Technology, Economic Growth, and the New Economy

William D. Nordhaus
Yale University June 13, 2000
DRAFT: Do not quote without permission

I. What is the new economy?

A. Definition We hear a great deal about the new economy. What exactly do we mean by this term? The new economy is a vague name for that part of the economy that is involved with information technology. Most of the action is in computers and software, but these are closely linked to communications and communications equipment. For this purpose, we should omit radio, TV, and most of telecommunications services, some of which date from the 19th century and remain very much old economy. A working definition of the new economy is as follows: The new economy involves acquisition, processing and transformation, and distribution of information. The three major components are the hardware (primarily computers) that processes the information, the communications systems that acquire and distribute the information, and the software which, with human help, manages the entire system. Sometimes, people have in mind what I would call the brand-new economy, which is that sector which produces or uses the Internet. While electronic communication dates from the 1960s, the qualitative change in the usage and power of the Internet came with the introduction of the World Wide Web in 1989. So far, however, the Internet doesnt amount to much in the real economy. B. Old Wine in New Bottles? When asked about a new technological development in the aircraft industry, Fred Kahn, who was charged with deregulation of this industry in the 1970s, responded, An airplane is just marginal cost with wings. Similarly, in viewing the new economy we should ask whether, when stripped of the rhetorical flourishes, the new economy is simply old wine in new bottles. In one important sense, the new economy is definitely old wine. After all, people have been adding up 1s and 0s for centuries and sending messages for millennia. But the new economy is qualitatively and quantitatively different from both old economy and -1-

the former number-crunching-and-commmunicating sectors. A number of features distinguish new from old economy. First, the new economy involves software, which for the first time begins to substitute for and replace human intelligence. Earlier industrial revolutions replaced other human attributes, such as when the power revolution substituted for human power, but for the first time software is able to substitute for that unique human feature, intelligence. The second feature of the new economy is the extraordinary rate of productivity improvement. It is not just that computers and software are getting better or that communications are becoming more rapid. They are improving at sustained rates that have never been seen in the recorded economic statistics. Third, a substantial part of the new economy particularly software is characterized by a cost structure that is peculiar to information: it is expensive to produce but inexpensive to reproduce. Combined with the communications power of the Internet, this means that any digitized information can be reproduced and transmitted around to world in virtually limitless numbers at virtually the speed of light. These are the most powerful economies of scale known to date. Fourth, much of the new economy has strong network characteristics. Networks can have powerful economic impacts in several dimensions, each of which is seen in different parts of the new economy. Networks have strong adoption (or demand-side) externalities; they tend to have tippy equilibria, seen in such features as a strong tendency toward market dominance or even monopoly; standards and history have an important impact on market evolution in networks; and networks stimulate very unusual and evil-looking market strategies, some of which surfaced in the Microsoft antitrust case. We can almost say that the new information technology is like a new factor of production, perhaps we should call it artificial intelligence, that may over the next few decades reshape the economic landscape. It is at this stage too early to say whether in fact the information revolution is changing the economy in a fundamental way; my task here is to give you an update on where we are at the present time.

II. Major Features of the New Economy

In this section, I will describe some of the dimensions of the new economy, focusing on its size and growth along with the price and productivity performance and its contribution to the overall economy. Most of this discussion concentrates on the United States.

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A. Sectors in the New Economy Figure 1 shows a breakdown of the major sectors with the value added in each of the major industries. According to this detailed breakdown, the new economy was about 4 percent of nominal U.S. GDP in 1998, and its share was growing rapidly. B. Growth of the New Economy With respect to the information technology sectors as I have defined them, the new economy has grown rapidly both in nominal and real terms. Because we do not have current data on industrial output, I have used another measure of the new economy, which is investment in Information processing equipment and software. This includes computers,

Industry Hardware Computers and equipment Calculating and office machines, nec Electronic tubes Printed circuit boards Semiconductors Passive electronic components Industrial instruments for measurement Instruments for measuring electricity Laboratory analytical instruments Total Hardware Computer Software and Services Computer programming services Prepackaged software Computer integrated design Computer processing and data preparation Information retrieval services Computer services management Total software Telephone and telegraph communications Telephone and telegraph communications Radio, TV, and communications equipment Magnetic and optical recording Total communcations

SIC

1990

1998

3571,2,5,7 3578,9 3671 3672 3674 3675-9 3823 3825 3826

28,677 2,607 1,318 4,997 17,855 13,099 3,765 5,352 3,019 80,689

45,082 3,478 1,717 7,603 70,092 29,802 5,547 8,399 4,781 176,500

7371 7372 7373 7374 7375 7376

14,903 10,615 9,424 10,256 2,435 1,369 49,003

n.a. n.a. n.a. n.a. n.a. n.a. 125,936

3661 3663 3695

9619 11278 1676 22,573

17374 27854 3293 48,521

All new economy Share of GDP

Source: Department of Commerce, "The Emerging Digital Economy," 1999.

152,264 2.66%

350,958 4.15%

Figure 1. Major Sectors in the New Economy

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peripherals, and software, communications equipment, and similar equipment. 1. Moores Law for computers One of the fundamental driving forces behind the new economy has been the phenomenal improvements in computer technology. One of the remarkable trends has been the improvement in performance. The rough trend was foreseen by Gordon Moore, co-founder of Intel, who observed in 1965 that the number of transistors per square inch on integrated circuits had doubled every year since the integrated circuit was invented. Moore predicted that this trend would continue for the foreseeable future.

