[Economic Report of the President (2000)]
[Administration of William J. Clinton]
[Online through the Government Printing Office, www.gpo.gov]


[[Page 97]]]

 
CHAPTER 3
Technology and the American Economy


AT&T Archives
One Telephone
Dumb;
Five Million, Eloquent

If there were only one telephone
in the world it would be exhibited
in a glass case as a curiosity.
Even in its simplest form tele-
phone talk requires a second instru-
ment with connecting wires and other
accessories.
For real, useful telephone service,
there must be a comprehensive system
of lines, exchanges, switch- boards
and auxiliary equipment, with an array
of attendants always on duty.
Connected with such a system a telephone
instrument ceases to be a curiosity,
but becomes part of the great mechanism
of universal communication.
To meet the manifold needs of telephone
users the Bell System has been built,
and today enables twenty-five million
people to talk with one another, from
five million telephones.
Such service cannot be rendered by
any system which does not cover with
its exchanges and connecting lines the
whole country.
The Bell System meets the needs of
the whole public for a telephone
service that is united, direct and
universal.

As new types of information technology link together computers,
telephones, and other types of communications devices, network effects
become increasingly important in determining the success or failure of
some products. In industries not subject to network effects, the total
value of  a product is simply the sum of its value to each user. But
in industries where network effects are present, such as telephone or
Internet service, the more links the network has, the more valuable it
is to each participant in the network.

Over the last century, the American economy has adapted again and
again to continuing technological change. Repeatedly during our history,
American firms and workers have exploited opportunities inspired by a
succession of technical advances, in the process creating new products,
new services, and even whole new industries. The new ideas that have
reshaped individual industries have often had a broader effect on the
economy as well. Innovation makes it possible to produce more output
from society's available labor and capital, increasing the productivity
of America's workers. Those productivity improvements have led to
rising prosperity and living standards, as Chapter 2 discussed.


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Innovations during the 20th century have led to dramatic changes
in how firms compete in the American economy. In some cases, new tech-
nology has given birth to new markets, where startup companies compete
on equal terms on a fresh and level playing field. In others, it has
opened a door for entrepreneurs to enter older industries and challenge
the established incumbents. As these forms of competition have spread
and flourished, consumers have benefited in numerous ways, from
expanded service, greater variety, and falling prices. These gains come
not just from the new entrants but also from the old incumbent firms,
forced to respond to the economic challenges posed by their rivals.

Today, new technologies are transforming the economy. No one can yet
predict all the changes to come, but it seems clear that the informa-
tion economy is changing the way companies compete and the nature of work.
In addition to changing the competitive playing field, technology is
increasingly redefining the role of the firm. Some firms are expanding
to take on new roles and integrate new activities into their enterprise,
some are finding it efficient to outsource some of their activities to
specialists outside the firm, and some are restructuring through mergers
and acquisitions. Two industries where these trends are strikingly evident
are telecommunications and information technology; this chapter will look
at both these industries, in which many firms, old as well as new, are
exploring the economic opportunities made possible by innovations in
computers, communications technology, and the Internet.

Although technological innovation brings constant and ultimately
beneficial change to the economy, it also requires a constant reevaluation
of government policies to determine how best to shape the forces of change
to promote the public interest. As technology becomes increasingly vital
to our knowledge-based economy, a crucial task of government is to design
an appropriate technology policy to maintain the flow of new ideas,
products, and methods that sustains long-run growth.

One element of technology policy is government's role in creating but
also limiting the property rights of innovators. Without the intellectual
property rights provided by patents and copyrights, for example, the
reward to innovation in many fields would fall, as imitators quickly
develop similar products. Yet strong property rights for innovation can
also create barriers to entry and competition, hampering not only the
mere imitators but also the true innovators seeking to build on the
existing knowledge base. This problem becomes particularly acute as
knowledge-based industries, such as software and information technology,
grow in economic importance.

A second element of technology policy in today's economy is supporting
the research and development (R&D) necessary to innovation. Although the
private sector in recent years has increased its R&D expenditure, some
of the

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basic and applied research that forms the building blocks for
tomorrow's discoveries may not take place without government support.
Rather than support technologies that have clear and immediate commercial
potential (which would likely be developed by the private sector
without government support), government should seek out new technologies
that will create benefits with large spillovers to society at large.
Basic research that expands human knowledge is one example of the type of
research that may have wide applications in many areas of the economy.
By supporting the research necessary for scientific advances, government funding can create the knowledge from which will emerge the new tech-
nologies, new products, and new jobs of tomorrow's economy.

Another critical task for government is to ensure that the benefits of
new technologies are widely shared. Well-functioning markets
inherently maximize the private benefits from exchanges between
individuals and firms, but markets do not always succeed in maximizing
social benefits at the same time. Inefficiencies in the market,
whether created by insufficient R&D incentives or from a firm's market
power, can limit the gains society receives from technological innovation.
One way to promote the widespread adoption of innovations is to ensure
that policy set by the public sector fosters rather than stifles
competition in the private sector. Antitrust policy is one tool
for encouraging competition. When the Nation's antitrust laws were
originally adopted, market power created by economies of scale in the
production of many industrial goods was a major concern, but in today's
economy the market power inherent in products that become de facto
standards for an industry may be just as troubling. In addition to a
vigorous antitrust policy, government can promote competition by changing
the regulatory framework within which industries operate, to remove
barriers to competition and spur innovation, thereby creating jobs
for American workers and new services for American consumers.

In other areas of the economy, such as the rapidly developing field of
e-commerce, the challenge for government policy is different. Here
new businesses are springing up spontaneously, and at an explosive pace.
By refraining from imposing unnecessary regulatory burdens, government
can ensure that innovative and valuable services will come to market.
Government antitrust enforcement will continue to ensure that mergers between large firms deeply involved in the information economy will not injure competition.

Innovation and Economic Change: A Look Back

The changes that technology continues to unleash on our economy today
are sweeping and may at times seem overwhelming. No one yet knows what

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transformations the Internet and e-commerce, to take only the
currently most celebrated examples, will eventually bring. In these
circumstances we should remember that we are not the first generation
to have to come to grips with rapid technological progress. Notable
examples of the rapid adoption of new innovations include electric power,
automobiles, and television. These earlier innovations spread through
American households much as have more recent innovations such as computers
and cellular telephones (Chart 3-1). As described below, throughout the
20th century new technological developments created new products and new
ways for firms to conduct business, and so changed the structure of the
economy. Those changes, in turn, produced changes in the role of
government in competition, regulatory, and technology policy.



(Chart 3-1)

One example, electricity, is a commonplace fixture in the economy
of today, but in 1900 the electric power industry was just getting under
way. At the turn of the century, fewer than 10 percent of homes had
electric service, and cities were still being wired for electric trans-
mission grids powered by central generating stations. At that time, only
about 5 percent of factories employed electricity as a power source;
most still used steam or water power to drive their machines through
intricate arrangements of wheels, belts, and shafts. Electricity was
initially used to power similar systems, but the shortcomings of mech-
anical power distribution systems remained. Once factory

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workplaces were reorganized so that groups of machines could be
separately powered by electric motors, however, manufacturers began to
realize the full potential of electricity to improve productivity. Over
time, electric power was incorporated into more and more elements of
the modern factory. Some have argued that the process may be repeating
itself today with computers. As modern businesses learn to use computers
to change the way they operate, they can find new ways to optimize
business procedures and increase productivity.


