[Economic Report of the President (2001)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 3

The Creation and Diffusion
of the New Economy



At the heart of the New Economy lie the many dramatic technological
innovations of the last several decades. Advances in computing,
information storage, and communications have reduced firms' costs,
created markets for new products and services, expanded existing
markets, and intensified competition at home and abroad. These
innovations have sprung from a remarkable recent flourishing of
entrepreneurship, much of it concentrated in high-technology
corridors such as California's Silicon Valley. Indeed, the rapid growth
of the information technology sector was one of the most remarkable
features of the 1990s. Domestic revenue in this sector--which comprises
computer hardware, software, and communications--has grown by 120
percent over the last decade. In just the last few years, the Internet
has spawned thousands of new companies and created billions of
dollars in market value. Wireless telephone carriers alone now
employ over 150,000 people in the United States and generate 10 times
the annual revenue they posted a decade ago.

The information technology sector has been going about its highly
innovative business since the 1970s. The last decade, however, saw
a rapid convergence of several of its most important technologies--
processing power, data storage and transmission, and software--that
translated these innovations into real productivity gains. This
chapter will show that these improvements in technology, along with
intense competition and innovative organizational practices, have
brought significant benefits to many industries throughout the
economy. In manufacturing industries such as steel and automobiles,
and in service industries such as retail trade and financial services,
firms that have embraced information technology and developed custom
applications are increasingly productive. Steel furnaces now use
high-speed computers running what are called neural networks to
improve quality and reduce wear and tear on equipment. In automobile
production, networked computers are used for a whole range of activities
from the design of new products to the coordination of supplier
relationships. In financial services, advances in information technology
have led to significant scale economies, reducing the costs of
back-office operations, risk management, and customer support. Similar
patterns of technological innovation are visible in many other industries.

Technology, however, is not the sole driver of this exceptional
performance. During the 1990s, firms in many industries found that
technology had its biggest impact when combined with complementary
organizational innovations such as incentive pay, flexible work
assignments, and increased training. Meanwhile intense competition,
both at home and abroad, has forced firms to improve their
performance--and weeded out those that do not.

This chapter surveys recent technological improvements, explores
the causes of the recent surge in innovation, and explains how changes
in technology, regulation, and competition have transformed
organizations throughout the economy, leading to significant
performance gains. The story is told in four parts.

The first part reviews recent improvements within the information
technology sector, focusing on microprocessors, disk drives, and data
transmission, and showing how costs have plummeted as capabilities
have increased. Future advances in networking, wireless communications,
and biotechnology--all fueled by the rapid technological advances of
the last 20 years--will likely lead to even more impressive gains.

The second part examines the causes of the surge of innovation.
Although the ultimate cause of all innovation is human creativity,
the scope and complexity of technical innovation today require a
particular support structure. Scientific and technical research and
development (R&D) must be funded, researchers must be trained and
equipped, inventors must receive adequate legal protection for their
intellectual property, and so on. The discussion here focuses on the
demand for technology, on financial market developments such as the
growth in venture capital and a stronger market for initial public
offerings (IPOs), on private and public R&D activity, and on
intellectual property protection. None of these factors alone
explains why the United States now finds itself awash in new
technology. Rather, it is the convergence of these factors during the
last decade that has created a unique climate for entrepreneurs to
discover new technologies and bring them to market.

The chapter's third part explains how firms are producing goods and
services more efficiently through greater use of computers and other
information technologies and the development of complementary
organizational practices. The emphasis is on how technology, regulation,
and competition interact to create new business opportunities and spur
performance gains. The financial services industry provides a useful
illustration. As mentioned above, advances in information technology
have led to significant scale economies in this industry. Deregulation
now provides financial institutions the opportunity--and increased
global competition provides the incentive--to exploit these scale
economies. The combination of these factors helps explain the dramatic
consolidation seen in this industry during the last few years. Further
examples of changes in firm boundaries, internal organization, and
performance are discussed, from the use of outsourcing and strategic
interfirm alliances to new arrangements for compensation and job design.
These changes in firm behavior, in many cases facilitated by the dramatic
improvements in information technology, are immediate causes of the rapid
productivity growth of the last 5 years.