Moore's Law and Processor Speeds

10,000,000
Growth rate of 27 percent per year (doubling in 2.7 years)

1,000,000 Speed (kilohertz)

100,000

10,000

1,000

100 1970

1975

1980

1985

1990

1995

2000

2005

Figure 2. Clock speed of different generations of Intel microprocessors () and trend line

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As Figure 2 shows, the actual rate of improvement over the last quarter-century through June 2000 is a compound 27 percent per year in clock speeds, starting with a speed of 108 KHz with the 4004 chip in 1971 and progressing through the 1,000,000 KHz or gigachip introduced in March 2000. (Data are from Intel at www.intel.com/intel/museum.) 2. Technological improvements in communications I know of no comparable estimates of the progress in software and communications. For illustrative purposes, I constructed a graph for communications similar to that for computers. This looks at the speed of communications devices from the telegraph of 1844 to the highspeed connections available today. For this, I measured the speeds available in relatively small establishments, such as a rural railroad station in the 19th century of a residence today. (Figure 3 is based on estimates by author.) What is apparent in this figure is the inflection point in the last quarter century, when the rate of improvement rose from around 4 percent annually to a rate of about 70 percent annually, or doubling of speeds each year.

Growth in Communications Speed

1,000,000 Growth rate of 70 percent per year (doubling every year)

100,000 Speed (bits per second)

10,000

1,000

100

10

Growth rate of 4 percent per year (doubling in 19 years)

1 1800
Figure 3.

1850

1900

1950

2000

2050

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C. Overall size of the new economy From an economic vantage point, the new economy is just marginal cost at light speed. Economic analysis puts on a green eyeshade and looks at the market values as well as the clock speed or bits per second. What is impressive about the new economy is its persistent growth and the rapidity of the price changes. Overall, the IT sector has grown to about onequarter of nominal total fixed investment and about one-third of real investment. It constitutes about 5 percent of total GDP (see Figures 4 and 5).

Share of New Economy (nominal)

Percent of Investment or GDP

30% 25%
Share of investment

20% 15% 10% 5% 0% 1960

Share of GDP

1970

1980

1990

2000

Figure 4. Share of Information Investment in Economy (nominal)

Share of New Economy (real)

35% Share of investment 30% Percent of Investment or GDP Share of GDP

25% 20%

15%

10%

5% 0% 1985

1990

1995

2000

Figure 5. Share of Information Investment in Economy (real) -6-

Information Technology Investments

Office Photocopy Instruments Computers

Figure 6 shows the breakdown in information technology investment by type. Clearly, computers and software are the dominant force. D. Which are the growing sectors in the new economy? Which sectors are growing most rapidly? Figure 7 shows the growth in nominal value added by major industry over the last three years. There is nothing particularly notable about manufacturing in the nominal output data, although communications is growing most robustly.

Comm. Equip

Software

Figure 6

Growth in Nominal Value Added, 1996-99

10%
Annual Average Growth Rate (%)
Const

Comm Serv FIRE

8% 6%
Durables TPU Trans Whole Retail

4% 2%

Agri Manuf Utilities

Gov

Nondur

0%
Figure 7.

Min

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Figure 8 shows the growth in nominal output in the major sectors of the new economy. This sector is growing about twice as fast as total GDP in nominal terms. We have no data on real output by industry since 1997, however.

Industry

Average growth rate 1998-1995

Computers and equipment Calculating and office machines, nec Electronic tubes Printed circuit boards Semiconductors Passive electronic components Industrial instruments for measurement Instruments for measuring electricity Laboratory analytical instruments Total Hardware Total software

11.0% 4.6% 5.2% 10.0% 11.0% 16.0% 3.5% 3.8% 3.8% 10.6% 14.0%

Telephone and telegraph communications Radio, TV, and communications equipment Magnetic and optical recording Total communcations

11.9% 5.7% 8.9%

All new economy Share of GDP Total GDP

11.5% 6.2% 5.1%

Figure 8. Growth Rate of Nominal Value Added in Different Sectors of New Economy, 1995-98 -8-

E. The significance of the Internet Today, most people think of the Internet as the new economy, and I have labeled this the brand new economy. In fact, the Internet is genuinely new and different. While electronic communications dates from the 1960s, the qualitative change here came with the introduction of the World Wide Web in 1989. As we all know, it has grown explosively since that time in many dimensions. The significance of the Internet in my mind comes primarily as an information distribution channel. And in this respect, it is awe-inspiring. The Internet has resulted in a phenomenal decrease in the time needed to access information. For example, if you are interested in searching for documents in English on Sweden and the New Economy, you can find 1,410 items using the search engine Google in approximately 1 second. Or to give another example, if I wanted to obtain data on retail sales or the unemployment rate that was not on my book shelf, it would take at least a few minutes or perhaps a few days to obtain the information. Using the Internet, these data can be retrieved in a few seconds. It seems accurate to say that nothing so revolutionary to information distribution has occurred since the invention of the printing press. Figure 9 shows an illustration of the changing nature of search due to the Internet.

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F. How important is e-commerce? While the Internet offers untold possibilities as a device for the distribution of information, lets focus for the moment on the narrower issue of how the Internet has affected the economy. Enthusiastic estimates of the impact of the Internet are legion. For example, Jupiter Communications recently announced, Web-impacted spending, which includes both online purchases and Webinfluenced off-line purchases, will exceed $235 billion this year [i.e., 2000] and reach more than $831 billion in 2005. (http://www.jup.com/ company/pressrelease.jsp?doc =pr000518) One of the surprises that comes from a careful look at the data is that the consumer component of the new economy (B2C) is still relatively small in its penetration of economic activity. The only reliable estimates to date are a special Census survey of the fraction of retail sales that was transacted electronically in the fourth quarter of 1999. (This number excludes travel services, financial brokers and transactions, and ticket sales.) Retail sales were $21.2 billion at an annual rate. As Figure 10 shows, only 0.6 percent of

