United States. Congress. Senate. Committee on the.

The Industrial reorganization act. Hearings, Ninety-third Congress, first session [-Ninety-fourth Congress, first session], on S. 1167 (Volume pt. 7) online

. (page 95 of 140)
Online LibraryUnited States. Congress. Senate. Committee on theThe Industrial reorganization act. Hearings, Ninety-third Congress, first session [-Ninety-fourth Congress, first session], on S. 1167 (Volume pt. 7) → online text (page 95 of 140)
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worse. RCA's computer di^•ision lost $90 million after taxes during the five years
of the Spectra-360 competition. (9)

The difficulties in following a cojupetitive strategy with the current structure
of the industry make the profits to be earned from competition questionable and

40-927—75 53



5662

far in the future. So long as a company is consciously undercutting other prices
or investing large amounts of money in new technology, it is unlikely to be making
substantial profits. It is buying market share for future profits. However, there is
always the risk, as happened with RCA and G.E., that the future profits will never
be realized. If no firm makes specific compatibility attempts, each can act in a
semi-monopolistic manner with a good deal of market protection. Competition and
general technological progress cannot be ignored because if prices are too high,
other firms will come into the market or customers will switch and pay the con-
version costs, but the entire market would be relatively insen.sitive to exact
price comparisons. If no firms made definite attacks on each other's customers
through compatibility and lower prices, the industry as a whole would reach its
maximum profit position. This would also be the worst position for customer
welfare. It appears that the industry is moving in this direction since the
exit of RCA.

AVhile full systems suppliers have three strategies open to them, partial line
suppliers have only the compatibility option available. Because they are com-
peting for one product on another manufacturer's .system, their products can be
made obsolete by a change in tlie .systems make specifications, leaving them vrith-
out a stable base of customers. Technical advances are limited by the need for
compatibility with the systems maker's equipment. The partial line suppliers are
made dependent upon the systems suppliers because of the lack of independent
CPU suppliers. Consequently, at pi'esent a customer cannot purchase an entire
system without using a CPU supplied by one of the systems manufacturers. An
example of the benefits that can come from having independently available
CPU s can be seen in the current market for used System 360's. Because leasing
companies bought large numbers of 360"s during the late 1960"s many are available
for remarketing and modification. The purchased 360 CPU's have been improved
with independent memory, input-output devices, and in some cases enhancements
to the operating systems in order to make them far superior machines to what was
allowed by IB]M specifications. However, the significance of this movement is lim-
ittHl by the numbers of purchased 360's available for modification because no
independent company is manufacturing CPU's.

The problems of the independent peripherals companies in competing with IBM
are documented in the selection from my forthcoming book, which has been pre-
sented as a written supplement to this testimony. Here I will summarize the eco-
nomic issues involved in the controversies between the peripherals companies
and IBM. The basic fact necessary to understanding the problem is that there are
high barriers to entry in the systems market but low barriers to entry in the
p.eripherals market. In any situation where a company possesses substantial mar-
ket iwwer in one product and less market power in a complementary product, the
most profitable policy is to tie the products together, refusing to sell one without
the other. If the products are totally tied together, the company can choose
the prices for each combination to optimize profit, without concern for competi-
tion. However, because of legal restraints on tying products, the company may
want to raise the prices on the product with monopoly power and reduce the
prices on the product subject to competition as a substitute for tying them
together. This is not as profitable as tying the products together, but is less likely
to get the company into legal difficulties.

IBM lias pursued a combination of both strategies in i-esponse to peripherals
competition. IBM has tied products together where the tie could he technically
justified, and has raised the CVV prices while reducing peripherals prices where
tying could not l)e defended on technical grounds. Examples of tying products
together are the integration of controllers with the CPT^ on the 370/145 and later
machines, and the tying of large quantities of minimum memory to the basic
CPT^ price on the 370/ir>,S and IfiS. Although it cannot be estalilished for certain
that the integration was a response to competitive pressure rather than simply
a design change to take advantage of new techn.ology, the circumstances sur-
roxniding the introduction of integration suggest that it was in response to com-
petitive pres.sure.

