The Emerging Digital Economy

CHAPTER ONE

THE DIGITAL REVOLUTION

The Industrial Revolution was powered by the steam engine, invented in 1712,¹ and electricity, first harnessed in 1831.² Harnessing the power of steam meant less labor was needed for manual work; it also meant that factories could locate anywhere, not just in geographical areas with strong wind and water resources.

Because it required a network to contain and transmit its power, electricity's potential had to wait until 50 years after it was first harnessed before the first power station was built in 1882.³ It took another 50 years before electricity powered 80 percent of factories and households across the country (Figure 1).⁴

Early uses of electricity were limited. While factories used generators for lighting, their primary power still came from line shafts and belt drives up to 1907. It was not until factories replaced the old power system for electric motors that fundamental changes in production occurred. Factory structures were streamlined, and key processes, such as materials handling and manufacturing flows, were made more efficient.⁵

The digital revolution is happening much more quickly. The harnessing of light for nearly instantaneous communications and the ability to use microscopic circuits to process and store huge amounts of information are enabling this current economic transformation.

In 1946, the world's first programmable computer, the Electronic Numerical Integrator and Computer (ENIAC), stood 10 feet tall, stretched 150 feet wide, cost millions of dollars, and could execute up to 5,000 operations per second. Twenty-five years later, in 1971, Intel packed 12 times ENIAC's processing power into a 12 mm² chip with a $200 price tag.⁶ Today's personal computers (PCs) with Pentium processors perform in excess of 400 million instructions per second (MIPS). At the current pace of development, by 2012, PCs will be able to handle 100,000 million instructions per second.⁷

As late as 1980, phone conversations only traveled over copper wires which carried less than one page of information per second. Today, a strand of optical fiber as thin as a human hair can transmit in a single second the equivalent of over 90,000 volumes of an encyclopedia.⁸ By 2002, a constellation of several hundred satellites orbiting hundreds of miles above the earth is expected to bring high-bandwidth⁹ communications to businesses, schools and individuals everywhere on the planet.

A global digital network using new packet switching technology¹⁰ combines the power of these remarkable innovations in computing and communication. The Internet ties together the computing power on desks, in factories and in offices around the world through a high-speed communications infrastructure. More than 100 million people around the world, most of whom had never heard of the Internet four years ago, now use it to do research, send e-mail to friends, make requests for bids to suppliers, and shop for cars or books.

Growing Economic Importance of the IT Sector
One of the most notable economic developments in recent years has been the rapid increase in the IT sector's (computing and communications) share of investment activity and of the gross domestic product (GDP). It grew from 4.9 percent of the economy in 1985 to 6.1 percent by 1990 as the PC began to penetrate homes and offices. The next spurt started in 1993, with the burst of commercial activity driven by the Internet. From 1993 to 1998, the IT share of the economy will have risen from 6.4 percent to an estimated 8.2 percent (Figure 2). With such rapid expansion, IT's share of total nominal GDP growth has been running almost double its share of the economy, at close to 15 percent.

What makes this rise in IT's nominal share of the economy even more remarkable is the fact that IT prices, adjusted for quality and performance improvements, have been falling while prices in the rest of the economy have been rising.

Computing power has been doubling every 18 months for the past 30 years. At the same time, the average price of a transistor has fallen by six orders of magnitude, due to microprocessor development. In just six years' time, the cost of microprocessor computing power has decreased from $230 to $3.42 per MIPS (Figure 3). No other manufactured item has decreased in cost so far, so fast.¹³

In 1996 and 1997, declining prices in IT industries lowered overall inflation by one full percentage point (Figure 4). Without the contribution of the IT sector, overall inflation, at 2.0 percent, would have been 3.1 percent in 1997.