The chapter turns finally to an investigation of the performance gains
brought about by these new ways of doing business. There is considerable
evidence that information technology and organizational change improve
the performance of plants, firms, and industries. Globalization is also
closely linked to improvements in firm performance: access to global
markets gives firms strong incentives to improve their products and
services, and the presence of foreign competitors in domestic markets
forces firms to make those improvements or perish. As the competitive
environment has changed, firms in many industries are increasingly
turning to intangible capital--patents and trade secrets, organizational
routines, reputation, and the like--as a source of competitive advantage.
This has important implications for firm strategy, as firms seek new ways
to build and exploit their stocks of these intangibles.

The Advance and Convergence
of Information Technologies

The productivity improvements associated with the New Economy have
their origins in a series of gradually unfolding advances in information
technology that grew out of post-World War II defense research. Over the
decades following these discoveries, the costs of processing, storing,
and transmitting information fell dramatically. During the 1990s this
process accelerated rapidly as computers became increasingly powerful,
communications networks became much faster and cheaper, and firms
developed the necessary software and organizational capabilities to
translate these new technologies into performance gains. The emergence
of the commercial Internet in the mid-1990s promises to extend these
gains even further.

Clearly, the information technology sector has been one of the most
innovative and visible in the New Economy. The sector now accounts for
an estimated 8.3 percent of GDP, up from 5.8 percent in 1990. Private
investment in information technology rose at a 19 percent annual rate
over the 1990s as a whole and accelerated to 28 percent after 1995
(Chart 3-1). Advances within each area of information technology have
created new markets, extended existing markets, and improved the
efficiency of firms and industries.



The most impressive technological advances have come in terms of
speed, storage capacity, data transmission capacity, and the improvement
of user interfaces. Moore's law--the prediction by semiconductor pioneer
Gordon Moore back in 1968 that transistor density on silicon wafers
would continue to double every 18 months--has generally held true,
generating one of the most remarkable phenomena of the late 20th century.
Since 1980 the speed of microprocessors used in personal computers has
increased more than a hundredfold, while the cost of performing 1 million
instructions per second has fallen from over $100 to less than 20 cents.
These advances, along with intense competition in computer assembly and
distribution, drove quality-adjusted prices for computers and peripheral
equipment down by 71 percent between 1995 and 2000. This coincided with a
dramatic increase in private investment in computers and peripheral
equipment (Chart 3-2). Complementary investment in software has nearly
doubled. However, quality-adjusted prices of software have fallen by only
2 percent, reflecting in part the fact that labor is the major input into
software production, and in part the difficulty of measuring quality
improvements in this area (Chart 3-3).

Advances in data storage, which complement these advances in computer
processing power, have also been impressive. The cost per megabyte of
hard disk storage has fallen from over $100 in 1980 to less than 1 cent
today. The newest generation of ``microdrives,'' designed for handheld
devices such as





wireless phones and digital music players, hold a gigabyte of data,
are smaller than a matchbook, weigh less than an ounce, and sell for
under $500. (By contrast, the first gigabyte-capacity disk drive,
introduced in 1980, was the size of a refrigerator, weighed 550 pounds,
and cost $40,000.)

Finally, data transmission capacity has skyrocketed: since 1996 the
capacity of a single fiber-optic cable has increased by a factor of 20
in widely available commercial systems, and experts expect such
technological progress to be sustained over at least the next 5 years.
These improvements, again along with healthy competition, have reduced
the cost of communications dramatically. Information can now be accessed
from anywhere in the world via the public Internet at no cost once the
user has connected. The emerging communications infrastructure allows
firms to collect, store, process, and transmit information at ever-higher
volume and lower cost. Between 1980 and 1999 the cost of sending 1
trillion bits of information electronically fell from $129,000 to 12 cents.

