When a Merger Softens Competition: The Oracle-Sun Case

A merger reduces competition if it leads direct competitors to increase prices or reduce innovation without attracting endogenous entry. This is what is expected in the market for enterprise database systems if the merger between Oracle and Sun goes through. The European Commission is correctly investigating on the anti-competitive effects of this merger.

The European Commission has just issued a formal Statement of Objections against the merger between Oracle (ORCL) and Sun Microsystems (JAVA), a merger which was previously cleared by US regulators. This delicate initiative shows the maturity reached by the European antitrust authorities in the field of merger regulation. The deal, or at least part of it, creates substantial concern for the future of competition and innovation, especially in the market for enterprise database software and especially in Europe.

Pros and cons

A merger can harm consumers in a specific market when it allows the merged entities to soften competition, increase prices and reduce investments in R&D – all of which ends up decreasing the welfare of current consumers (because of higher prices) and future ones (because of less innovations). This is possible if and only if the merger is between firms that are directly competing and if it does not attract endogenous entry of new and better producers that may exploit the softer competition.

At first glance, a merger between a company that is mainly focused on software (Oracle) with one focused only in part on software and to a large extent on hardware (Sun) would not appear to raise many antitrust concerns. However, a closer look at the interests of the two companies in the area of software provides a different impression, especially if we recall that on a number of occasions Oracle has engaged in acquisitions aimed at substantial business change that led to higher prices (for instance in the case of the BEA Web Logic products) or discontinued production (for instance in the recent case of the Virtual Iron products).

A key issue concerning the current merger is that, while Oracle is focused on commercial software, most of the software by Sun is open source. This is the case of Solaris, the most popular operating system derived from enterprise Unix, and MySQL, the most popular database for websites (bought by Sun last year). In general, one may wonder what will be the destiny of these technologies and of their current users, and what will be the impact on the large European open source sector.

Dominant supplier

If the Oracle-Sun merger goes through, the company of Larry Ellison would become the dominant company as a single supplier of enterprise hardware and software. In this unique position, it may try to limit competition, reduce consumer choice and increase prices. The problem is crucial in the market for database management systems, whose current leader is Oracle if we look at revenues, but is My SQL if we look at units. The reason for this difference relies on the different business models. Oracle provides a proprietary database and gains from both licenses and maintenance fees; Sun freely distributes its open source product and gains only from maintenance and support fees.

Together, Oracle and Sun account for the large majority of database sales and about 90 % of the Linux/Unix segment (which is almost half of the total). This joint leadership is even stronger in Europe, where open source software is more popular because of the wide presence of small and medium size firms with lower IT budgets compared to US companies. The other two relevant competitors in the database market are IBM and Microsoft, followed at distance by Teradata (focused on data warehousing), Sybase and a fringe of open source products unable to provide valuable alternatives (as Ingres and PostgreSQL).

In the global database market, which is worth about $ 20 billion, Oracle and Sun compete directly. Sun is traditionally ahead as a web server database and rapidly growing as a business database (for both small and large companies) and as an embedded database (to be used within other products). Thanks to many recent improvements, Sun has made available by far the best open source alternative, which has forced Oracle to invest heavily in R&D to innovate and maintain its lead.

Using a suggestive label by leading scholars in the theory of innovation (Aghion and Griffith 2005), this was a sort of “escape competition effect” forced by the entry pressure exerted from the best fruits of the open source community. Moreover, the free distribution of MySQL has created a binding price constraint on Oracle, which has been unable to perpetuate a high mark up policy and has been forced to reduce its prices to match the low “total cost of ownership” associated with the open source solution (characterized by free distribution plus cheap maintenance).

This outcome is reminiscent of the behaviour of a market leader facing endogenous entry of competitors associated with the dominant firm theory – just the effect that can guarantee an efficient evolution of the market.¹ One may compare these competitive effects with the positive effects exerted by Linux and the competitive pressure of the open source distributors of operating systems on the innovative and pricing strategies for Windows.

For the competitive pressure to continue to be effective in the database market, Oracle should remain constrained by a fringe of rivals and by the most efficient one in particular. This is exactly what Oracle is trying to avoid through the merger with Sun, a sort of “escape competition merger” made possible by the lack of other effective or potential entrants in the database market.

Future entry is difficult

It is important to notice that no other company could replace (“fork” in jargon) the strategic role of MySQL in the open source business. The reason is that Oracle, as the new copyright owner of its source code, could adopt the so-called “dual license”, excluding commercial exploitation by other firms and at the same time enjoying any enhancement made by others under the open source GPL. Since the existing database vendors have been unable for years to became a substantial threat, this simple merger would allow Oracle to get rid of its main competitive stimulus (and possibly to find a method to deal with similar threats in the future), and therefore to soften competition. The consequence for the database market would not be that different from what would happen in the market for operating systems if Microsoft was allowed to be in control of Linux.

After the merger, absent any competition between Oracle and MySQL, any innovative effort of the latter would slow down, turning MySQL into a niche product and locking in its customers. Oracle would have all the incentives to force the customers of MySQL to migrate toward its proprietary database and, given the wide product range of Oracle, they would face excessive switching costs to move toward different solutions. All this would allow Oracle to increase the mark ups for its own products. Followers as IBM and Microsoft may not loose money from such a softer competition, but they may loose in terms of market shares (not by chance IBM tried to merge with Sun before Oracle). Without doubt, the largest losses would be for the customers in terms of higher prices and less choice, especially for small firms currently relying on open source solutions.

The concern should not be limited to database systems. After the merger Oracle would control also the celebrated Java technology, which is a widely used standard for application-hosting used on over 6 billion devices worldwide (way more than Windows), including mobile phones and server platforms. After the merger, competition for Java-based application servers and for the wider Java middleware market (accounting for about $ 5 billion) would be limited to two major companies, Oracle and IBM, without any strong competitive pressure. Again, this is the typical situation in which a merger softens competition and allows the duopolists, post-merger Oracle and IBM (which, by the way, have been historically close cooperators), to increase margins and profits while hurting the final consumers.

Conclusion

The concern of the European Commission about the Oracle-Sun deal is not surprising when we look at role of the two firms in the software industry. In the market for enterprise database systems MySQL is increasingly robust and successful as a competitive constraint on Oracle (especially in Europe), and the merger would substantially reduce competition and innovation. The easy solution would be that Sun divests MySQL (logically it cannot be sold to either of the other big market players), but we doubt that Oracle would pursue the deal in such a case.

References

•Aghion, Philippe and Griffith, Rachel (2005), Competition and Growth. Reconciling Theory and Evidence, Cambridge: MIT Press.
•Etro, Federico (2007), Competition, Innovation, and Antitrust. A Theory of Market Leaders and its Policy Implications, New York and Berlin: Springer.
•Etro, Federico (2008), “Stackelberg Competition with Endogenous Entry”, The Economic Journal, Vol. 118, 531 (October), pp. 1670-97.

¹ See Etro (2007, 2008) for a modern version of that theory and its antitrust implications.