Exiimples of raising the CPTT price while loAvering the peripherals price in
response to competitive pressure were the Fixed Term Plan, which reduced the
price of peripherals, followed by a general CPU price increase, and the reintro-
duction of the 370/15.T and 10."» as the 370/1 .08 and 108 with a 30-54% increase
in CPU price and a 57% cut in memory price. Such price manipulations would
not be possible is as much competition existed in CPU production as in periph-
erals, or if the CPU's were made by a separate company from the peripherals.



5663

The ability of IBM to shift price between peripherals and CPU's reduces the
beneficial effects to customers of competition in peripherals as well as threaten-
ing the existence of the independent peripherals companies.

A second aspect of market structure which accounts for actions in the periph-
eral market is the disruption caused by equipment installation and removal, even
when compatibility is not a problem. This means that extra revenue can be ob-
tained when a price cut is necessary by retiuiring an equipment exchange to take
advantage of the price cut. This tactic was used effectively with both the 2314
disk drive and the 2420-7 tape drive. In both cases IBM needed to make price
cuts in order to remain competitive. In both cases, the price cut products were in-
troduced as new products with identical performance specifications, the 2314
as the 2319 and the 2420-7 as the 3420-7. The price was reduced 31% on the
2319 (from $1455 for three 2314 spindles to $1000 for three 2319 spindles) and
34% on the 3420-7 (from $1020 per month on the 2420-7 to $670 per month on the
3420-7). The customer could only get the price cut by physically removing the
old product and installing the new one. The freight charges and disruption in-
volved, as well as the lack of information or lethargy on the part of some com-
puter managers, allowed IBM to have a competitive low price product while still
receiving the higher rent from many customers for some time after the price cut.

The third structural characteristic that accounts for tlie actions of IBM toward
the plug compatible manufacturers is the necessary time lag between IBM in-
troduction of a product and competitive copying of it in order to insure compati-
bility with constantly changing IBM systems specifications. In the early days of
peripheral competition, IBM overestimated this lag and erroneously felt that it
would make the PCM competition a minimal threat. Later, IBM introduced tlie
fixed term plan and more rapid minor product changes in order to capitalize on
the time lag. When a new product is introduced, customers have little incentive
not to accept it on the fixed term plan because no competitive replacement was
ready. Tlie heavy iienalities for early tei-mination under the FTP effectively re-
duced the competitors prospects to those customers finishing a lease. By making
rapid minor product changes, such as switching control functions between drives
and control units, IBM was able to further reduce the PCM's marketing effec-
tiveness without reducing prices.

The foregoing analysis is not meant to suggest that there was anything wrong
with IBM reducing prices. Prices of pei-ipherals before the competitive com-
l)anie.s entered the market were much liigher than necessary to give a normal re-
turn to capital. The proper functioning of a competitive market as well as tech-
nological progress should and did force the prices of peripherals down. The prob-
lem is that customers did not get all the benefit of the lower prices ; some of the
savings from the peripherals was merely transformed into higher prices for the
CPU. The beneficial effects of competition in peripherals were thwarted by
monopoly power in the production of CPU's.

In considering possible methods of improving the performance of the computer
industry, it is necessary to concentrate on removing the factors which have led
to the current problems. Because of the brand loyalty which arises from inte-
grated systems production, splitting IBM into several smaller integrated systems
manufacturers would be unlikely to solve the problem. The greatest current
competitive emphasis in the industry has been from the independent peripherals
makers, not the smaller systems suppliers. Although the industry would be more
competitive with less dominance by one firm, it would not be likely to reach the
l)est possible performance. A better solution is to split IBM by functions ; to
make separate companies out of the production of CPU's, periiiherals. mainte-
nance, and marketing functions. This would prevent monopoly power in one
segment from being spread into the other segments. There will continue to be
barriers to entry to the CPU business because of the economies of scale in the
production of systems software, but that market power could not be enhanced by
control over a wide variety of other activities. If such a split were made, each
segment of IBM would have to compete on a fair basis with other companies. If
IB:sI were really more efficient, it would continue to dominate. However, it could
not use power in one area to manpulate standards or price ratios in order to
fight competitors in another area. Neither could one activity subsidize another be-
cause they would he separate companies.