Decline in Search Time

10,000,000 Search time declines 2.2 per year (halves every 34 years)

1,000,000 Search time (seconds)

100,000

10,000

1,000

100

Search time declines at 90 percent per year (halves in 0.6 years)

10 1800

1850

1900

1950

2000

Figure 9. Search time for document deposited at Library of Congress. - 10 -

retail sales were electronic by that time. These numbers are consistent with the estimates of Forrester Research, which estimated that consumer spending (including travel) was around $36 billion at an annual rate in early 2000. (http://www.forrester.com/ER/Press/Release/0,1769,308,FF.html) We dont have good data on value added in e-commerce. If the cost of materials was half of sales, which is a reasonable guess, then retail e-commerce constituted about 0.16 percent of personal consumption expenditures. This number helps put in perspective the vast distance e-commerce has to go to meet the high expectations that many have for its future. G. Commoditization One feature of the new economy is the tendency to commoditize many facets of economic activity. By commoditization I mean the process of grading and standardization of goods and services to make them homogeneous for transactions purposes. Once goods and services are commoditized, they are subject to auctions, and prices tend to be significantly reduced. One of the most interesting examples of this is the proposal of the major automobile companies to set up an exchange (initially called AutoXchange) for purchasing their parts and supplies. This will How Big is the E-conomy, 1999? involve considerable e commerce ($21 billion) standardization and thereby commoditize a substantial fraction of the auto companies supplied.

old economy ($3,264 bill)

Figure 10. Retail sales, old and new economy, 1999

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It is natural that sellers resist commoditization. The following colloquy describes the efforts to resist commoditization by the worlds most famous monopolist. Microsofts Bill Gates wrote an e-mail which stated, Our competitors are still hard at work trying to obsolete Windows. More people than ever now believe they will. Netscape and Sun endeavor to commoditize the [Windows operating system]. The following colloquy extracted a definition from Gates: Q. (Boies) When people used the word with you "commoditize" as in the statement that Netscape was threatening or endeavoring to commoditize the operating system, what did you understand commoditize to mean? A. (Gates) That they were creating a product that would either reduce the value or eliminate demand for the Windows operating system if they continued to improve it and we didn't keep improving our product. The new economy encourages commoditization because of the gains from standardization and from broadening markets. Just as grains and other old-economy products became standardized and sold on exchanges in the 19th century as transportation expenses fell, or as securitization in financial markets led to broadening of the market in the 20th century, just as creation of environmental property is leading to trade in emissions rights, the same tendency will continue in the 21st century as market participants attempt to get the cost reduction that comes from standardization of all kinds of goods and services. Commoditization along with good information about prices will tend to reduce the dispersion in prices among markets and among market participants. This will directly improve the well-being of consumers, particularly uninformed consumers, and it will indirectly tend to chip away at the margins and eventually the existence of high-cost and high-price producers.

III. Economic Performance in the New Economy

A. Price trends Historians remind us that a new economy a new industrial revolution is born every few years. Railroads, electricity, telephony, radio, antibiotics, highway networks, air travel, and television were important historical examples. Our new economy, the IT revolution, is the latest and a most dramatic industrial revolution.

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It is interesting to speculate on how the current new economy stacks up against new economies of the past. Modern economic and statistical techniques allow us to measure output and prices on a standardized basis in ways that were not possible in an earlier era. We therefore have begun to measure the price of standardized goods like computers, software, and automobiles and in some cases to include these improved measures in our consumer price indexes and national income and product accounts. The most dramatic case in point is computer prices, for which the U. S. government calculates a hedonic price back for almost 30 years. Figure 11 shows the price and output calculation that come out of that calculation. The fall in computer prices is nothing short of phenomenal. We know of nothing like it in recorded economic history. Figure 12 shows the relative price trends of computers along with another revolutionary product, electricity. For comparison purposes, it is useful to deflate them by wages so as to show the relative prices of computers or electricity to labor. Electricity prices begin in 1883, shortly after the first marketing of electricity, while computers begin with the earliest introduction of computer price hedonics into the U.S. national accounts.

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The sustained rate of decline in relative prices of computers was 3 to 4 times larger than that of electricity. Given the tremendous decline, along with its versatility as a factor of production, it is little wonder that the output of computers and other IT products have grown so rapidly. B. Productivity 1. Measurement Issues

100
1972

Price of computers (1996=1)

10

1980

1990

1
1999

0.1 0.01

0.10

1.00

10.00

100.00

1000.00

Computer output (billions of 1996 $)

Figure 11. Computer prices and output in the U.S. economy, 1972-99

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The major economic question about the new economy is the extent to which it has raised, or will in the future raise, the economys productivity. The new economy has two important impacts on productivity: it improves access to existing information, and it speeds the transmission speed and bandwidth of information. The question is, how much has or will the improved access to information increased productivity? In answering this question, we must make four preliminary points. First, we must distinguish between the contribution of the new economy to final output (consumer goods and services) and the contribution as an input. To the extent that the new economy contributes directly to consumer welfare (say, through the joy of e-mailing the family), that is unlikely to be accurately reflected in economic measures of productivity. Second, measuring the contribution of the new economy to productivity as an input to conventional output is likely to be accurately captured. For example, if better computer programs improve managing oil refineries and thereby lower the cost of producing various petroleum products, this will show up in output and price measures for petroleum products. Third, it may be difficult to know how much of the improved productivity (say in petroleum products) was due to the new economy, however, if we do not have accurate measures of the output of the new economy. The decomposition of output growth between the contribution of new-economy inputs and other (labor, other capital, etc.) inputs and technological change cannot be properly made without accurate measures of the output of new-economy inputs. Fourth, an important route by which the new economy will show up in measured productivity is through the final output of new-economy services and products. These would be investment and consumption of computers, software, telecommunications equipment, and telecommunications services. If these are not accurately measured, a large part of the economic contribution of the new economy will simply be missed. This raises a major difficulty for economic statisticians because the measurement of real output in these areas requires use of complicated and sophisticated hedonic techniques to capture the very rapid quality change in the equipment and services that are produced. In this area, most countries are probably underestimating the contribution of the information economy to their economies. Few countries accurately capture the price trends of computers, and no countries to my knowledge measure accurately the prices of software, communications, or communications equipment. This means we are underestimating, perhaps significantly, the growth of our economies.