A revolution in software development has been built upon these advances
in hardware. Private investment in software has risen from $11 billion
in 1980 to $50 billion in 1990 and about $225 billion in 2000. The trend
in software design is toward independent modules that can be combined
for a variety of applications, and away from less flexible programs
designed for individual users. Software has also become more sophisticated.
Since about 1990, large firms have been spending billions on ``enterprise
resource

management'' programs: complex systems that integrate ordering,
procurement, inventory, finance, and human resources. Smaller firms can
get similar services from what are called applications service providers
operating over the Internet.

To reap the full benefit of these technological advances, firms are
reorganizing many of their business practices. In some industries,
firms are taking advantage of technological improvements by refining,
expanding, and consolidating their operations so as to reduce costs;
in others, startup companies are using technology to create new
products, processes, and markets. Consumers are now being offered an
increasing array of goods and services for wireless communication,
digital entertainment, shopping, education, and other activities.

As firms have rushed to adopt this increasingly ubiquitous, lower
cost technology and incorporate it into their businesses, employment
in the computer and data processing services sector has exploded, more
than doubling between January 1993 and November 2000 (Chart 3-4). This
compares with only a 23 percent increase in total private U.S.
employment during the same period.

Each on its own, these dramatic technological advances would have
been unlikely to generate the profound transformations of firms and of
consumer behavior that define the New Economy. Rather, it is the
simultaneous convergence of these technologies that has made the
difference. The rapid expansion of computer networks, culminating in
the commercial Internet,



clearly illustrates this convergence. Economists use the term ``network
effects'' to describe how the benefits of participating in a network
depend on how many other people are also on the network. (Who would want
to be the only person in the world with a fax machine?) The number of
Internet hosts, a proxy for the number of existing connections to the
Internet, has increased exponentially since 1990 (Table 3-1). Nearly 42
percent of U.S. households have access to the Internet, and surveys
indicate that over 50 percent of U.S. businesses sold products on line in
2000. The number of secure web servers for e-commerce in the United
States rose from 7,513 in 1997 to 65,565 in 2000. Traditional firms
and new firms alike are competing to deliver consumers higher speed
access to the Internet and more sophisticated content and services for
this new medium. Together this evidence suggests that the benefits of
being on the Internet are growing at an extraordinary rate.

As the case of the Internet clearly shows, the most important
breakthroughs of this information era have resulted from the convergence
of fast processing, inexpensive data storage, and rapid communications.
This technology is considerably more valuable to firms when combined
with complementary human capital and the appropriate organizational
routines, and when contractors outside the organization are available
for development, implementation, and maintenance. The convergence of
these technological advances, in combination with changing firm routines,
has fueled much of the development of the New Economy.



Why Is the U.S. Economy
Awash in Technology?

What explains the recent surge of technical innovation? Of course,
the ultimate cause of all innovation is human creativity. But
technical innovation does not occur in a vacuum; it requires a
structure of incentives and institutions. Firms demand new technology
that will let them reduce costs and provide new products and services
valued by their customers. For other firms to respond to that demand,
scientific and technical R&D must be funded, researchers must be
trained, their inventions must receive legal protection, and so on.

Government policies that foster competition, encourage R&D, and reduce
trade barriers are important in this regard. The Administration has
worked hard to provide an environment that allows entrepreneurship to
flourish, particularly in the high-technology sector. For instance, the
Administration supported a moratorium on U.S. Internet taxes under the
Internet Tax Freedom Act and worked for a freeze on trade duties for
electronically traded goods within the World Trade Organization (WTO).
To encourage open markets in high-technology goods and services, the
Administration signed the WTO's Information Technology Agreement, which
will eventually eliminate tariffs on $600 billion worth of goods, and
the WTO's Basic Telecommunications Agreement, which will promote
competition and privatization in a global telecommunications services
market worth $1 trillion.

To help ensure the competitiveness of U.S. firms in that market, the
President signed the Telecommunications Act of 1996, the first
comprehensive telecommunications reform legislation in over 60 years.
In September 2000 the President signed an executive memorandum directing
Federal agencies to work with the Federal Communications Commission
and the private sector to identify the radio spectrum needed for third-
generation wireless technology.