The proposed type of organization already exists to some extent in the mini-
computer market, and appears to l)e very effective. Minicomputers are generally
sold as distinct components. CPU. software, peripherals, etc. Although tlie ma.ior
manufacturers do provide complete systems, it is also common for sysf^ems to be



5664

made up of several manufacturers' components. Specialized companies have been
formed to choose the appropriate minicomputer system components, write soft-
ware, and deliver complete packages to customers. (10) A wide selection of
peripherals is offered by many different manufacturers with interfaces for a
variety of minicomputers, rather than only for one manufacturer's product as in
the main systems industry. (11) The British National Computing Centre is de-
veloping a common assembly language for a substantial number of minicomputers
in order to provide total program compatibility. (12) Entry into all phases of the
minicomputer business has been easy, prices have dropped rapidly, and the entire
industry has been much more competitive than the main systems industry in
spite of relatively heavy concentration. (13) Consequently, it appears that the
lack of competitiveness in the main computer industry is a i-esult of integrated
systems selling rather than concentration in itself.

References

1. IBM, "Examples of Some EDP Products and Services," reprinted in "3400

Organizations Required by Court Order to Furnish Confidential Data to
IBM," Computers and Automation (February, 1972), pp. 21-24.

2. "IBM's Proposed Findings of Fact and Conclusions of Law Relating to

Telex's Antitrust Claims," (Telex v. IBM, No. 72-C-18 and 72-C-S9, North-
ern District of Oklahoma, hereafter referred to as Telex v. IBM), p. 150.

3. Elmer G. Scluister, Selective Demand Determinants in the Computer Ac-

quisition Process, Ph.D. dissertation, The American University, 1969 (Ann
Arbor : University Microfilms, Inc. ) , pp. 31-35

4. IBM, "OEM Memory Competition," June 5, 1970 (Telex v. IBM, Plantiff's Ex-

hibit 306) p. 26

5. Allan T. Demaree, "RCA After the Bath," Fortune LXXXVI (September

1972), pp. 123-138.

6. IBM, "Greybook— System 370 Model 135," February, 1972 (Telex v. IBM,

Plaintiff's Exhibit 115) , p. 24.

7. James P. Anderson, "The Burroughs D825," Datamation X (April, 1964), pp.

30-34.

8. "The Battle of the Computer Marketeers," Fortune LXXI (January, 1965),

pp. 171, 172.

9. Demaree, op. eit. p. 123.

10. Michael Merritt, "Small Businessmen Get Special Care from Vendors," Coni-

puterworld VI (August 30, 1972), p. S-8.

11. Vic Farmer, "Minis, Peripherals Dominate New NCC Hardware Products,"

Computerworld VIII (May 15. 1974), p. 9.

12. Don Leavitt, "Is One Assembler OK for all Minis" Computerworld VIII

(iMarch 20, 1974), p. 17 and John J. Archer," 'Unisym' Discotmts Differ-
ences Among Minicomputers," Computerworld VIII (July 3, 1974), p. 13.

13. Digital Equipment had 44% of the number of minicomputers shipped in

1973 and Data General had 11%. "Minicomputers that Run the Factory,"
Business "Week (December 8, 1973), p. 76.



Exhibit 2. — Excerpt From "Competition Among Peripherals Suppliers" Re
ProMems of Independent Peripherals Companies in Competing With IBM

[Taken from Gerald Broelc. "The U.S. Computer Industry 195-'f-1973: A Study
of Market Poircr (Cambridge, Mass. Ballinger Publishing Company, forthcom-
ing). Chapter 8. Copyright 1975. Ballinger Publishing Company. Presented to the
Subcommittee on Antitrust and JJonopoly, U.S. Senate, by permission of Ballinger
Pul)lishing Company.]

Chapter 8. — Price and Product Actions — Partial Systems

The previous chapter outlined three strategies that have been followed by com-
plete systems manufacturers ; technological innovation, compatibility, and product
differentiation to protest one's established market. This chapter extends the
analysis to competition Itetween the systems manufacturer and companies which
supi)]y only parts of the system such as a tape drive or a disk drive.^ The poten-
nnt iierf<u-m as expected, it can generally be replaced rapidly and without substan-

1 In orrter to avoid confusion over the many products discussed in tliis chapter, a sum-
mary description is contained on the last page.