At other times during the century, technological advances in basic
industrial products such as oil dramatically increased productivity
and output, by expanding the scale at which firms could operate their
plants. But some of the largest firms also formed combinations, like
the Standard Oil trust, to limit competition. Concern about the market
power of some of these large new industrial combinations led to passage
of two of the cornerstones of public policy toward competition. The
Sherman Antitrust Act (passed in 1890) governing anticompetitive actions
by monopolies and the Clayton Act (passed in 1914) governing mergers
remain the basis of antitrust law today.

The automobile, too, had made its appearance by the end of the 19th
century, but it remained a high-priced luxury item until Henry Ford built
the first automobile assembly line in 1913. Ford's innovation
revolutionized the way cars were manufactured. Mass production of the
Model T allowed Ford to offer, on an unprecedented scale, a product
that combined relatively high quality with a dramatic reduction in cost.
It made automobiles available to millions of American consumers for the
first time. As increasing numbers of people bought the newer, cheaper
cars, Ford continued to invest in his factories, increasing their
efficiency and realizing huge economies of scale. Greater scale, in
turn, allowed Ford to lower the cost of his automobiles still further and
sell even more. By the early 1920s the Ford Motor Company dominated sales
of automobiles in the United States, with a market share of 56 percent.
Ford's dominance was short-lived, however, as other manufacturers, with
newer models and innovations of their own, adapted their production
processes following Ford's example. They were able to effectively compete
with Ford by satisfying consumer demand for variety. Ford's innovation had
a number of implications far beyond the automotive industry: it helped
make America a more mobile society, for example. But perhaps the most
important outcome for the economy as a whole was that other manufacturers
in other industries soon copied the assembly line concept. The impact of
this spillover from Ford's idea to other industries was enormous: mass
production proved an economically efficient way to produce a vast range
of other consumer products.

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Another industry that saw major changes at the turn of the last
century was telecommunications. The Bell system had enjoyed a monopoly
in telephone service in the United States until its basic patents on
the telephone expired in 1894, after which a wave of new competitors
began providing phone service. The Bell system had concentrated on
serving major cities and business customers, leaving many smaller
communities unwired. Many of these independents extended service to
the underserved communities, while others concentrated on competing with
Bell in some major urban centers. By 1907, new entrants accounted for
almost half the market. Service levels increased rapidly with this new
competition: telephone penetration (measured as the number of phones per
100 people) rose from fewer than 2 in 1900 to more than 10 by 1916. Many
of the new entrants adopted the latest innovation in telecommunications,
automatic switching, much more quickly than the Bell system, which
continued to rely upon operators to connect calls manually. Yet despite
the advantages of this new switching technology, within a few years the
number of independents began to decline. Faced with competitive pressure
from the Bell system, most independents either failed, were acquired, or
signed sublicensing agreements that allowed them to connect with the Bell
system but limited their ability to compete with Bell.

The competitive failure of the independents was due at least in part to
the Bell system's successful exploitation of the network dimension of
telecommunications. The Bell system invested heavily in the technology
and equipment needed to create a long-distance network. Although most
customers at that time used the phone almost exclusively for local
calls, businesses found the long-distance service very attractive. The
independents tried but were unable to duplicate Bell's long-distance
network connections, particularly in major urban areas where the Bell
system had its largest networks, and where much of the long-distance
business originated. Bell allowed the surviving independents to inter-
connect with its system, but only under the competition-restricting
sublicensing agreements. Many independents chose this route, even
though it meant signing away their own ability to expand and challenge
Bell in the future.

In this case, the network characteristics of telecommunications
proved critical to the competitive outcome. By providing long-distance
services that its rivals were unable to duplicate, the Bell system was
able to keep more people connected to its network and exploit economies
of scale in long-distance service. But as it connected more users to
its network, the Bell system also made it difficult for other companies
to compete effectively. Without effective competition, the Bell system
was in a position to limit service and set prices for that service at
monopolistic levels.

Government policy toward these new technologies and new industries was
as varied as the industries themselves. In the cases of telephones
and electricity,

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government often chose to permit one monopoly provider
to serve a geographic region but subjected the monopoly firm to rate
regulation to prevent consumers from being overcharged. In part, this
policy response reflected a view that some industries are ``natural
monopolies.'' In a natural monopoly, high fixed costs may make
competition inefficient because a single provider could instead
deliver service at the lowest possible cost. Also, in industries like
the telephone industry, where demand-side network effects are important,
previous attempts at competition had ultimately foundered as one dominant
network emerged.

In other industries, however, competition seemed more effective at
restraining market power, and government policy favored continued
competition. In the case of automobiles, despite large economies of
scale at individual plants, several producers were able to effectively
compete in the large market pioneered by Ford, and policy intervention
was unnecessary. In the oil industry, where combinations such as the
Standard Oil trust threatened competition, government did intervene,
but rather than establish a regulated monopoly, it used the antitrust
laws to create more competition. These early policy responses shaped each
of these industries during the years that followed, and these policies
are still applied to some firms today. Just as the economy has changed
over the last century, however, so, too, has the range of policy
responses available to promote competition as an alternative to regulation,
as discussed more fully below.

Innovation and Change in the American Economy Today

Many of the same manufacturing industries that were just emerging at
the beginning of the century continue to thrive, but new technologies and
new processes are revitalizing these established industries and creating
new ones. These innovations are taking place throughout the economy, and
many involve both new technology and new ways of organizing the workplace.


Manufacturing industries remain dynamic and innovative, reflecting the
pace of technological change. Manufacturers creating new products
and processes account for about three-quarters of company-funded
industrial R&D expenditure in the United States. Productivity growth
in manufacturing also remains high, averaging 4.2 percent per year
between 1993 and the third quarter of 1999, and these firms remain
an important source of jobs for workers without college degrees. In
an increasingly global economy, however, many manufacturing businesses
have faced pressure to adapt to new ways of doing business in order to
compete effectively with foreign companies.

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One example is the ``lean'' production techniques first pioneered in
the Japanese automobile industry. These methods, which involve redesigning
the manufacturing process to eliminate waste and reduce the number of
product defects, resulted in far lower costs and higher quality than
traditional techniques in the U.S. automobile industry could achieve.
Competition from Japanese and other foreign firms using these methods
compelled U.S. automakers to focus on improving quality, and they
have dramatically lowered costs and improved quality as a result.

Innovation in production technology has also changed the nature of
the Nation's steel industry. Innovative U.S. minimill firms found that
they could produce many steel products much more cheaply than could
the traditional integrated mills by using electric arc furnace technology
to recycle scrap steel and produce basic steel products. A U.S. minimill
firm was also the first willing to gamble on constructing a full scale
thin-slab caster using a foreign firm's technology. This new technology
allowed minimills to compete in the large market for rolled sheet steel,
used in such products as automobile body panels. U.S. companies using
these new technologies are now offering increased competition to the
traditional integrated mills; by the mid-1990s minimills accounted for
close to 40 percent of U.S. steel production.