To encourage private sector R&D across the gamut of U.S. industries,
the Administration worked to extend the Research and Experimentation
tax credit through 2004, the longest extension of this policy ever. At
the same time, the Administration has supported significant increases
in funding for the National Science Foundation (NSF), an independent
government agency responsible for promoting science and engineering.
The NSF budget was increased by more than 13 percent in fiscal 2001,
the largest increase ever. Overall, the President's 2001 budget request
included more than $2 billion for R&D in information technology, a
marked increase over the previous year's amount.

Within this favorable climate, technological innovation has proceeded
at a rapid pace. This part of the chapter discusses the demand for
technology, financial market developments such as the surge in venture
capital and initial public offerings that support technology firms, the
role of R&D expenditure in technological development, and the importance
of legal protection for technical discoveries. It highlights four
important features of the New Economy.

First, intense competition and feedback drive the development and
adoption of new technologies. The availability of one technology
stimulates demand for complementary technologies, which in turn lowers
production costs and encourages further demand for the initial technology.

Second, significant financial market developments have lowered the
cost of capital for new businesses. Although the public stock markets
are still extremely important, providers of private equity such as
venture capital firms are playing a larger role, particularly in the
technology sector.

Third, the process of funding R&D has changed. The Federal Government
continues to be a major provider of this funding. However, the emphasis
of Federal funding has shifted from defense-related technologies to
civilian products and services. More important, private R&D has soared,
particularly at smaller firms and service firms. Private firms are also
devoting an increasing fraction of their research budgets to basic,
rather than applied, research. This suggests that the current technology
boom is far from over.

Fourth, the innovative process has itself been transformed.
Traditionally, innovation has been a highly integrated activity,
performed mostly by large firms working independently of each other.
Today, innovation is a less integrated process, performed increasingly
by large and small firms in collaboration with each other, with academic
institutions, and with government agencies. This is seen clearly in the
computer hardware industry. Formerly dominated by large, vertically
integrated firms, the industry is now frequently led by smaller, more
specialized firms using modular technologies that are easily shared
among market participants.

The combination of these features explains why the United States has
seen so much technological innovation over the last decade. For the most
part, these appear to be long-term trends, implying that technological
progress will continue to be an important driver of U.S. economic
performance.

The Demand for New Technology

Central to the dynamics of the demand for new technology is positive
feedback: technological improvements generate increased demand for
technology, which fuels further improvements. Several types of feedback
are important here. First, in a market characterized by network effects,
the more users have adopted a particular technology, the more valuable
that technology will be for additional users. For example, the telephone,
the fax machine, e-mail, and instant Internet messaging all are more
valuable to any given user the larger the number of other users. Today,
household telephone penetration in the United States is nearly 95
percent, more than 9 million fax machines are in use, over 100 million
Americans have e-mail accounts, and more than 60 million use instant
messaging software.

Second, for products that exhibit increasing returns to scale or strong
learning effects in production, sufficient demand can generate larger
markets by reducing the unit cost of production, which in a competitive
market lowers price and drives demand even higher. Firms in the
commercial aircraft and chemicals industries have long recognized the
need to "price down the learning curve" to drive demand and maximize the
returns on their investments. Semiconductor manufacturing, for example,
is characterized by increasing returns to scale. Producing microprocessors
or memory chips entails high fixed costs and low variable costs. The more
the firm sells, the lower it can price its chips and still profit from its
investment. As technological innovation brought ever-faster chips, the
fixed costs of building a semiconductor manufacturing plant rose from $100
million in the early 1980s to $1.2 billion in the late 1990s. This
suggests that increasing returns in the semiconductor industry are
becoming increasingly important.

Finally, feedback can occur when strong complementarities between
component products of a given system create an interdependent system of
demand. For example, the demand for computers depends on the price and
quality of software and of peripherals such as printers, modems, and
scanners. Yet the demand for software and peripherals is, to a certain
extent, determined by the price and quality of computers. More generally,
since the complexity of so many information technology products makes it
efficient to design each component for a particular purpose, and to
establish standardized interfaces between components and even entire
products, demand for individual components and given products becomes
highly interdependent.

