CHAPTER I

INFORMATION TECHNOLOGY AND THE NEW ECONOMY

Two remarkable developments occurred in the second half of the 1990s. After
quietly improving in speed, power, and convenience since 1969, the Internet
burst onto the economic scene and began to change business strategy and
investment. At the same time, the U.S. economy has enjoyed a remarkable
resurgence. Productivity growth, one of the most important indicators of
economic health, doubled its pace from a sluggish 1.4-percent average rate
between 1973 and 1995, to a 2.8-percent rate from 1995 to 1999 (Figure 1.1). 
(1)

Evidence is increasing that these two phenomena are not coincidental but derive
substantially from the same phenomenon: the synergistic convergence of dramatic
increases in computer power, an explosion in connectivity, and increasingly
powerful new software. These advances in technology have produced sharp
declines in the prices of computer processing, data storage and retrieval, and
communications, that are in turn driving both the surge in Internet activity
and the increases in business investment in IT hardware and software. Such
investment has been a major source of recent U.S. economic strength.

The advances in computer power overwhelm imagination. Since the 1960s, the
number of transistors per microprocessor chip has been doubling roughly every
18 to 24 months, resulting in a massive increase in processing capability and
sharply declining costs. (Figure 1.2)

Technologies associated with computer use, such as data storage technologies,
have also shown dramatic improvements in performance and even more dramatic
cost reductions. The capacity of today's hard- disk drives is doubling every
nine months and the average price per megabyte for hard-disk drives has
declined from $11.54 in 1988 to an estimated $.02 in 1999. (3) As a consequence
of technological advances in microprocessors, storage, and other components,
already steep annual declines in computer costs from 1987 to 1994 accelerated
sharply beginning in 1995 (Figure 1.3).

Similar improvements have occurred in communications technologies. In recent
years, for example, wavelength division multiplexing, digital subscriber lines,
and cable modems have produced exponential increases in the speed of data
communication and the carrying capacity of the communications infrastructure.
The carrying capacity of fiber is currently doubling every 12 months. (4)
Between 1994 and 1998 (the last four years for which data are available), the
price of telecommunications equipment declined by 2 percent per year.

Price declines for computers and peripheral equipment and for communications
equipment have spurred major increases in business IT investment and
extraordinary growth in U.S. production of computers, communications equipment
and semiconductors. (Figure 1.4) Output growth in these industries has jumped
from about 12 percent a year in the early 1990s to roughly 40 percent in the
past six years.

In addition, the declining costs of computing and communications are helping to
drive complementary investment in new software that harnesses and further
enhances the productive capacity of IT hardware and infrastructure. Overall,
U.S. businesses have increased their investments in new software from about $28
billion in 1987 to $149 billion in 1999. (Figure 1.5) (5)

The new economy is being shaped by developments not only in computer hardware
and software, but also in electronic connectivity. Larger businesses have been
increasing efficiencies through standardizing and automating routine
transactions electronically for some time. Until recently, however, most small
and medium sized businesses found that the costs of necessary hardware,
software, and communications service for these systems exceeded the benefits.

The advent of the Internet as an instrument of commerce fundamentally altered
this equation by cutting the costs of software and communications services
needed to conduct electronic transactions. Beginning in the mid-1990s, as a
result of the convergence toward digital formats and the development of de
facto standards for digital networks, such as the Internet's technical
specifications, the expansion and commercialization of the Internet made
connecting computers and communications devices easier and cheaper. Commercial
opportunities on the Internet and the falling costs of computer and
communications hardware created an extraordinarily fertile environment for
innovations that are creating new value and new efficiencies for businesses of
all sizes.

The Internet is both an effect and a cause of the new economy. It is, in part,
a product of the powerful technological and economic changes that are shaping a
new epoch of economic experience. However, as this report shows, the Internet
and related networking technologies are also increasingly the new economy's
medium.

Networks, like telephone networks or the Internet, are subject to a phenomenon
called "network effects" or "network externalities." Establishing a network
involves large, up-front fixed costs (e.g., for purchasing equipment, laying
new cable, or developing new software), but adding an additional user to an
existing network costs very little. Conversely, the value of a network to
participants is low when the number of participants on the network is low, but
rises rapidly as network participation expands. For example, a network of a
single telephone is of no use. Adding another telephone increases the value of
the network because now calls can be made between the two phones. As phones are
added, the number of possible connections rises almost as fast as the number of
phones squared. (6) Any person with a phone can reach more people, so the
network's value to them increases.

Similarly, as the number of people online has grown, so has the value of being
online to each Internet user. Moreover, as the Internet gains popularity, its
technological specifications have become a default standard, encouraging new
hardware and software innovations that use Internet technology as a platform.

Fundamental engineering breakthroughs alone do not have important economic
effects until their costs and applications become favorable. For example, by
the mid-1970s, Xerox PARC had already made several breakthroughs underpinning
today's IT revolution: a microcomputer with a mouse, graphical user interface,
and Ethernet communications capabilities. But there was no mass market for
their machine, which at the time cost about $25,000 each to produce, (7)
especially given its slower processing speed and the absence of applications
software that drives computer use today. In contrast, technological advances in
recent years have brought IT costs down to a far more commercially attractive
range, and new software applications for networked systems have been developed.

Nothing approaching the activities now conducted over the Internet was possible
a few years ago. Push back the technology or cost declines in any one of the
four elements--computer processing, data storage, software, or
communications--just a few years and the Internet activities we now view as
commonplace would be too frustrating or too costly for a mass market. Likewise,
roll back any one of those elements and business would have found IT investment
to be far less productive. As applications software is developed to exploit the
continuing plunge in hardware prices in coming years, businesses and consumers
will find new ways to create value and increase efficiency.