Thus, in real terms, the expansion of the IT sector accounts for an even larger share of overall economic growth in the mid-to late-1990s. In recent years, IT industries have been responsible for more than one-quarter of real economic growth (Figure 5).¹⁴

Companies throughout the economy are betting on IT to boost productivity and efficiency. In the 1960s, business spending on IT equipment represented only 3 percent of total business equipment investment. In 1996, IT's share rose to 45 percent (Figure 6). For some industries like communications, insurance and investment brokerages, IT equipment constitutes over three-quarters of all equipment investment.

Information technology supports high-paying jobs. In 1996, 7.4 million people worked in IT industries and in IT-related occupations across the economy. They earned close to $46,000 per year, compared to an average of $28,000 for the private sector.

The impact of IT is also reflected in the capital IT firms currently represent. The collective market capitalizations of five major companies, Microsoft, Intel, Compaq, Dell and Cisco, has grown to over $588 billion in 1997 from under $12 billion in 1987,¹⁵ close to a fifty-fold increase in the space of a decade.

• Building out the Internet: In 1994, three million people, most of them in the United States, used the Internet.¹⁶ In 1998, 100 million people around the world use the Internet.¹⁷ Some experts believe that one billion people may be connected to the Internet by 2005.¹⁸ This expansion is driving dramatic increases in computer, software, services and communications investments.
  
  
• Electronic commerce among businesses: Businesses began using the Internet for commercial transactions with their business partners about two years ago. Early users already report significant productivity improvements from using electronic networks to create, buy, distribute, sell, and service products and services. By 2002, the Internet may be used for more than $300 billion worth of commerce between businesses.¹⁹
  
  
• Digital delivery of goods and services: Software programs, newspapers, and music CDs no longer need to be packaged and delivered to stores, homes or news kiosks. They can be delivered electronically over the Internet. Airline tickets and securities transactions over the Internet already occur in large numbers. Other industries such as consulting services, entertainment, banking and insurance, education and health care face some hurdles but are also beginning to use the Internet to change the way they do business. Over time, the sale and transmission of goods and services electronically is likely to be the largest and most visible driver of the new digital economy.
  
  
• Retail sale of tangible goods: The Internet can also be used to order tangible goods and services that are produced, stored and physically delivered. Though Internet sales are less than 1 percent of total retail sales today, sales of certain products such as computers, software, cars, books and flowers are growing rapidly.

¹.Gordon, John Steele. "What has Watt wrought?" Forbes. July 7, 1997. pp.144-171. Thomas Newcomen developed the first practical steam engine in 1712, used primarily for pumping water out of mines. This engine was only practical near a source of wood or coals. James Watt's steam engine of 1769 added a separate condenser which increased the fuel efficiency by a factor of four. Due to this addition, a steam engine could be put anywhere and the fuel hauled to it. In 1782, Watt modified the engine by introducing a rotary motion that could turn a shaft.

².Michael Faraday first harnessed electricity in 1831 by means of motion in a magnetic field. Forty years later, Thomas Edison and Joseph Swan invented the incandescent filament lamp.

³.Thomas Edison's Pearl Street Station in New York City began generating electricity on September 4, 1882. Smithsonian Institution, National Museum of American History.

⁴.David, Paul, "The Dynamo and the Computer: An Historical Perspective on the Modern Productivity Paradox." The American Economic Review. Vol. 80, No. 2, 1990. pp. 355-361.

⁵.Ibid.

⁶.Gwennap, Linley. "Birth of a Chip." BYTE. December 1996.

⁷.Moore, Gordon. "The Continuing Silicon Technology Evolution inside the PC Platform." Intel archives. http://developer.intel.com/solutions/archive/issue2/feature.htm

⁸.Lucent Technologies. http://www.lucent.com/netsys

⁹.Bandwidth determines the speed at which data can flow through computer and communications systems without interference. In the early days of the Internet, most messages were simple text that did not require large amounts of bandwidth. Bandwidth requirements have increased as people began to send images, sound, software, video and voice over the Internet.