In the United States, deregulation, openness to foreign competition,
and low administrative barriers to entry and exit have led to highly
competitive markets, providing strong incentives for firms to adopt new
technologies. Yet organizations often resist technological change.
Adopting new technologies can be costly and risky for firms; some of
this risk stems from the changes in relationships, communications
practices, and organizational structures that are required to take full
advantage of the new technology. A firm with a protected market
position can avoid making these productivity-enhancing changes and still
remain viable and profitable. Firms in competitive environments cannot.
Beyond the highly competitive information technology manufacturing
sector, which has been a remarkable user of new technology, competition
has driven the demand for new technology in such service industries as
telecommunications services, trucking, banking, and retailing, to
name a few.

Financial Market Developments

Firms--especially small, innovative startup companies--need funds,
guidance, and other forms of support for all aspects of their operations.
The United States has offered a uniquely supportive climate for
technology start-ups. In many cases a single individual investor, or
``angel,'' has provided money at the seed stage, where a new firm's
product concept is developed. Additional funds may be obtained through
the private placement market--essentially equity offerings to a limited
group. The Federal Government has also played a role in supporting
innovation through the Small Business Innovation Research program. One of
the most important factors in the financing of new technology, however,
has been the recent acceleration in growth of venture capital, which
itself has benefited from a thriving market for IPOs. The availability
of venture capital has lowered the startup costs for aspiring
entrepreneurs, and favorable taxation of capital gains has increased the
demand of entrepreneurs for capital. Furthermore, a rising stock market
may encourage venture capitalists to support startups, in the expectation
that a subsequent public offering or private sale will generate
large returns.

Venture Capital

Venture capital is a form of private equity that targets startup
firms primarily in emerging industries. Venture capitalists do much more
than supply funds, however. Besides matching entrepreneurs with
investors, such as wealthy individuals, banks, and pension funds, they
also advise, monitor, and support the projects they fund. Technology
firms face two special obstacles in procuring finance. First, the
profitability of the projects they pursue is extremely difficult to
assess, and second, the entrepreneur's behavior is difficult for
providers of capital to monitor and evaluate. Venture capital firms
address these difficulties by getting deeply involved in the development
of the typical startup. Typically, one or more of the venture capital
firm's lead investors join the board of directors of the new firm, and
from that vantage point they closely monitor the entrepreneur's
activities. The method in which financing is provided allows additional
control: the investment is typically staged, with funds disbursed only
as the firm passes certain preset milestones. Venture capitalists often
advise firms on the selection of key personnel and on the acquisition of
legal and financial services. They are also deeply involved in the
firm's strategic choices.

During the 1980s venture capital investment grew on average by 17
percent per year; then, during the 1990s, the pace doubled. Total
venture capital investment jumped from $14.3 billion in all of 1998 to
$54.5 billion in the first three quarters of 2000 alone (Chart 3-5).
One company that tracks the venture capital industry estimates that
$134.5 billion was under venture capital management at the end of 1999.
Analysts pointed to the large



sums raised at the beginning of 1999, and to a new group of promising
projects in Internet-related businesses, as the driving factors behind
this surge in financing. Whether the rapid pace of growth can be
maintained depends on a number of economic factors, one of which is
the strength of the IPO market. Venture capital firms frequently move
on to new projects once a firm has been successfully launched. For
example, 3 years after an IPO, only 12 percent of lead venture
capitalists retain 5 percent or more of the funded company's shares.
And the most profitable manner for venture capital investors to exit
their investment positions and take their profits is by having the new
firm float a public issue. Therefore maintenance of a large and buoyant
public equity market is critical.

The Federal Government has long been active in the venture capital
business. Congress created the Small Business Investment Corporation
(SBIC) program in 1958. This program allows the formation of SBICs,
which are privately owned and managed investment firms, licensed by
the Small Business Administration, that may borrow funds from the
government in order to provide venture capital funding to entrepreneurs.
In 1999 SBICs provided $3.7 billion to 3,700 companies.