The pharmaceutical industry is one that is taking advantage of
technological developments in biomedicine as well as in information
technology. Traditionally, companies sifted through thousands of compounds
to find those with desirable medical properties. Today's companies,
in contrast, use a deeper understanding of human physiology that allows
them to design, from the molecules up, drugs that target specific
illnesses. The industry is also using the Internet to recruit patients
for clinical trials of new drugs and to provide more complete and
accessible information on new drugs to physicians.

Perhaps the most dramatic evidence of the economic impact of the
information technology sector itself comes from the capital market,
as reported in a recent study by a financial services company. According
to the study, America's venture capital industry raised funds at a $25
billion annual rate in the first half of 1999, about two-thirds of which
were placed in the information technology sector, and of that about three-quarters in Internet companies. In terms of market capitalization, the
information technology hardware sector now accounts for about 14 percent
of the U.S. total, versus 6 percent in 1989. The software component has
expanded from about 2 percent in 1989 to around 9 percent today. Stocks
in the Internet sector have a market value equal to around 4 percent of
the total.

The importance of the information technology sector to the U.S. economy
is not reflected in stock market valuations alone. The computer and
telecommunications industries contributed between 21 and 31 percent of
GDP growth in each of the years from 1995 to 1998 (Chart 3-2). And the
contribution of these



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(Chart 3-2)


hardware-producing industries is only the tip of the iceberg. The bulk
of employment today is in the private service-producing  sectors, which
also account for nearly two-thirds of GDP. Leading the growth in the
service sectors have been a number of know-ledge-based industries such
as finance, insurance, and professional services (a category that
includes business and legal services, among others). Measuring the
contribution of these new services to GDP is important to developing
an accurate picture of economic growth (Box 3-1).

In these knowledge-based industries, information technology has
become increasingly important as a way to create new products and deliver
them to customers. Broadly defined, information technology comprises
technologies that process, store, and communicate information.
For example, large U.S. banks now spend approximately 20 percent of
their noninterest expense on information technology designed to integrate
back office functions such as check processing with other functions such
as customer service. Changes in information technology are transforming
the economy by allowing people to communicate ideas and data in a variety
of ways, from wireless phones to the Internet. The following sections
examine several examples of this trend.


Developments in Telecommunications


The telecommunications industry is an example of an older industry that
the new information technologies have transformed. From its origins as
a provider of simple voice telephony, this industry has evolved into a
source of advanced infrastructure and sophisticated services that are essential to a host

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Box 3-1. Measuring the Economy in an Era of Technological Change

Technological advances raise challenging measurement issues for
government statisticians seeking to measure the size of the economy or
its rate of growth. If technological improvements in the manufacturing
process simply raised the quantity produced of a standard product (for
example, the number of yards of a particular fabric type) from given
inputs, there would be little problem_one could simply count the
additional output. But many technological advances improve the quality
of existing products or even create new ones (such as Internet services).
The statistical challenges these advances present are enormous.

Existing statistical techniques do provide measures of some of the
quality improvements and new products. For example, the GDP
statistics incorporate adjustments for improvements in computing power
when measuring real investment expenditure for producer's durable
equipment. Similarly, when calculating the consumer price index, estimates
of real expenditure on automobiles incorporate adjustments for improvements
in the quality of new cars over time, reflecting changes, such as
antilock brakes and airbags, that make cars safer and better.

In many industries, however, the measurement issues defy easy
statistical solution. The field of medicine offers numerous examples of
new drugs, devices, and treatments that have revolutionized care_for
example, new techniques for treating heart attacks have raised patient
survival rates; the development of an insulin pump has reduced the
incidence of medical complications among diabetics, while raising
their quality of life. Some of the most perplexing measurement
problems involve industries that are heavy users of information
technology, such as finance, insurance, and business services. The
widespread introduction of automatic teller machines, for example, makes
it possible to obtain banking services (mainly deposits or withdrawals)
at any hour of the day or night_a service that was nearly impossible to
obtain a few decades ago. And the mutual fund industry provides
individual investors with diversification possibilities that would have
been barely conceivable 30 years ago.

The widespread use of information technology for e-commerce poses
especially complicated measurement problems. As more and more
businesses across a range of industries_from services to manufacturing
to retailing_use e-commerce for some components of their operations,
it becomes increasingly difficult to account for what portion of a
final product or service may have been changed or enhanced by the use
of information technology.

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Box 3-1.--continued
These difficulties in measurement should not obscure the very
real contribution that technological advances make to the economy.
Government statistical agencies and others are therefore actively
pursuing new measurement initiatives to better gauge and understand the
impact of these changes.

of businesses from data processing to online publishing. Indeed, these
changes in telecommunications have been just as important for these
information providers as for the telecommunications industry itself,
since, as discussed below, major telecommunications advances like the
Internet are already having a major impact on how businesses do business.

These changes came about from a convergence of factors in which both
technology and government regulatory policy played a part. Beginning with
the Department of Justice's antitrust case and the resulting 1982
consent decree that divided the American Telephone and Telegraph Company
into its local and long-distance components, prevailing government policy
toward telecommunications regulation has focused on how to reduce barriers
to competition for both traditional telephone service and emerging new
services. To allow more competition in wireless service, portions of
the radio spectrum were auctioned off, allowing new competitors to create
their own networks in competition with incumbent cellular providers.
Using provisions of the 1996 Telecommunications Act, new competitors in
local phone markets have begun to negotiate interconnection agreements and
to sell local telephone service in competition with the dominant incumbent
local exchange carriers (Box 3-2). To encourage the regional Bell
operating companies to make such entry possible, the Telecommunications
Act required them to meet a list of conditions on opening their markets to
new entrants before they were allowed to offer long-distance service in
their own regions. In December 1999 the Federal Communications Commission
found that one regional Bell company had met those conditions in New York.

The changes in the telecommunications industry that have resulted from
these two developments_the emergence of new technologies and the
new regulatory environment created by the 1996 Telecommunications Act_
have been dramatic. Hundreds of new companies have entered all segments of
the industry; the number of publicly held telecommunications companies
alone nearly doubled over a recent 5-year period. These new competitors
have been responsible for much of the recent growth in the local,
long-distance, wireless, and equipment industries. Structural adjustments
to this new competition have forced layoffs at some firms, yet the tele-
phone service and equipment sectors are responsible for the net creation
of approximately

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Box 3-2. Implementing Local Competition Provisions in the 1996 Telecommunications Act

The Telecommunications Act of 1996 reduces barriers to entry in
local telephone markets. To facilitate the entry of competitors into
networks owned by incumbent local exchange carriers (ILECs), the act
allows a requesting carrier to obtain access to the incumbent's network
in any of three ways. It can purchase local service at wholesale rates
for resale to end users, it can lease various (unbundled) elements of
the incumbent's network needed for service, or it can interconnect its
own facilities with the incumbent's network.