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Relative Price Change: Electricity and Computers

0.1
Price/wage ratio

0.01

Electricity Computers
0.001 0 10 20 30 Years after early introduction 40 50

Figure 12. Relative Price Decline for Electricity and Computers in Years After Early Introduction - 16 -

2. B2B or B2C? Most of us look to the consumer side of the new economy with the exciting opportunities at browsing the Internet, shopping, playing games, and a myriad of other activities. What is the relative importance of the consumer sector compared to the business sector? The best way to get at this is to look at the destination for the output in different sectors. Figure 13 shows the U.S. data for 1996, which is the latest year for which we have complete input-output data. Communications and audio/video/communications equipment have a large share going to personal consumption one-third and two-fifths respectively. For computers, instruments, and electronic components, the share is between nil and extremely small. While the consumer share (B2C) has probably grown rapidly in recent years, it is likely that the major impact of the new economy is currently in the business-to-business (B2B) sector. The point here is to suggest that most of the impact of the new economy is likely to be seen either as output (investment) or as inputs to production rather than as new consumer products and services. This suggests that we have a good shot at capturing the impacts on the economy. 3. Trends in Measured Productivity Economists have been waiting for an upturn in productivity growth, hoping that the revolution in information technology would spur rapid growth through the economy. Indeed, innovations in information technology (computer hardware, software, and communications) have produced astonishing improvements in every corner of the economy.

Share of item in total production: Item: Consumption

Computer and office equipment Audio, video, and communications equipment Electronic components and accessories Scientific instruments Communiciations except radio and TV 11.2% 34.3% 0.1% 5.3% 42.9%

Private Investment GDP

62.2% 52.4% 0.0% 42.5% 2.2% 55.9% 78.8% -5.7% 72.1% 52.2%

Total production (billions)

$93.7 78.0 129.4 118.8 287.5

Figure 13.. Share of different components in new economy, 1996

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The prices of computers have fallen more than a thousand-fold in the last three decades. Electronic mail and the Internet are changing the face of retailing. Computers are the nerve system of business running airline pricing and reservation systems, scanning price and quantity data in stores, dispatching electricity, clearing checks, dunning taxpayers, and sending students their tuition bills. Some economists think that computers are like a new factor of production. Until recently, experts were puzzled, in the words of Robert Solow, that Computers can be found everywhere except in the productivity statistics. Even as computers invaded every aspect of economic life, productivity growth showed little response. But this changed in starting about 1995, when productivity began growing rapidly and regained a substantial part of the ground lost after 1973. Having grown at 3.2 percent per year from 1948 to 1973, productivity growth slowed to 1.4 percent in the 1973-1995 period; productivity then surged ahead at 2.9 percent per year from 1995 to 1999 (see Figure 14).

4 Average Annual Growth Rate (%)

Labor Productivity Growth in U.S. Business Sector

3

0 1959-73 1973-97 1998-99

Figure 14. Labor Productivity in U.S. Business Sector [Source: Bureau of Labor Statistics]

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Enthusiasts spoke of a new era and a brave new world of American capitalism. Even Fed Chairman Alan Greenspan, known primarily for his understatement, joined technological enthusiasts, stating: A perceptible quickening in the pace at which technological innovations are applied argues for the hypothesis that the recent acceleration in labor productivity is not just a cyclical phenomenon or a statistical aberration, but reflects, at least in part, a more deep-seated, still developing, shift in our economic landscape. Economists who have looked at the numbers under a microscope uncovered some interesting facts about productivity in the late 1990s. Among the important factors in the productivity acceleration were the following: Productivity explosion in computers. The productivity explosion (and consequent price decline) in computers is extraordinary. Measuring productivity as the dual using price decreases, from 1972 to 1995, the relative price of computers fell at about 18 percent per year, and in the 1995-99 period the decline amounted to 29 percent per year. Computer productivity alone added 0.23 percent per year to the productivity acceleration after 1995 according to the Council of Economic Advisers. Capital deepening because of investment in computers. Companies have invested heavily in computers and software over the 1990s. According to the Council of Economic Advisers, this investment has added almost 0.5 percent per year to labor productivity. Putting all these factors together, the Council of Economic Advisers estimated that one-half of the upturn in labor productivity in the late 1990s about 0.70 percent per year was due to production and use of computers. The balance was a combination of cyclical productivity and productivity increases in other sectors. 4. The Gordon Hypothesis Some economists believe that outside of computers and measurement, there has been little or no improvement in productivity growth. This view has been particularly associated with Robert Gordon of Northwestern. According to the Gordon hypothesis, the entire upturn in manufacturing productivity growth is due to computers while the improvement in nonmanufacturing is due to the business cycle and to measurement improvements. Because of data gaps, it is difficult to assess the Gordon hypothesis. To test it, I have examined the growth in labor productivity by industry. Unfortunately, the data by industry currently go only through 1997 and do not yet incorporate the major data revisions of October 1999. Nonetheless, the results are extremely provocative.

