism.

Image Credit: purprin

For example, the telephone is an amazingly useful piece of technology. But how would you like to be the only one having a telephone? I’m betting you wouldn’t. Who would you call? Who would call you? Without other people having a telephone, the instrument is worse than a paperweight! The more people who have a telephone, the more people you can call and who can call you back. The value of the telephone increases simply because more people use it.

This means that products that have network externalities associated with them and have a large user base might completely wipe out the competition even though their product is of a poor quality. Since the value of a product can increase due to the number of people using it and not because of its inherent quality, a dominant product can get away with having a worse product than the competition.

Let’s take the case of Windows. Most people install Windows on their PCs. Why? One major reason is that there is a lot more software that is written for Windows than for, say, Linux or the Mac OS. Why is there more software for Windows? Say I’m a developer and I’m just going to start writing code for my new software. Should I write it for the Windows platform or for another one? If I write it for, say, Linux, then no one using Windows can use my software. Since the overwhelming majority of people use Windows, I would get a better payoff if I wrote my software for Windows because there are more chances of people buying it.

So the more number of people who use Windows, the more software there is out there for it, and, therefore, when I purchase a new computer, I would choose one that has Windows running on it because of the larger amount of software available for it.

Windows has a dominant market leadership in the OS world simply because it has a dominant market leadership! Such is the self-propagating nature of network externalities. Now let’s assume that Microsoft stops piracy completely. Almost all of India, China, and other Asian countries would be forced to use another software simply because, in these countries, the price of Windows is too high for almost anyone to purchase. In India, people would maybe buy Windows if they could purchase a copy for Rs. 200. That means $5! You think Microsoft is ever going to sell Windows for $5? No way.

So now that half the world has stopped using Windows since there is no more piracy, Windows has lost the only advantage it ever had – a dominant market leadership. When half the world starts using Linux, for example, then more developers will write software for Linux, and so even more people would buy it. It might happen that Windows will never recover from this shock (since you cannot improve your position unless you improve your position – a catch-22 situation).

This is the real reason why Microsoft will never stop piracy. They know that if they do, then half the world will stop using Windows, and they figure that, if that happens, they’re doomed.

Patents grant ownership rights to inventions and other technical improvements. Copyright confers ownership rights to authors, artists, and composers. Trademark establishes rights in distinctive commercial marks or symbols.

Intellectual property rights are the foundation of knowledge-based economies. It pervades all sectors of the economy and is fast becoming important for ensuring competitiveness of business enterprises.

In a free market economy, the state is concerned with improving consumer welfare by constraining the behavior of firms with market power. Intellectual property rights confer a certain degree of monopoly power on the owner of the intellectual property. Both have a common goal of enhancing consumer welfare.

From an economist’s point of view, there are two broad classes of goods:

1. Private goods which are rival in consumption.

2. Public goods which are non-rival in consumption.

Private goods can be publicly owned and public goods can be privately owned. Public goods are non-exclusive. People cannot be excluded from using them. It can be used simultaneously by many people; its use by one application does not make it harder for other people to use the same good. Private goods cannot be used simultaneously by more than one person.

The necessity to promote competition and protect intellectual property rights is embodied in the guidelines and regulations issued by the Department of Justice and the Federal Trade Commission in 1995.

Granting exclusive property rights to the creator of an idea provides an incentive to create ideas, and excluding others from using an idea enables the creator to determine the price above marginal cost and impedes their dissemination and application.

Once a good has been discovered, the cost of producing a non-rival good is zero. The marginal cost of such good is zero. When prices are equated to marginal costs, resources are allocated efficiently. Efficiency is lost if the price of a non-rival good is above zero. If the price cannot be more than zero, there can be no motivation for development. By acquiring an intellectual property right in a non-rival good, it is possible to make it excludable and prevent it’s use by others.

To give people an incentive to produce socially desirable new innovations, the law allows the creators of a non-rival good to appropriate the returns of their innovation for themselves alone through intellectual property rights. But since intellectual property rights make a non-rival good excludable, it constitutes an inefficiency – the price of the good will be above the marginal cost of producing the good. Conferring ownership of intellectual property rights is tantamount to conferring a monopoly.

Unlimited protection of intellectual property gives rise to two problems:

1. Discouraging dissemination of inventions and ideas, i.e. under-utilization.

2. Encouraging a race among inventors, i.e. over investment in research and development.

As such economists have to adjudicate as to the desirability of using intellectual property rights as a spur to innovation and as an instigator of monopolistic inefficiency.