Six months after the 1996 act was passed, the Federal Communications
Commission (FCC) issued its First Report and Order implementing the
local-competition provisions. Thereafter, numerous ILECs as well as some
state utility commissions challenged the rules, claiming that the FCC
had exceeded its jurisdiction. In January 1999 the Supreme Court affirmed
the FCC's role in providing a roadmap for competition.

The FCC continues to monitor the progress of competition with
traditional ILECs, and its recent reports show that local competition,
although still limited, is growing rapidly. Industry analysts also
support this conclusion: one source finds that, by the middle of 1999,
new entrants had increased their revenue market share to 6.3 percent of
local revenue. The FCC's new orders on DSL-based services extend the
process to this new technology by further clarifying which network
elements competitors may access.  This, too, should encourage local
competition.

200,000 new jobs in 5 years. Both new and existing firms have invested
tens of billions of dollars in facilities, services, and R&D. These investments in turn have led to increased network capacity, the deploy-
ment of new technology, and the rollout of advanced communications
services.

These changes are particularly evident in the communications
equipment industry, which has boomed in the last few years. Investment
in communications equipment grew from $46 billion (in inflation-
adjusted dollars) in 1993 to $86 billion per year in 1998_a 13 percent
annual growth rate over 5 years (Chart 3-3). Some of that equipment is
being used by the new providers of wireless services that are building
out the systems made possible by the wireless spectrum auctions. By 1998,
companies providing wireless telephony had invested more than $50 billion
in new capital equipment, and wireless phones are now increasingly common,
with more than 69 million Americans now subscribing to cellular service.

In addition to wireless services, demand for new equipment and fiber
optic cable by new local providers of switched voice and high-speed data
services like those used for accessing the Internet has spurred investment.
These

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(Chart 3-3)

developments reflect dramatically declining costs for both data trans-
mission and computing power. The cost of transmitting a single bit of data
over a kilometer of fiber optic cable has fallen by three orders of
magnitude since the mid-1970s. At the same time, the cost of infor-
mation processing has fallen as more and more transistors can be packed
onto a single semiconductor chip. As technology continues to advance,
semiconductor manufacturers have been able to double the power of
computer microprocessors every 18 months. Improvements in semiconductors
and reduced costs for other components have helped account for the 20 to
30 percent annual decline in the quality-adjusted price of computers. With
new innovations in semiconductor technology still coming onstream, the cost
of information processing continues to plummet, increasing the capabilities
of the information industry and expanding the market for information services.

These falling prices have encouraged investment in the grid of
telephone lines, cables, optical fibers, and signal processing and
routing equipment that forms the backbone of the U.S. tele-
communications infrastructure. The increasing public demand for fast and
ready information has driven this backbone industry, motivating
tremendous volumes of private investment. The growing demand for
carrying capacity, or bandwidth, has led to investment in high-capacity
fiber optic lines by telecommunications systems to meet the new infra-
structure demands. The number of fiber-miles (the miles of sheathed
fiber in a bundled cable times the number of fibers in the bundle) is
one way to measure system capacity. By this measure, the total volume

[[Page 110]]

of fiber optic cable deployed by telecommunications carriers in the
United States grew by about 16 percent in 1997, and by more than 21
percent in 1998, according to data from the Federal Communications
Commission.

Consumer demand for telecommunications services is leading
more and more American households to purchase additional telephone
lines. Although some of these lines are used mostly for voice service,
many are dedicated data lines. The number of additional lines more
than doubled from 1993 to 1997, from 8.8 million to 17.9 million. This
surge in growth mirrors the growth in American consumers' use of the
Internet. In addition to extra phone lines, many residential users
are beginning to purchase new high-speed broadband connections to the
Internet being offered by phone and cable companies. For users who need
to download large files, the speed of the connection can make an
enormous difference in total transfer time. For example, a 10- to 20-
minute digitized movie clip might take 10 megabytes of computer memory
and require about 24 minutes to download with a 56-kilobit-per-second
modem. By contrast, a cable modem or a high-speed digital subscriber
line (DSL) connection offered by the phone company can download the same
file in less than a minute. Rollout of these new services is just
beginning: many phone companies are only now beginning to offer high-
speed DSL connections in response to cable companies' offerings. By the
end of the third quarter of 1999, cable modems were available to an
estimated 37 million homes in North America, and approximately 1.4
million cable customers had signed up for the service. In contrast, only
about 275,000 DSL lines were in service in the United States in October
1999. Deployment of DSL is expected to expand rapidly, however: as many as
2.1 million DSL lines may be in service by the end of 2000.

These investments are supporting the rapid growth of the Internet as
it becomes a standard feature in American homes and workplaces. According
to one survey, more than 118 million Americans had access to the Internet
in November 1999, of whom more than 74 million were actively using the
new medium. The use of e-mail at home has also risen sharply in the last
few years, but this usage varies by income: more affluent Americans are
much more likely to have e-mail access at home (Chart 3-4). This surge
in connectivity has helped put the United States far in the lead in
Internet use worldwide. The United States far surpasses Germany, Japan,
or the United Kingdom in the number of Internet host computers per capita.
Only Finland has a higher concentration than the United States, according
to statistics compiled by the Organization for Economic Cooperation and
Development (OECD). The OECD also found that the United States leads
all other OECD member countries in the number per capita of web servers
designed for electronic commerce. The combination of relatively

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(Chart 3-4)

high penetration of personal computers among U.S. households and low
Internet access costs in this country also has helped contribute to
the greater success of electronic commerce here than in other
countries. Internet access costs in the United States are much lower
than in many other OECD countries (Table 3-1).



[[Page 112]]

How Information Technology Is
Changing the Economy

In addition to providing a new communications medium, the
Internet and its kindred technologies possess vast potential to enhance
the economy's productivity and make firms more efficient. Much as Ford's
assembly line concept had broad spillover effects beyond the automobile
industry, so, too, the Internet and e-commerce are having broad effects
throughout a number of industries. Many firms are investing aggressively
in these technologies to speed the flow of important business information,
internally as well as externally, and so raise productivity. Over the
past 20 years, the real net stock of information technology equipment in
the private sector has been rising steadily. The last 5 years have
seen particularly sharp increases in the net stock of computers and
related equipment relative to other durable equipment (Chart 3-5).

Even across industries that are making large investments in
information technology, however, the amount of that investment per
worker varies widely (Table 3-2). Telecommunications firms,
nondepository financial institutions, and radio and TV broadcasting
firms all invested more than $15,000 per worker in information technology equipment, according to 1996 data from the Department of Commerce. Other firms in industries that are also major investors, such as banks, insurance carriers, and railroads, invested between $4,000 and $6,000 per worker in information technology equipment.


[[Page 113]]



(Table 3.2)

As firms adopt these new technologies, they are also changing the
definition of what constitutes a firm in today's economy. For some
manufacturing firms, information technology offers new ways to integrate
their suppliers more closely in the design and manufacturing of products.
Even where the firms in the supply chain remain separate entities, the
degree of cooperation may come to resemble what might occur in a
vertically integrated firm. At the same time, other firms are finding
that transactions that were once organized internally may now be
better organized as market transactions, with competitive bidding even
for specialized orders of custom-made parts.