5665

tial strategies are much more limited in this situation. Because the product is de-
signed to replace part of a system, it must be compatible with the other parts of
the system. Becau.se of the need for compatibility, the partial line company doe?}
not have the option of introducing new products before the fuil ^'Stems manu-
facturer; it must wait until the specifications of the target product have been
revealed and then try to duplicate them. Partial products therefore always have
a shorter effective life than the products they are designed to rephice. A full
line system can continue competing against a competitor's new line by lowering
the price, hut if the CPU is replaced and the new CPU requires different peri-
pherals, then the partial line producer cannot sell his old product regardless of
the price.

The partial line producer does have an important advantage over the full line
producer who tries to achieve compatibility. No. complete system has yet been
devised which could replace another manufacturers system without some changes
to progi-ams, incurring a cost and the possibility of t^ijniificant disruption. A care-
fully desi^ied peripheral unit can replace another unit without any change at all
in programs or job control language. The customer can then ignore the problems
of evaluating weighted averages of various characteristics and only be con-
cerned with the price of the replacement product and whether the product per-
forms as well as the product to be replaced. Almost perfect compatibility can be
achieved except for the problem of confidence in whether or not the replace-
ment product will perform as promised. Even the confidence problem is much
less serious than in complete systems because if the replacement product does
not perform as expected, it can generally be replaced rapidly and without substan-
tial cost by the original product. The partial line supplier is freed of the largest
area of economies of scale, software, and of the greatest difficulty in achieving
market acceptance, the cost of conversion and difficulty of evaluating complex
products. Less capital is required than for full systems manufacturers. Con-
sequently, the barriers to entry are far less than in the systems market. The
barriers are not zero because of the economies of scale in production and the
generally shorter life of the replacement products, but prices cannot be raised
very far a))Ove the competitive level Avithout attracting new competitors.

Independent companies have manufactured components for computer systems
since the earliest days of the industry. However, before the late 1960's, fhese
components were sold to the computer systems manufacturers rather than directly
to the final customers. For example, both Honeywell and RCA purchased disk
drives from Bryant Computer Products in the early 1960's and then incorporated
the drive into their systems. Each system manufacturer's CPI" required a diffei*-
ent interface with the peripheral units, and in many cases, different models of
the same system manufacturer's line could not be attached to the same peri-
pheral unit.' With the introduction of the IBM System/360 with a standard peri-
pherals interface for all models, a much wider market for each single peripheral
unit was created. With some limitations, the same tape or disk drives could be
attached to any model of the System/360. The standard interface, combined with
the tremendous success of the 360, created a large target for direct marketing of
peripheral units to the end user in competition with IBM.

The marketing of replacements for the IBM 720 and 2401 tape drives in No-
vember. 1967 marked the beginning of competition for IBM peripheral units. Tlie
drives were manufactured l)y Potter Instrument Corporation and marketed by
Z^IAI (^Management Assistance, Inc.) to end users in direct competition with IBM.
In June, 1968, Telex entered the market with a replacement for the 729 and
2400 drives. (1) * By July 1968. IBM was concerned enough about the begrinnings of
peripheral competition to study the problem in detail. IBM considered the com-
panies a potential threat to all revenue represented by '*basic systems I/O", which
IBM defined as "channel attached devices for general application and use." At
that time the value of basic systems I/O on IBiNI machines was only slightly lower
than the value of CPU's installed ($93 million per month rental versus $101 mil-
lion per month for CPU's.) Thirty percent of the basic .systems I/O was accounted
for by direct access devices such as the 2311 and 2314 disk drive and the 2321
data cell. 35% by tape drives, 22% by printers, and 13% l\v card equipment. The
tape drive and disk drive market were the ones sul).iect to innnediate attack.

At that time, a total of 35 MAI tapes drives were installed. In addition, six
replacement 2311 disk drive spindles manufactured by Memorex and marketed
by :m.\I and one 2311 spindle manufactured by Marshall labs were installed,
and 1400 were on order. IBM had 19,000 2311 spindles installed with 10,500 on

♦References may be found on p. .50.80.