¹⁰.In a packet-switched system, a message is broken into chunks and each chunk or "packet" is individually addressed and individually routed across the network to its destination. At the destination, the message is reassembled. Packets that do not arrive at the destination are retransmitted. As Vint Cerf, one of the inventors of the Internet, describes it: Packet switching is conceptually similar to the way the postal service works. That is, each letter or postcard is individually addressed and moves geographically from point-to-point as it travels towards its destination. Two postcards mailed from a post office in San Francisco may take different routes to New York, but once they arrive at the New York City post office, they are assembled with the other mail going to the destination address and delivered. Each "packet" is like a postcard and network routers are like the mail stops along the way.

¹¹.Meeker, Mary and Pearson, Sharon. Morgan Stanley U.S. Investment Research: Internet Retail. Morgan Stanley. May 28, 1997. pp.2-2, 2-6. Notes: Data for TV and other media are U.S. figures. PC figures reflect worldwide users. Morgan Stanley uses the launch of HBO in 1976 as their estimate for the beginning of cable. "Though cable technology was developed in the late 1940's, its initial use was primarily for the improvement of reception in remote areas. It was not until HBO began to distribute its pay-TV movie service via satellite in 1976 that the medium became a distinct content and advertising alternative to broadcast television."

¹². In 1989, the World Wide Web (WWW) protocols for transferring hypertext via the Internet were first used in experimental form at the European Center for Particle Research (CERN) in Switzerland. In 1991, the National Science Foundation lifted the restrictions on the commercial use of the Internet. That same year, the World Wide Web (WWW) was released by CERN. In 1993, the alpha version of Mosaic, the graphical user interface to the WWW, was released, giving non-technical users the ability to navigate the Internet. This report uses 1993 as the date when the Internet became truly open to the public. See: Cerf, Vint. "The Internet Phenomenon." National Science Foundation Web page. Http://www.cise.nsf.gov/general/compsci/net/cerf.html

No exact figures exist on Internet usage worldwide, but different sources point to 1997 as the year when Internet usage approaches/crosses the 50 million mark. For instance, NUA, an Internet consultancy and developer, compiles figures from different research analysts and finds the following ranges of Internet usage: 1995: 8-30 million, 1996: 28-40 million, 1997: >100 million. (Note: some research groups report U.S. figures only. Global figures for 1995 and 1996 were derived from NUA estimates on U.S. Internet usage as a percent of global Internet usage.) http://www.nua.com/surveys/how_many_online/index.html

¹³.Intel. "Moore's Law: Changing the PC Platform for another 20 years." http://developer.intel.com/solutions/archive/issue2/focus.htm

¹⁴.Making adjustments for price and performance, the IT sector contributed 28 percent of real GDP growth between 1996 and 1997. Measured in nominal terms, the IT sector contributes 15.7 percent of GDP growth over the same time period. (See IT chapter for more detailed explanation and charts.)

¹⁵.Parekh, Michael et al. Goldman Sachs U.S. Research: Cyber Commerce: Internet Tsunami. Goldman Sachs. August 4, 1997.

¹⁶.Meeker, Mary and Pearson, Sharon. Morgan Stanley U.S. Investment Research: Internet Retail. Morgan Stanley. May 28, 1997.

¹⁷.Ibid.

¹⁸.Nicholas Negroponte, founder and director of the MIT Media Lab, estimates that 1 billion people will use the Internet as early as 2000. See: "The Third Shall Be First: The Net leverages latecomers in the developing world." Wired. January 1998. In his book, Digital Economy, Don Tapscott cites the New Paradigm Learning Corporation when he estimates that there should be well over 1 billion Internet users by 2000. Others feel that 2000 may be too optimistic, as much of the developing world does not even have a basic telecommunications infrastructure. As new investments in fiber, satellite, wireless and cable are made, more of the world will be connected to the Internet. One billion people on the Internet by 2005 could therefore be possible.

¹⁹Forrester Research, numerous business executives.