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The methodology used to construct these indexes are as follows. I have gathered data for real output (generally, double-deflated value added) and hours worked for 10 major industry groups in the private economy. I then construct three different measures: Private total productivity growth is the growth in private GDP per hour worked. This is the usual measure examined. Private weighted productivity growth is the weighted average productivity growth of the 10 major sectors. This measure corrects for the composition of output and productivity by sector, which can lead to extraneous changes to productivity. Private weighted productivity growth less computers removes the new economy sectors from the calculation. For this calculation, I have excluded the output in the two sectors Electric and electronic equipment and Machinery, except electrical. These two industries constitute about 4 percent of total hours worked in the private sector. Figure 15 shows the results of this calculation. Labor productivity in the private sector (weighted) accelerated from slightly 0.96 percent per year in 1978-89 to 1.93 percent per year 1996-97.

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However, as the last set of bars shows, the entire acceleration was due to acceleration in labor productivity in the two new-economy sectors. Indeed, after removing the new economy sectors, the growth in labor productivity in the private sector declined from 0.70 percent per year in 1978-89 to 0.60 percent per year 1996-97. The entire increase in productivity growth was accounted for by the 4.6 percentage point acceleration in nonelectrical machinery and the 13.8 percentage point acceleration in electrical machinery.

2.0% 1978-89 1.5%

Growth labor prod (% per year)

1990-95

1996-97 1.0%

0.5%

0.0%

Private: total

Private: weighted

Private: wtd less computers

Figure 15. Growth of Labor Productivity in Private Economy

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5. Skeptics Many are skeptical about the Gordon hypothesis. They point to the fact that overall productivity growth in the late 1990s was actually above the long-term trend. They also argue that much of the benefit of the information revolution is not captured in the official numbers. Some economists believe that productivity continues to be significantly underestimated for non-pre-packaged software and communications equipment. This of course would not reverse the finding of no productivity acceleration outside the new economy sectors. Another source of skepticism about the Gordon hypothesis is that many of the contributions of the new economy are enjoyed by consumers who save by shopping on the Internet, or save time and postage from the switch from snail-mail to e-mail, or enjoy the convenience of cellular telephones none of these show up in measured productivity. Yet another possibility is that the true gains from computers lie in the future. Stanford economic historian Paul David, who has studied past inventions like the electric motor, believes that it takes decades for the economy to reap the full benefits of fundamental inventions. However, Figure 12 above, which shows the relative price movement of electricity and computers, casts some doubt on the David counterpoint view. Computers have actually been an important feature of the economy for at least four decades, and the relative price movement has been must steeper than that of electricity. After computer prices have fallen by more than a factor of 100, it is difficult to believe that we are just beginning to see the benefits of computerization. 6. Profits One important question is what the new economy has done for profits both in the overall economy and in the new-economy more narrowly focused. a. Aggregate profits

There are many cross-currents operating on profits in the present economy. On the whole, the rhetoric of American capitalism would lead us to believe that profits were being relentlessly ground down by the forces of competition. Heightened international competition, lower trade barriers, better price discovery through the Internet, deregulation in many markets, the trend to commoditization all these should be operating to reduce supernormal profit rates. On the other hand, improved management practices and inventory control, increased out-sourcing, reduced power of labor unions, a conservative and pro-market political trend these would tend to lower costs and to increase profit rates. Figure 16 shows the post-tax profit rate on U.S. non-financial corporations. The fact is that the profit rate has grown steadily over the last two decades, although it has not reached the peak of the 1960s. Surprisingly, the profit rate has stabilized since the mid-1990s. How - 22 -

reported corporate earnings could have grown so sharply with a near-constant rate of return is a puzzle for accountants to explain. b. Profits in the new economy

Productivity growth is the social return to new and improved technologies; profits are the private return. An interesting question is how profitable the new economy has been. Here, as in the old economy, forces are operating in many directions. Some new-economy firms,

Rate of Profit of Nonfinancial Corporations

9% Rate of profit on reproducible capital 8% 7% 6% 5% 4% 3% 2% 1% 0% 1960

1970

1980

1990

2000

Figure 16. Rate of profit on U. S. domestic non-financial corporations. [This is total profits and interest after tax as a percent of the replacement cost of tangible capital for all non-financial corporations. Source is Bureau of Economic Analysis and used unrevised data on profits and capital.] - 23 -

such as Microsoft, have built up enormously profitable empires; on the other hand, many new Internet dot.com companies seem to produce mainly prodigious losses. Figure 17 gives an idea of the basic dimensions of private profit as of May 2000. This table shows a rundown of the position of the 200 largest new economy firms. A few points emerge. First, outside of a few standouts, this sector has yet to show substantial profits. Figure 18 compares the capitalization of new and old economy firms. It shows that, after the top ten (IBM, Microsoft, Cisco, Hewlett-Packard, etc.), the next 190 new economy firms earned about $3.4 billion last year. They had a market value of $1.2 trillion and a price-earnings ratio of 348. It strains the imagination to project a scenario in which future developments could rationalize the markets view of their value. If there is one single place to locate the irrational exuberance described by Robert Shiller, it is in the startups of the new economy. The last two exhibits described the markets view of the future of new economy firms. Another measure is the rate of profit on investments of new economy firms. These calculations are tricky, however, because much of the investment in this sector is not
Priceearnings ratio
85.2 59.8 384.6 34.6 139.7 54.5

Sector
Software and Programming Computer Storage Devices Computer Services Computer Peripherals Computer Networks Computer Hardware

Market value [billions]

$1,017.9 142.5 444.0 54.8 487.0 674.8

Earnings [billions]
$11.9 2.4 1.2 1.6 3.5 12.4

All new economy firms* All new economy firms less big 5 big 10 S&P 500 less new economy

85.7

2820.9

32.9

162.3 348.3 26.6

1566.5 1173.4 9276.5

9.7 3.4 348.9

* With market capitalization above $1 billion in January 2000.