At the retail level, the rise of the Internet has made possible
the ``virtual firm,'' which exists only to market goods through a
website. With outside specialists available to handle details like
filling orders, a firm can be run without the extensive supply
infrastructure that many traditional brick-and-mortar firms have built.
As companies grow larger, however, some have found that outsourcing
important activities is not necessarily the best way to handle growing
volumes of customers. Instead these firms are now investing in the same
type of real-world infrastructure that their more traditional competitors
have always used.


Managing Information Flows

Information technology is having a major impact on how some firms
organize their own internal operations. Investments in computer hardware
like those described above often represent only a small portion of a
company's

[[Page 114]]

total investment in information technology. Effective implementation
of this technology also requires investing in the staff who will operate
it, in developing specialized applications, and in user support. Cost
surveys of firms in the services sector suggest that, at small,
centralized sites, the costs of the staff required for operations
and specialized software development may account for 74 percent of
total costs, far exceeding the more visible expenditures the firm may
make on hardware and prepackaged software. To develop the applications
they need, many service firms are now conducting more of their own R&D,
and this activity is beginning to show up in the aggregate R&D statistics.
Whereas in 1987 nonmanufacturing industries accounted for only about 8
percent of non-Federal R&D funds, by 1995 that figure was 25 percent.
These investments have been concentrated in computer programming and
data processing services, in wholesale and retail trade, in communications
services, and in research, development, and testing services.

One area in which information technology can enhance productivity is
the management of inventories. For example, electronic scanners have
been a familiar sight in grocery checkout lines for some time, but
some retailers have begun to adopt new and more efficient distribution
methods that rely on these scanners and the wealth of transactions data
they can provide. One large retailer with a chain of grocery superstores
has used information technology to track what is selling in its stores and
to use that information to build a more efficient distribution system.
This firm uses its buying power to generate large orders to manufacturers,
which then deliver the demanded goods to the firm's warehouse distri-
bution centers. Those centers, in turn, are responsible for resupplying
the individual retail stores. To keep revenue high and costs low, the
firm also analyzes its scanner data on sales to maximize the use of its
shelf space. Detailed information captured by scanners at each store track
how fast products are selling, so that stores can be resupplied at
frequent intervals from the distribution centers. This avoids the need to
keep large and expensive inventories at the stores themselves. In total,
this company has reduced its operating costs to a mere 17.5 percent of
sales, compared with 22 percent for a traditional supermarket.

The increased investment in information technology by companies has
coincided with a reduction in the economy-wide ratio of inventories to
sales during the current economic expansion (Chart 3-6). Although, to be
sure, information technology is used in many areas besides inventory
management, some of those investments may have helped businesses to
better manage inventory growth and improve productivity during the
current expansion.

Information technology is also being used to better manage information
flows between firms, such as between a final-goods manufacturer and
the different levels of its supplier chain. In the automobile industry,
for example, one recent report notes that companies have largely
replaced paper drawings

[[Page 115]]

(Chart 3-6)




with digital representations as a means of storing, analyzing, and communicating data on products and parts. One original equipment
manufacturer estimated that it exchanges product data both within the
company and with its suppliers as many as 453,000 times a year.

Retail E-Commerce

Information technology is having an impact on how businesses do
business in yet another way, through the growing use of the Internet
by firms as a communications tool. The Internet is already
revolutionizing distribution technology at both the retail and the
wholesale level. With millions of people now online, the potential to
use the Internet as a low-cost means to communicate information to
customers and receive orders for products is growing ever larger. At
the retail level, new firms are springing up to market a whole range
of consumer products from books and music CDs to cars. E-commerce
retailing has several potential advantages over traditional retailing,
some of which it shares with traditional mail-order firms. Like a mail-
order firm, a firm with a website may be able to offer more products
online than a traditional brick-and-mortar store, because it is far
less limited by shelf space constraints. It can make extensive
product information available to interested customers around the country
and the world, who can then make their selections automatically, without
the need for a salesperson.

[Page 116]]

For e-retailers, the Internet replaces paper catalogs as the medium
used to distribute information to customers, but these retailers still
face some of the same challenges as traditional catalog and store-
front retailers in delivering the goods. In response, some large
electronic retailers have now begun building their own warehouse distri-
bution centers, providing a real infrastructure to complement their
virtual one. At present, the Internet is so new that no one can predict
which business strategies and which retailers will succeed in the new
medium. Many Internet retailers continue to lose money as they build
their businesses and strive for the economies of scale needed to survive
in a marketplace shared with both other Internet rivals and
traditional competitors.

Unfortunately, despite a proliferation of anecdotes, hard data on the
importance of e-commerce and the digital economy more generally remain
scant. This lack of appropriate data hampers analysis of the impact of
the digitization of the economy. For example, it is not currently possible
to separate out e-commerce activities from other types of commercial
activities in the statistical series produced by the Federal Government.
Data specific to e-commerce currently come, for the most part, from
market research firms, which use divergent definitions and methodologies.
To address this problem, major Federal statistical agencies (the Bureau
of Economic Analysis, the Bureau of the Census, and the Bureau of
Labor Standards) are working together to formulate an e-commerce
initiative that will help ensure that official government statistics
accurately reflect the new digital economy.


Using private data for 1998, estimates of the value of online
retailing range from $7 billion to $15 billion; even taking the high
end of this range, e-commerce would account for only about 0.5 percent
of retail sales. In one 1998 survey, however, nearly half of households
with Internet access had made online purchases within 6 months of the
survey.  In addition, a much larger quantity of sales is influenced in
some way by the Internet. For example, many consumers research their
purchases, such as automobiles or books, online before buying them
offline, through traditional outlets. By one estimate, roughly $50 billion
in offline retail sales was influenced by the Internet in 1998.


Business-to-Business E-Commerce

The Internet plays a significant role today in providing new distri-
bution channels for wholesale transactions between businesses. By
one estimate, business-to-business e-commerce is expected to grow from
$43 billion in 1998 to over $1.3 trillion by 2003 (Chart 3-7). Using the
World Wide Web, companies can automate the order process and reduce costs.
One major supplier of computer components had routinely been receiving
orders by phone or facsimile from several hundred customers all over
the world. Processing these orders was cumbersome, and moving several
hundred of these

[[Page 117]]




(Chart 3-7)

customers to a web-based solution promised to improve customer service
and give managers better access to information on the status of orders.
The company built a website targeted to these customers and soon was able
to move $1 billion in orders per month online.

Another firm that sells networking hardware also uses the Internet to
reduce its costs. Many of the company's products are built to order from
customers' specifications. The firm routinely checks those specifications
to make sure the product will work as configured, but it found that nearly
one in four orders taken by phone, fax, or e-mail contained errors that
caused the order to be rejected or required additional customer contact.
After moving the process of configuration and pricing online, the company
now reports that 98 percent of orders pass through the system without
an error, saving both the company and its customers valuable time and
expense. Across all its operations, having moved more of its technical
support and marketing functions online, the company estimates that it
now saves more than $300 million per year in operating costs.

