TCS Daily


Information Age Economics

By Richard Alm - June 5, 2000 12:00 AM

In the past decade, economic growth averaged more than 3% a year. The United States created 18 million jobs, driving unemployment down to a 30-year low of 3.9%. Recession receded into memory -- only eight months in 17 years. As productivity surged ahead, Wall Street gave the economy rave reviews, and the Dow Jones Industrial Average quadrupled since January 1990. All the while, inflation remained tame. Consumer prices rose 5% a year at the start of the 1990s but less than 2% a year from 1996 on.

Times are not supposed to be this good. The decade-long boom, now the longest in U.S. history, presents a riddle for conventional thinking about the economy. How can the nation grow so fast for so long without setting off a ruinous round of inflation?

The answer lies in technology. Over the past two decades, a New Economy emerged from a spurt of invention and innovation, led by the microprocessor. These thumbnail-sized devices serve as the "brains" for computers and thousands of other products, some as cutting edge as Doppler radar and others as mundane as a musical birthday card. The microprocessor's ability to manipulate, store and move vast amounts of information shifted the economy's center of gravity, creating the era of smaller, cheaper, faster, smarter and better.

The first microprocessors arrived two decades ago, but not until the 1990s did the technology reach a critical mass necessary to alter the cost structure of the entire economy. In one industry after another, increasing powerful computer chips -- and intense competition in the marketplace -- are turning the economic assumptions of the Industrial Age on their head.

Inflation in the old economy

For most of the post-World War II era, economists warned that strong growth and low unemployment would kindle inflation. They presented a world of tradeoffs -- between unemployment and inflation, between stable prices and growth.

When the economy started to percolate, surging demand would create supply bottlenecks and rising wages would ignite inflationary pressures. Once the inflationary genie was out of the bottle, the remedy involved braking the economy, which meant fewer new jobs and more layoffs.

The dismal science reached another dismal judgment: Good times cannot last because prosperity sows the seeds of its own demise.

The economics of the Industrial Age centered on the cost structure of yesterday's major industries -- manufacturing, mining, agriculture and construction. Their costs fall as output increases but not for long. At some point, well before demand is satisfied, enterprises exhaust economies of scale and start bidding up prices for scarce inputs, slowly at first but then more rapidly.

The bottom line: As Industrial Age companies and industries expanded, they had little choice but to raise prices to cover higher costs. In an economy dominated by rising-cost industries, additional demand carries the risk of igniting inflation.

That view of basic costs, quite accurate in the context of an industrial economy, led economists to conclude that rapid growth posed a threat to price stability.

The New Economy's new rules

The Information Age technology creates cost savings that businesses can pass on to consumers. Supercomputers produce a thousand-fold improvement in seismic data, allowing BP Amoco to find oil for less than $1 a barrel, down from nearly $10 in 1991.The Internet alone opens the doors for huge reductions in cost. Processing an Internet transaction costs a bank just a penny, compared with $1.07 with a pen, paper and teller.

Even more important, the microprocessor gave birth to companies and industries with a decidedly different cost structure. Their output exhibits increasing returns to scale over a wide range of output. Instead of rising with additional output, average costs continue to slope downward. Goods and services actually become cheaper to produce as the size of the market increases. It gives companies a powerful incentive for aggressive pricing, including quantity discounts.

Information Age enterprises need more customers to capture the rewards of their investment in new-product development. In today's world, bigger is often better, a fact that helps explain a surge in mergers and acquisitions in the 1990s. Companies combine to increase in size and capture the advantages that come from downward sloping long-run average cost curves.

What frees today's technology from the old model of increasing costs? It is partly changes in the nature of what we produce.

Yesterday's goods and services exhibited a "rivalry" in consumption, one person's purchase preventing anyone else's. In the New Economy, more companies make products -- such as information and entertainment -- that do not disappear or even degrade with use. They can satisfy many consumers at the same time, so additional demand does not lead to shortages.

Many New Economy businesses, moreover, involve connecting people. In establishing networks, it is expensive to link one or two users, but it is far less costly to add customers once the delivery systems are big enough to serve a critical mass. That was true for telephones, trucking routes, airlines, television and electricity. Now it applies to the Internet, media and telecommunications, all industries on the leading edge of the economy.

An era of faster growth without inflation

Finally, the Information Age is largely a world of high fixed and low marginal costs. Modern technology often involves staggering startup costs, with tens or even hundreds of million dollars going to design products, recruit workers, purchase equipment and establish a presence in the marketplace. Once in production, delivering additional goods or services is often rather cheap.

Consider prescription drugs. It requires an average of $350 million to bring a new pill to market. At that price, the cost of producing the first dose is exorbitant. If it takes a penny to produce each additional one, though, average production costs fall quickly -- to $350 at 1 million pills, to $3.51 at 100 million and to 4 cents at 10 billion.

Many of the new technologies show the same cost structure. For new software, companies pay millions of dollars to programmers who write line after line of computer code. Additional copies are virtually costless if downloaded via the Internet. Once they invest in equipment, Internet service providers can add new subscribers at small additional cost.

Computers, software, high-speed data transmission and other new technologies lower the costs of doing business across wide swaths of the economy. Even such old-line industries as steel, textiles and automobiles are taking advantage of Information Age cost cutting. As a result, the cost structure of the overall economy can slope downward, even if many companies face decreasing returns to scale.

The New Economy manifests America's future, but making the most of it requires new thinking. We no longer can operate under the old assumptions about how fast the economy can grow, how low unemployment can go and when policymakers should apply the brakes to prevent inflation. Faster growth and low inflation do go together in the New Economy, not just in the short run but in the long term as well.

Check out www.IntellectualCapital.com, where Myths of Rich and Poor: Why We`re Better Off Than We Think is available from Amazon.com.
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