Figure 17. Valuation of New Economy Firms, May 2000.

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tangible capital but software development and other forms of intellectual and human capital. Together with Jason Cummins of NYU, I have developed alternative measures of the rate of return on investment of different firms. These calculations estimate the real return (profit-type income) on total tangible and intangible capital. To make this calculation, we have capitalized research and development (R&D) and added that to estimates of the replacement cost of capital for firms. The data are for publicly held firms that are reported in the Compustat data base.

Price-Earnings Ratios: Old and New Economy

400

300

P-E Ratio

200

100

0 New Economy
Figure 18.

NE less big 10

Old Economy

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The results of this calculation are shown in Figure 19 . A few points are interesting. One is the astonishing and growing profit rate earned by Microsoft over the last decade. While the protagonists will continue to debate Microsofts future structure, there can be little doubt that the firm was a prodigious money maker. The second surprise is that software firms as a whole (excluding Microsoft and IBM) have earned a respectable profit on their investments, with the profit rate approaching 20 percent after tax by decades end. These profit rates may overstate profits because they only capitalize R&D and may omit other similar investments, such as those for advertizing, but they do suggest that this area as a whole has been a fruitful source of social investments.

100%

Microsoft IBM
80%

All firms Software (ex Microsoft and IBM)

Rate of profit (percent of assets)

60%

40%

20%

0%
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

-20%

Figure 19. Rate of Profit on Invested Capital and Research and Development in Old and New Economy Firms.

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IV. Summary on the New Economy

We can summarize the major points about the new economy as follows: The new economy involves acquisition, processing and transformation, and distribution of information. The three major components are the hardware (computers) that processes the information, the communications systems that acquire and distribute the information, and the software which with human help manages the entire process. The computer sector has produced a phenomenal record of technological improvement unparalleled in recorded economic history. The new economy has been a major force in the economic resurgence of the United States in the 1990s. It has added approximately 1 percentage point to the growth of real potential output, and there is no reason to believe that the impetus is slowing. On the basis of industrial data through 1997, there no sign that the new economy is yet producing an acceleration of productivity growth outside its boundaries in electric and non-electric machinery and communications. This tentative conclusion is likely to be revised when the industrial data is available later this summer. The new economy sectors as a whole are earning an above-average return on invested capital and R&D even excluding the extraordinary profit rate of Microsoft which reached 88 percent in 1999. The stock markets enthusiasm for the new economy is remarkable. Outside of the top ten profitable firms (Microsoft, Cisco, IBM, etc.), the price earnings ratio on the top 190 new-economy firms was 348 in early May 2000. A rough guess is that the overvaluation in that sector is approximately $2 trillion.

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V. Policy in the New Economy

The growth of the new economy raises many important questions, and I will sample a few of those in this concluding section. In one sense, from a policy perspective there is nothing fundamentally new in the new economy. The objectives of government policy remain largely the same in new and old economy promoting efficiency, ensuring stability and economic growth, and fostering a fair and equitable distribution of economic opportunities and outcomes. The trillion dollar question is whether the major changes in information technology will put new and important strains on the economy. Information is becoming cheaper over time at a phenomenally rapid rate and this might well lead to significant economic impacts. I will address four questions that seem to me important: the generation of new knowledge, the impact on governments control of the economy, competition and antitrust policy, and the impact on international trade. A. The generation of new knowledge The new economy involves acquisition, processing, transformation, and distribution of information. It is a marvelous device for allowing us to collect and transmit existing information, of which there is an enormous amount dispersed around the world. But will the new economy encourage or discourage the production and generation of new knowledge? The answer is unclear. On the one hand, the rules of the new economy promote the generation of new knowledge because the lower distribution costs make the potential market for new information much larger and more lucrative. On this other hand, the lower cost of transmission and distribution may erode the property rights in intellectual property and make the production of new knowledge less profitable. How these two forces will be resolved is unclear. The history of the encyclopedia is an instructive one in this regard. For more than two centuries, knowledge was codified in major encyclopedias, of which the Encyclopedia Britannica is justly thought the most impressive of the modern era. The Britannica contained impressive articles by major scholars and was the authoritative word on major questions. Encyclopedias have much the same cost structure as the new economy. Marginal production costs for books are typically between 10 and 20 percent of the price. The encyclopedia enterprise was economically viable because the encyclopedias were expensive to produce and virtually impossible to reproduce in their entirety. This allowed the Britannica to survive competition, war, and alternative sources of information for almost two centuries. - 28 -

What brought down the Britannica was new technology, first the CD-ROM and then the Internet. The first CD encyclopedia was introduced by Grolier in 1985. In 1993, Microsoft released Encarta, a multimedia encyclopedia on CD-ROM, which was often given away. A version of Encarta 98 on CD can today be bought for $5.75 plus shipping. Faced with the dirt-cheap computer version, Britannicas market began to crumble, as it reduced its price from $1500 to under $1000 and then eventually turned to a CD version, currently selling at $49.95. The long-run question is whether high-quality encyclopedias will simply disappear because the market will not support them. The scholarship and information provided by high-quality encyclopedias is now freely and quickly available on the Internet or on cheap CDs. Internet information is, however, often of questionable accuracy and sometimes has a commercial motivation. What happened was that lowprice information drove out high-price information, but the low-price information may turn out to be low-value information as well. Whether this history will be repeated in other areas, whether the quality of the commercial and non-commercial research and scholarship will decline under the avalanche of free information, is worth pondering. B. Government control of the economy One of the most intriguing questions is the implication of the new economy for governments control of the economy whether through regulation, taxation, or simple application of laws. Many analysts have argued that the new economy, particularly the Internet, sounds the death knell for governments because individuals can easily evade government rules and controls in the new borderless world. Others worry that government revenues will fall sharply as the cost of smuggling goods and services through increasingly porous borders falls sharply. Unpopular, despotic, and undemocratic governments surely worry about the ease with which protests, samizdat literature, and conspiracies can be facilitated through electronic communication. And all these trends will surely be exacerbated as cheap and virtually unbreakable encryption technologies come into widespread use. I believe that some of these trends are inevitable. It will no longer be possible in moderately open societies to wall out subversive information that the government wishes to contain, and this is surely a trend that most people will welcome. However, most of the hysteria involves the possibility that Internet commerce will lead to a rapid erosion of government revenues, particularly taxes on consumption, such as state sales taxes in the United States or value-added taxes in Europe. I think these concerns are highly exaggerated for three reasons. (This discussion has been inform ed by Austan Goolsbee, In a World Without Borders: The Impact of Taxes on Internet Commerce, forthcoming, Quarterly Journal of Economics.) First, my reading of the potential of e-commerce is that it is unlikely to penetrate as far into the economy as - 29 -