Business-to-business e-commerce is also resulting in new and more
competitive markets. The Internet's size and reach have created
deeper markets, with larger pools of both buyers and sellers, for many
basic commodities. Where before specialized brokers were needed to
match buyers and sellers in transactions, new websites today allow
multiple buyers and sellers to find each other and enter into
transactions quickly and efficiently. In the steel industry, for example,
the electronic equivalent of a spot market now matches customers and


[[Page 118]]

suppliers for surplus quantities of steel of various types. One firm that
provides such a virtual marketplace for transactions in this industry has
seen both the number of suppliers and the volume of product offered on
its site expand substantially. In just one year, offerings on the site
rose from about 20,000 tons a month to over 120,000 tons.

Purchasing managers are also using information technology to actively
manage and reduce their firms' procurement costs by changing
traditional relationships between the firm and its suppliers. For
example, many manufacturers buy custom-made materials that they
incorporate into finished products. Because these materials are often
made to buyers' specifications, there are no catalogs or price lists to
allow buyers to make price comparisons. Fragmented supply markets and
the importance of product quality in supplier selection also make
purchasing difficult. Concerns about the quality of new suppliers'
products, for example, may cause a firm to rely instead on existing
suppliers that are known quantities. One company achieves significant
cost savings for the purchasing managers who are its clients by
using electronic bidding technology to conduct auctions among alter-
native suppliers of a whole range of inputs. The company has
organized auctions for goods ranging from printed circuit boards
to injection-molded plastic parts (Box 3-3).

Although this firm's electronic auction software is an example of
information technology at work, an important part of the service that
the firm provides is a detailed, specific analysis of the desired
components, followed by an extensive search for potential suppliers.
In addition to the traditional suppliers that a firm has relied on in
the past, the auction firm may find that other suppliers around the world
can produce the demanded good as well. Working with the buyer, the
company screens these firms to determine whether they are capable of
producing the good that meets the buyer's specific needs. This use
of information technology to cast a wider net poses both challenges
and opportunities for suppliers. For efficient firms, it offers a way
to compete for business they might not have been able to bid on
previously. But existing suppliers must compete more aggressively than
ever before if they wish to retain or expand their business in an
increasingly global economy.


Information Technology and the Theory of the Firm

These developments in information technology raise a number of
questions about the organization of firms in a market economy.
Information technology has the potential to dramatically lower the
cost of acquiring and disseminating information of significant value
to firms and their customers. Using various types of information
technology, firms can convey information about products to
potential customers, obtain more detailed and targeted market data
about customers and their needs, and then sell products to more customers.
But how will lower costs of communication affect the structure of



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Box 3-3. Holding an Online Auction
An online auction specialist allows corporate buyers to lower
their procurement costs by providing the technology and support
for computerized auctions. Rather than sending out a paper request
for proposals and obtaining a single bid from each potential
contractor, buyers holding online auctions can allow bidders to observe
how their bids compare with those of their peers. To generate
more competition, however, the auction specialist does more than
simply provide a connection for the client firm's existing suppliers.
The auction specialist also searches out new potential suppliers that
meet the buyer's specifications.

In one such auction for printed circuit boards, the auction specialist
first identified 29 bidders in North America, Asia, and Europe. Eight of
the firms had done business with the buyer before, but the remainder had
not. Each supplier was linked electronically to the auction firm's
computer server, so that it could submit bids online, observe the bids
placed by its competitors, and then decide whether to submit a new, lower
bid of its own. Within 5 minutes after the auction opened, the bids
received for the circuit board contract quickly dropped to 18 percent
below the buyer's historical average cost for such goods. As the auction's
closing time approached, more and more bids were submitted. By the time
the auction had concluded, after about 1 hour, three bidders had sub-
mitted virtually identical low bids, and the buyer was able to reduce
its expected cost by 42 percent, or $6.4 million.


the firm itself? When information is less costly to communicate, some
firms may decide to expand their operations to exploit greater economies
of scope in selling different products. Alternatively, other firms may
find that, with more customers for what had previously been low-volume
markets, it is more profitable to specialize, seeking lower production costs
through greater economies of scale. The evolving nature of the new
technology makes it hard to predict which effect will predominate, and
the answers could easily vary across different lines of business.

Information technology may also have far-reaching implications for the
structure of firms if it changes the sources of competitive advantage in
the markets where they conduct business. Using the new information
and communications technologies, firms have greater potential to
respond quickly and more flexibly to challenges posed by changing
circumstances. Older sources of competitive advantage, such as
established distribution networks, may now seem outdated and unnecessary
in light of new communications tools like the Internet. By
eliminating middlemen from the distribution network, a firm can cut its costs while still serving its customers.

[[Page 120]]

However, the same technology that disintermediates some actors
in the economic chain between producers and consumers is also opening
up new opportunities for other firms that can effectively add value in
a different way. The auction firm that finds new suppliers, for example,
replaces an internal procurement decision process with a market-based
specialist. As firms continue to restructure themselves to take advantage
of these new opportunities, they may find it worthwhile to expand or
contract their activities to focus on those where they add the most value
to the economic chain.


Information Technology and Network Effects
As new types of information technology link together computers,
telephones, and other types of communications devices, network effects
become increasingly important in determining the success or failure of
some products. In industries not subject to network effects, the total
value of a product is simply the sum of its value to each user; adding
more users increases the total value only by the product's value to the
new users. But in industries where network effects are present, such
as telephone or Internet service, the value of the product to each
user, including the existing users, rises as the total number of users
rises. In the case of a phone network, for example, each person is con-
nected to the network by a wire (or a wireless) link. The more links
the network has, the more valuable it is to each participant in the
network, because the network can be used to contact more people. This type
of network effect, also called a network externality, creates a cycle
of positive feedback in a growing network. As more people join the network,
it becomes more attractive to potential new members, and the network
increases in size, continuing the cycle. The same network effects that
create positive feedback in a growing network, however, can work against
a network that is shrinking. As a network shrinks, it becomes less
valuable to members, and more members leave, causing the network's value
to spiral downward.

Markets with strong network effects are referred to as ``tippy,''
because they can tip in favor of one firm or another, depending upon
which firm is able to generate enough positive feedback to win the
allegiance of a sizable majority of consumers. The winning firm in
such a market then becomes the dominant network and may be in a position
to establish a de facto standard for the industry. Firms engaged in
such a ``standards war'' may even choose to give their product away
initially if doing so increases the firm's likelihood that it will own
the dominant technology. Once a firm wins the standards war, consumers'
switching costs may well be high enough that the firm can exercise
market power to earn above-normal profits.

As the history of the Bell system at the beginning of the century
demonstrates, network effects can have a dramatic impact on market
outcomes when one network becomes very large relative to its competitors.