5666

order in the U.S. with another 15,000 on order or installed in other countries.
IBM rented the drives at $.590 per month and sold them for $25,510. The Memo-
rex drive was plug compatible with the IBM drive; that is, it could be attached
to the IBM 28A1 controller without any changes in the rest of the system. The
only substantial change was a different arm movement technology which gave the
Meiuorex drive a 33% faster access time. The Memorex drive rented for $.500
per month (15% price cut over IBM) e,nd sold for $15,500 to $20,000 depending
on quantity (39% to 22% price discount over IBM).

In July. 1968, practically no equipment had been delivered by the plug com-
patible companies, but several companies were poised for a large scale attack on
IBM's peripherals market. Telex, MAI, Mid Western Instruments, and Data
Processing Financial & General had all announced replacements for IBM's 729
or 2400 series tape drives with price cuts up to 57% over IBM and equivalent or
better performance. MAI. Marshall Labs, and Polter had all announced replace-
ments for the 2311 disk drive, and Memorex had announced a 2314 replacement.
Given the large price differentials offered by the independents and the lack of
compatibility difficulties to protect IBM's base, IBM could have been expected to
see a large threat to their installed base. However, IBM concluded at that time
that it was "too early to forecast effect" of the competition and that "IBM strategy
sound over plan period". The IBM strategy for protection of the disk market was
a double density 2311 for delivery in 1969 (never done) and a ''2314 B Prime"
(the 3330) for delivery in 1972. The tape protection strategy was to develop a new
techoiogy to replace the exposed drives and to make "tactical 729 price cut" while
moving the rental from the drive to the controller. (2)

During the following year, the potential peripheral threat became a reality.
The numbers installed remained fairly small as the companies built up pro-
duction capacity and attempted to overcome initial customer reluctance to accept
non-IBM equipment for direct attachment to IBM systems. The IBM prices were
high enough that the independents were profitable in spite of large price discounts
and less production efficiency than IBM. The changes in technology since the IBM
target products had been designed allowed the companies to offer higher per-
formance as well as lower prices and compatibility, a very attractive package.

By July, 1969, IBM was becoming more concerned with the previously fore-
cast limits on competitive penetration. The Management Committee minutes
state: (3) "Hume reported that he had investigated OEM inroads in the tape
area and concluded that our forecasts regarding competition are low by a factor
of two. . . . The DP Group is now working on alternative actions including the
possibility of price actions. Opel entered and stated that at this point he is
against any price action but that Frank Gary feels differently."

The question was whether a price cut of sufficient magnitude to stop the
peripheral competition at that time would have been more costly in terms of
lost rental revenue than the lost market share due to the competitive inroads.
In retrospect, it appears that a substantial price cut early in 1939 on exposed
peripheral products would have largely prevented the plug compatible industry
from developing, an advantage worth more than the temporary loss of revenue
fi-om IBM's point of view. Companies contemplating entering a new market are
carefully attuned to the profit possibilities in that market. If the price is cut
enough "that the market does not appear profitable, companies will not make the
investment. However, once a company has entered a market, it will be reluctant
to leave if there is any possibility of future profits. Consequently, a much more
substantial price cut would be required to eliminate established competition
than to prevent new entry. However, at the time. IBM felt that the plug com-
patible comi>etition would remain small in spite of IBM inaction and that there-
fore a price cut was not needed.

As the plug compatible manufacturers (PCM) continued to flourish during
late 1969, IBM's concern increased. In January, 1970, the General Services Ad-
mini';tration requested each agency to provide a list of all IBM 729 and 2401
series tape drives and all 2311 and 2314 disk drives on lease. The agencies were
also to indicate for each machine that it was being replaced with a POM machine
or a reason for maintaining the higher priced IBM version. Also that month, IBM
undertook a complete survey of all installed IBM equipment to get an exact
count of the PCM attachments. The results are shown on Table 8-1. While the
total PCM installations in early 1970 remained a small percentage of IBM's
peripheral products, it could no longer be treated lightly, especially in light of
the GSA order. The GSA order was significant not only for the potential losses
of large numbers of government installations, but also for its effect on private



5667

companies. If the government were involved in an active pi-ogram of switching



Online LibraryUnited States. Congress. Senate. Committee on theThe Industrial reorganization act. Hearings, Ninety-third Congress, first session [-Ninety-fourth Congress, first session], on S. 1167 (Volume pt. 7) → online text (page 95 of 140)