many advocates believe. As noted above, to date the share of B2C commerce is still relatively small (0.6 percent of retail sales). While it is growing rapidly, there are natural limits on its size. Figure 20 shows illustrative estimates of the penetration of ecommerce in personal consumption by sector. These guesstimates lead to an estimate of the penetration of e-commerce in the order of 10 percent of personal consumption. (This applies to actual purchases as opposed to bill paying.) It is simply not credible that a major share of housing, food, energy, or medical consumption will be conducted on line. Second, there is no intrinsic reason why governments should lose control of the tax base just because people buy goods and services electronically rather than in person, by mail, or by the telephone. In some respects, indeed, electronic purchases are

Category Personal consumption expenditures Durable goods Motor vehicles and parts Furniture and household equipment Other Nondurable goods Food Clothing and shoes Gasoline, fuel oil, and other energy goods Gasoline and oil Fuel oil and coal Other Services Housing Household operation Electricity and gas Other household operation Transportation Medical care Recreation Other Total

Potential share of Personal consumption purchases Purchases from expenditure from Internet e-commerce

Share of Total Consumption from ecommerce

316.1 290.5 152.1

25 20 20

79.03 58.10 30.42

1.3% 0.9% 0.5%

904.1 306.3 138.7

5 20 5

45.21 61.26 6.94

0.7% 1.0% 0.1%

494.0 902.5 362.2

20 2 5

98.80 18.05 18.11

1.6% 0.3% 0.3%

255.0 941.3 246.2 948.4 6257.4

2 2 10 10

5.10 18.83 24.62 94.84 559.29

0.1% 0.3% 0.4% 1.5% 8.9%

Figure 20. Estimate of the Potential Share of E-commerce in Personal Consumption Expenditures - 30 -

more easily tracked than other kinds of purchasing as they leave an electronic paper trail around the country (as Gates and Co. were reminded in the Microsoft antitrust case). To evade consumption taxes, purchasers would have to purchase from a firm outside the countrys jurisdiction and gain delivery without customs or other delivery agents recognizing that a taxable transaction took place. The one major exception to this is sale of electronic material (such as CDs, software, or movies on line). This is likely to be a relatively small fraction of total sales. Moreover, the problems in collecting revenues are spreading beyond governments to the owners of the intellectual property themselves; as the owners of electronic property begin to lose control of sales, as is currently occurring for music and video, the owners themselves are likely to take steps to change the legal regime or the technological format so as to frustrate thieves and pirates. Finally, for countries with value-added taxes, the share of value added that takes place through electronic commerce is likely to be relatively small. If I ever were to buy an automobile on line, it is likely that 95 percent of the value added would take place upstream from my purchase. I estimated above that the value added of e-commerce is today only 0.16 percent of personal consumption expenditures. Moreover, to the extent that there are large economies of scale in e-commerce, it is likely that sales will be concentrated in a small number of sellers, like Amazon.com. This will actually make the tax collection problem easier than in todays bricks-and-mortar-with-Mom-and-Pop economy, where underreporting of proprietors incomes in the United States is today estimated to exceed 50 percent of income. In short, I believe the e-commerce tax problems are ones that can be readily solved. C. Competition and antitrust policy One of the major questions that is likely to arise in the new economy is the role of competition policy. Here of course the fate of the giant software company, Microsoft, looms large, and there is the further question of whether our future is likely to be full of other wicked Microsofts in new arenas. To being with, I would observe that informational technology contains powerful structural features that lead to market power or even monopoly. This tendency arises because information, particularly in the case of software, has high setup or fixed costs and low to zero marginal costs. Once a piece of software has been written, it costs next to nothing to distribute it (and the costs may be literally zero over the Internet) and there is no limit on production runs. When zero marginal production costs are combined with strong network effect, as is the case with the Windows operating system as well as applications packages such as word processors or spreadsheets, the monopoly may become deeply entrenched. When to these two characteristics are added - 31 -