[[Page 121]]

Using its size and its superior long-distance service, the Bell
system became the dominant firm in areas of the country where it had
once competed with independent phone companies. To convince consumers to
sign up for its service over those of the independents, the Bell system
advertised the advantages of its larger number of connections.  By refusing
to interconnect with competing systems, the Bell system was able to
exploit the advantage of its large network to the detriment of its
competitors.

Establishing a new network in an industry with strong network
externalities can be very difficult, because users of the existing
network may have to incur costs to move to the new network. In some
cases, such as the software industry or the computer networking
equipment industry, these switching costs may include major investments
in equipment and training to use the new network. An even larger cost
for users of the new network, however, may be that imposed by the lack
of connections with the incumbent network.

These switching costs, however, do not necessarily allow the incumbent
firm to rest on its laurels. A new network can supplant an established
network in certain circumstances. One advantage a new network may have is
that its new technology may simply work better for some applications than
the established network's technology. Where the old network may have to
worry about compatibility with existing standards, a new provider can
start from scratch and take advantage of technological developments to
create a better product. With a superior technology, a new network
provider may be able to convince some users to incur the switching
costs because the advantages of the new technology are large enough to
make it worthwhile even if users cannot connect easily with the old
network. Once it has established a niche market among these users,
the provider can then seek to expand the use of its network to more
mainstream customers. The computer industry, for example, has seen
several waves of technology go beyond an existing dominant standard, and
each of those waves in turn developed into its own standard. Early
computer technology was dominated by mainframes, but mainframes were
later supplanted by minicomputers for many uses, and by personal
computers for still more uses. In each case the new technology started
out not by directly challenging the incumbent, but by appealing to a group
of users not well served by the existing technology.

As information technology advances, the economic effects of new data
and communications networks will become increasingly important. The
Internet provides a model for how those networks can work together.
The Internet can be described as a ``network of networks'' held
together by a standard communications protocol. The hardware and
software running any individual local network may be completely
incompatible with the hardware and software running a different local
network, but with a standard communications protocol the two networks
can talk to each other. This increases the


[[Page 122]]


value of each network to its users. Where these new technologies will
take us in the 21st century will only become evident over time, but
by encouraging connections between networks, government and the private
sector can work together to provide a strong platform on which new ideas
and new technologies can grow.

The Role for Government Policies

We have seen how firms in a range of industries are now realizing
some of the productivity gains that recent advances in information
technology have promised. For its part, this Administration remains
committed to a policy that encourages innovation and competition in
the private sector to the fullest extent possible. One element of that
policy is establishing the rules for protecting intellectual property
rights to new products through patents. Although patents have been used
to protect the property rights of inventors in their inventions since
the founding of the Republic, the last several years have seen an explosion
in the number of patents granted in the United States (Chart 3-8).
Several hypotheses have been advanced to explain this surge in patent
grants, including the possibility that it reflects today's rapid pace
of technological discovery. A recent court ruling clearly indicating
the patentability of computer software may also have encouraged the
patent surge.





(Chart 3-8)

[[Page 123]]

Intellectual property rights in works of authorship, including those
disseminated through the Internet, are protected through copyright.
The Administration has worked to set up a legal framework for elect-
ronic contracting and has supported protection of intellectual property
rights in the digital environment. In the latter area, the Administration
has supported initiatives to ensure that copyrighted works are
adequately protected on the Internet. Information in the form of soft-
ware, texts, music, and audiovisuals is increasingly important to the
economy, and all these media can be efficiently delivered over the
Internet. Without legal protections commensurate to those enjoyed
by distributors of physical media, intellectual property owners might
choose not to make their works available in the digital environment.
The Administration has also been active in advocating the development
of international standards for the protection of copyrights on the
Internet and in promoting a balanced approach to protecting data bases.

Support for Research and Development

Maintaining and increasing the flow of innovative ideas to the economy
also require continuing efforts in R&D to create new products and
services. Over the last several years, private industry has continued
to expand its funding of R&D, but many of these efforts are focused on
the development required to bring new products to market. To fill in the
gaps in private R&D efforts, government must go a step beyond encourag-
ing private innovation and competition. By supporting both the basic
and the applied research necessary to create new technologies yet
unimagined, government can act as a catalyst for growth in the
American economy in this new century.

In supporting R&D, the objective of government policy is to identify
projects with large potential spillover benefits to the economy. Funding
basic and applied research is one way to accomplish this objective
because it expands the knowledge base of society. Although this research
can generate large payoffs in the form of new technologies, the private
sector is unlikely on its own to provide the amount of research, basic
or applied, that is best for society. Firms may underinvest in research
because the social benefits from the innovations they might make exceed
the payoff that the firm itself can capture with traditional mechanisms
such as patents and protection of trade secrets. Some of the most
innovative ideas that research might generate may not immediately result
in commercially useful products or methods; they may require an extended
period of further development before that can happen, and often companies
may not want to wait that long. Hence government support for basic research
is critical in a knowledge-based economy, where growth ultimately depends
upon the flow of new ideas.

This problem seems particularly vexing for what are sometimes called general-purpose technologies (GPTs). A GPT is a technology that may have

[[Page 124]]

many possible uses but that depends on the development of complementary
innovations for those uses to be exploited. For example, an ordinary
desktop computer can be put to a vast number of different uses, but
all require complementary investment in software. Until a ready store of
such complementary innovations is available, a GPT may not be very useful,
and its creators may have limited incentive to make improvements in the
technology. As these complementary innovations occur, however, the gains
from further innovation to improve the GPT itself increase. And in turn,
as the GPT is improved, the gains from creating still more complementary
innovations rise, these innovations then appear, and so on in a virtuous
cycle. Jumpstarting this virtuous cycle may be difficult, however, when
the commercial gain appears to be low. In such circumstances, government
can again play an important role by providing the initial funding for
new technologies that still need more basic research.

The Internet itself is a GPT that developed in just this way. For all
the considerable excitement today about its commercial potential, the
Internet did not start out as a commercial project at all, but as a way
to interconnect government computers at different sites to share infor-
mation and data. At its creation in 1969 under a U.S. Department of
Defense project, the predecessor to the Internet (then known as ARPANET)
consisted of just four nodes at different locations. Over time, more
nodes and more users were added, until eventually the National Science
Foundation (NSF) took over the primary role in funding what by then
had become the Internet. With the introduction of the World Wide Web by
the European Center for Particle Research in 1989, and of a graphical
user interface called Mosaic by the NSF's National Center for Super-
computing Applications in 1993, the Internet took a giant step further.
From a tool used by a relatively small number of government workers
and academics, it was transformed into a widely accessible
public communications medium, and usage increased dramatically. As the
number of users expanded, commercial development began and
government sponsorship became unnecessary.

Technology Initiatives in the Budget

The Administration is committed to maintaining strong support for
R&D efforts in a wide variety of areas. The centerpiece of this
commitment is the 21st Century Research Fund, which aims at ensuring
stability and growth for the Nation's highest priority research programs.
In the President's budget for 2001, approximately $43 billion has
been committed to science and technology endeavors through this fund,
a 7 percent increase over the previous year.  Through the fund,
the Administration seeks to finance a broad and balanced national
R&D portfolio to ensure that technological advancements continue to be
made in areas of the economy where they are needed. Having

[[Page 125]]

a balanced R&D portfolio is necessary because advances in one discipline
may depend upon research gains in separate fields.