rough and nasty business practices, we get the Microsoft case, which is the major American antitrust case of the last two decades and the first major new economy antitrust case. The case raises important issues concerning the definition of predatory pricing, predatory innovation, and anticompetitive behavior in the new economy. Along with three other economists, I intervened as an amicus curiae in the remedy phase of the Microsoft case. (We were not on the payroll of any organization and intervened as public parties. Our brief can be found at http://www.econ.yale.edu/ ~nordhaus/homepage/homepage.htm) We argued that the most satisfactory approach to remedying the anticompetitive practices is the full divestiture option. This would combine the functional divestiture of separation which was proposed by the government and accepted by the court with a monopoly dissolution. The novel feature in our proposal was the monopoly dissolution, under which the illegal monopoly (that part of the company owning the Windows operating system) would be divided into three identical companies, each of which would own and sell Windows products. We argued for this further step as the most effective way of guaranteeing competition in the operating-system market, of reducing the applications barrier to entry, and of reducing or removing Microsofts ability to project its operating systems monopoly into other markets. While the courts remedy is a first step, it is worrisome in that it leaves two powerful monopolists in adjacent markets who, like barons on the Rhine river in medieval times, will pile market power on market power. Our proposal, radical to be sure, was criticized as a quixotic solution. In fact, it is a new economy remedy one reflecting the evolution of our economy from one based primarily on tangible and natural-resource assets to one based increasingly on informational assets. Informational capital like software has a crucial difference from tangible capital in that it is expensive to produce and inexpensive to reproduce. Earlier physical-capital-intensive monopolies like Standard Oil or AT&T could be broken up, but they could only be reproduced or duplicated at extraordinarily high costs. Informational capital in software like the Windows operating systems, by contrast, can be replicated at a cost that is far lower than the costs of developing it. The costs are not zero, because some of the informational capital is embodied in people who have developed or are operating the software, and are therefore necessary for understanding, further developing, and adapting it to new uses. Still, the costs of creating a new and independent operating system are modest relative to their original development costs a major difference from the industries previously subject to divestiture orders. The informational nature of Microsoft's assets therefore motivates a completely different approach to structural reform in structural antitrust cases. Once this point is grasped, we see that the monopoly dissolution we proposed has important precedents in conduct and licensing remedies even though there are no important precedents in - 32 -

major structural cases. Close relatives of dissolution can be found in remedies which mandate the licensing of patents. In essence, these are cases where demonopolization of intellectual property has occurred by dissolving the grant of exclusive authority to the patent holder and giving other firms open or widespread access to that property. The fascinating drama of the Microsoft case has just begun. Higher courts will be unable to resist leaving their imprint on this important case, and other firms along with private plaintiffs are circling the wounded damage waiting for an opportune time to pounce and draw blood. Perhaps it will even be grist for the Hollywood mill. D. New economy in the open economy A final question concerns the impact of the new economy on a countrys international competitiveness and trade. This question is particularly important for smaller technologically advanced countries but is also important for large countries or regions like the United States, Japan, and the European Union. To begin with, it is worth emphasizing that for most countries the overall trade position is determined primarily by macroeconomic conditions rather than by the impact of a single sector. This is particularly obvious for the United States. Even though the U.S. has been the epicenter of the tectonic shifts in the new economy, its trade deficit has risen steadily over the last two decades (see Figure 21.) Indeed, the technological acceleration of the last five years was accompanied by an accelerated rise in the deficit. The paradoxical association between technological change and trade flows arises because the trade deficit is largely associated with differential trends in output growth as well as movements in the exchange rate rather than with relative movements in productivity. The long boom in the United States along with the long slumps in Europe and Japan have led to booming imports and stagnant exports for the United States. The technology boom in the United States attracted financial capital, helped the appreciation of the dollar, and contributed to the trade deficit. Indeed, the technological acceleration due to new-economy forces kept inflation under check, allowed the Federal Reserve to keep interest rates low, lengthening the expansion , and thereby directly increasing the trade deficit. All this is a useful reminder that trends in the overall trade balance are driven mainly by macroeconomic and especially monetary policies rather than by individual sectors.

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A second question is the impact of the new economy on a nations real income and comparative advantage. Standard international trade theory would suggest that changes such as those currently driving information technology would affect a country both through the effect on relative domestic costs in different industries and through the standard terms-of-trade channel. The net impact will depend upon the relative size of the changes to domestic costs and world prices as well as on initial trade flows. The net impact is likely to be extremely complex. One simple case provides a clear and somewhat paradoxical result, however. If there is no change in domestic costs, we have the conclusion that external developments in the new economy would harm countries whose exports are relatively information-intensive and benefit those who are information importers. This is easily illustrated in the case of software and computers. Most countries are importers of Intel microprocessors and Microsoft software. Prices of both have fallen substantially over the last decade. This change in the terms of trade has improved the real incomes of importing countries who benefit from substantially cheaper computation costs. The

2 Net exports as % of GDP 1 0 -1 -2 -3 -4 65

70

75

80

85

90

95

00

Figure 21. Net exports, 1965-2000 - 34 -

economic effect is really no different from a fall in oil prices. A final and more speculative question involves the impact of the information revolution on the openness of economies. There is some evidence that lower transportation and communications costs associated with the new economy will shift the boundary between non-tradable and tradable goods and services. Some goods and services which had previously been non-tradable are now potentially tradable using new communications systems. Some examples are where consumers can buy in other countries over the Internet, where businesses can manage production abroad, where companies can operate on-line auctions in many markets, and the increasing use of videoconferencing to allow distance learning, consulting, or surgery. Broadening the boundaries of international trade is part of the more general phenomenon wherein the new economy is likely to intensify competition in many sectors. In essence, the reduction in communications costs, particularly the immense increase in connectivity due to the Internet, will allow much improved price discovery, comparison shopping, online auctions, and other features that in effect increase the size of markets. This trend will be particularly intensified with the increasing push toward commoditization, discussed above, which broadens markets and intensifies competition. Added together, these trends suggest that the main impact of the new economy on open economies indeed on individual firms and individuals who are after all tiny open economies will be to intensify competition, erode pockets of market power, and reduce the frictions that keep markets from operating effectively and even ruthlessly. This is surely good news for consumers and for nimble businesses but may be bad news for sluggish firms, rigid economies, and inflexible or poorly educated workers. In the new economy, as Pascal said, risk favors the prepared mind.

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