A number of programs undertaken by the 21st Century Research Fund are designed to leverage Federal R&D investments through partnerships with
firms in the private sector. For example, the Partnership for a New
Generation of Vehicles seeks to develop less polluting, more fuel-
efficient technologies for cars by combining the research efforts of
Federal Government laboratories with those of the major U.S. automakers.
The Advanced Technology Program, administered by the National Institute
of Standards and Technology, is another example of the Administration's
efforts to encourage public-private partnerships in R&D. This program
provides funding for scientific and technical projects that may offer
substantial economic returns to the United States.

This year's budget also proposes a multiagency National Nanotechnology
Initiative that increases the level of funding for nanotechnology research
in 2001 by more than 80 percent, to nearly $500 million. The initiative
focuses on the manipulation of matter at the atomic and molecular levels,
offering an unprecedented chance to study new properties, processes, and
phenomena that matter exhibits at a scale between atoms and molecules. The
initiative hopes to culminate in technologies with the unprecedented
ability to create new classes of devices as small as or smaller than a
human cell. This research could lead to continued improvement in
electronics and electro-optics for information technology; to higher
performance, lower maintenance materials for manufacturing, defense,
space, and environmental applications; and to accelerated biotechnical
applications in medicine, health care, and agriculture. The results of
this effort could be as significant to our economy as the development of
the transistor and the Internet.

This year's budget also increases support for information technology
R&D from $1.7 billion to $2.3 billion. This program funds the
fundamental research in computer science that is expected to lead to
major breakthroughs in the next generation of supercomputers,
networks, software, and applications. This ongoing work includes the
Next Generation Internet Initiative, which is connecting universities
and national laboratories with high-speed networks that are 100 to 1,000
times faster than today's Internet. R&D in information technology also
funds development of extremely powerful supercomputers for applications
in a variety of fields. Long-term research under this program's umbrella
will create high-technology, high-wage jobs and will improve our quality
of life. All of these projects serve as examples of how a small invest-
ment today may yield significant benefits in the years to come.


[[Page 126]]

Maintaining Competition

Another way in which government policy can encourage economic
growth is through reducing barriers to competition and entry rather
than imposing restrictions that in effect protect incumbent firms.
For example, by making more of the electromagnetic spectrum available
for wireless services, as discussed above, the Federal Government has
enabled a number of new firms to enter the market for these services.
The prices that consumers pay for wireless phone service have dropped,
on average, as a result. In designing the spectrum auctions, the
Federal Communications Commission was careful to limit the ability of
existing cellular incumbents to acquire the lion's share of spectrum
available, and this laid the necessary foundation for more competition
between competing wireless networks. Similarly, the Telecommunications
Act of 1996 removed barriers to entry across telecommunications markets,
and it set conditions for regional Bell operating companies to enter
long-distance markets after making changes to permit the entry of new
competitors for local telephone services. In December 1999, the
commission  found that one company had met those conditions in New York
State and allowed it to begin offering long-distance service in New
York. Companies in other States are expected to qualify in the future as
more local markets are opened to competition for both business and
residential customers.

Vigorously enforcing the Nation's antitrust laws is another
important element of a policy that promotes competition. As noted
above, concerns about the competitive implications of mergers are not
new, but the recent wave of large mergers has highlighted this aspect
of antitrust policy. One reason for this merger activity is that firms
are seeking to achieve efficiencies and become more competitive in the
global marketplace. The vast majority of these mergers pose no
competitive concern because they do not combine two significant
competitors in a market that would raise a concern about diminished
competition. In other cases, however, the antitrust agencies at the
Department of Justice and the Federal Trade Commission have opposed
elements of planned mergers that would have diminished competition in
several cases, including gasoline marketing and refining, grain
distribution, avionics, waste disposal, banking services, and
mobile telephony. In these cases the antitrust agencies have opposed
mergers because of their potentially adverse impact on consumers and
have sought divestitures that would preserve competition.

In analyzing mergers and other potentially anticompetitive conduct,
antitrust agencies increasingly must consider the effects that arise not
only from traditional economies of scale in production, but also from
the effects of market power created by network effects. For some products_
for example, some types of basic computer software and hardware_having a
large installed base of users creates a de facto standard both for those
users and for product developers, who must use that standard to create
new, complementary products. Users accustomed to


[[Page 127]]

using a particular standard may have built up a large investment in
knowledge and complementary products of their own that makes switching
to any alternative, nonstandard product costly. Users also may be
reluctant to switch when alternatives to the prevailing standard do
not have enough developers creating the complementary products that
would enhance the value of the basic product. In these circumstances, a
company that controls a standard might use that market power to prevent
other products from gaining the critical mass of users that would enable
them to challenge the standard and undermine its market power. Antitrust
agencies vigorously enforce the antitrust laws to preserve competition
and eliminate unreasonably exclusionary practices related to standards.

For completely new areas of economic activity such as e-commerce,
the Administration believes that growth can best be encouraged by limiting
the regulatory burden. Regulatory forbearance and policies that let
nascent markets grow have encouraged continuing investment in
information infrastructure and made possible unprecedented growth in
the development, adoption, and use of e-commerce. As one example,
the Administration has successfully opposed the imposition of
discriminatory taxes on Internet activity: the Internet Tax Freedom
Act establishes a 3-year moratorium on new and discriminatory taxes
on electronic commerce.

Finally, all policies that rely on the private sector to provide
valuable new technologies or other innovations face a common
challenge, namely, that of ensuring that all members of society
benefit from those technologies and those innovations. Evidence is
growing of a ``digital divide,'' in which some racial, ethnic, and
income groups in the United States use the Internet less than others.
Created under the Telecommunications Act of 1996, the E-rate program
for wiring schools and public libraries is an important means of
increasing the diffusion of Internet use and ensuring that access
to information is widely available (see Chapter 4). The discounts
available under this program have allowed more than 1 million classrooms
to be connected to the Internet. This policy, along with others
discussed in the following chapter, will help Americans develop
the skills they need to participate in an increasingly information-
driven economy.

Conclusion

Recent developments in technology and regulation underscore the
vital role that government has to play in ensuring the foundations
for a growing economy and a vibrant private sector. By providing support
for basic and applied research, government can act as a catalyst for
new innovations and new technologies that may someday prove critical in maintaining America's technological lead in an increasingly information-dependent world.

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Similarly, by reducing barriers to competition wherever possible, the regulatory environment that government creates can encourage
the birth of new services that will lead to continued growth, while
ensuring that all Americans have the opportunity to benefit. The
dramatic changes in the American economy over the last century should
remind us that future changes, still unpredictable, are sure to follow,
creating new challenges and opportunities during the century that has
just begun. If government continues to encourage firms and workers to
meet those challenges, America can maintain a strong, yet flexible
economy that fosters growth and provides opportunity for all its citizens
for many years to come.