Does the enormous growth in the amount of funds described as venture
capital really signal a correspondingly large increase in the net
resources available to entrepreneurs, or does some of it merely
substitute for other sources of funding? There is evidence that not all
venture capital is new money: some large firms, often in the computer
hardware and software industries, now make about 15 percent of total
venture capital investments through semi-autonomous organizations they
set up. These investments might have been counted as internal corporate
investment in the past. However, venture capital and traditional
corporate R&D do seem to have different effects. In particular,
recent evidence suggests that venture capital spurs innovation, as
measured by patent activity.

More generally, the thriving venture capital industry is but one
part of a growing domestic private equity sector (as distinguished
from the public capital markets, that is, the stock and bond markets).
In the United States the private equity sector has largely divided
itself into two subsectors, each focusing on different types of
investments. One consists of the venture capital firms already
described, which focus on early-stage investments in startup or newly
formed entities. The other consists of investment groups that pursue
opportunities in existing, more mature companies. At least 800
established buyout firms operated in the United States during the 1990s.
These privately held firms specialize in leveraged acquisitions,
recapitalizations, management buyouts, and other restructurings. In
principle, buyout firms perform an important function by actively
monitoring corporate managers, thus avoiding the collective action
problems that limit effective control of management by institutional
owners such as banks and pension funds. During the last five years or
so, the distinction between venture capital and buyout firms has
blurred: several buyout firms have begun investing in Internet startups,
while venture capital firms that previously specialized in managing
early-stage ventures have participated in buyouts of established
technology firms.

Initial Public Offerings

In addition to venture capital, the public capital markets have also
served as an extremely important source of capital during the second
half of the 1990s and beyond. Between 1993 and the end of November 2000,
IPOs raised $319 billion, more than twice the amount raised in the
preceding 20 years, even after adjusting for inflation (Chart 3-6).
Although some of the largest IPOs have been those of established firms
seeking to raise additional capital, IPOs have also been an important
source of capital for new firms, particularly in information technology
and biotechnology. An active IPO market fosters innovation by providing
capital for new enterprises and, as already mentioned, by providing an
attractive exit mechanism for financiers of early-stage, risky ventures,
making these financiers more willing to provide risky capital. It also
provides liquidity for entrepreneurs, who can appropriate some of the
value their efforts have created while retaining at least partial control
of their firms.



Of some concern, however, is the recent strange behavior of IPO
pricing, especially in 1999 and 2000. In 1999 the average first-day
return (calculated as the percentage by which the price at the end of
the first day of trading exceeds the offering price) for IPO securities
was an amazing 69 percent (Chart 3-7). This was three times higher than
the average first-day return in any year between 1975 and 1999. This
anomaly could be due to either ``irrational exuberance'' on the part of
investors, persistent underpricing by the underwriters of these
securities, or both. Economists have developed several possible
explanations for the underpricing of IPO securities. Some focus on
differences in the information held by the firm and the market, whereas
others focus on the incentives of managers, underwriters, and investors.
In general, underpricing is not necessarily the result of a market failure.

Evidence on the long-term performance of IPOs is mixed. Equity markets,
particularly in the technology and Internet sectors, were extremely
volatile in 2000. Internet commerce and Internet services firms recorded
remarkably high market values between 1998 and early 2000, but their
market values fell sharply after peaking in March 2000. Consequently,
although the average number of IPOs per month in late 2000 was only
slightly less than the average for the first half of 2000, the average
monthly proceeds from IPOs fell by nearly 40 percent. The overall market
value of equities remains high,



however. As of December 2000, the price-to-earnings ratio of S&P 500
firms stood at 26, substantially above its average of 22 in the 1990s.
The price-to-earnings ratio of the Nasdaq composite stock index, which
includes a high concentration of technology firms, was 98 near the end
of 2000.

The availability of well-developed, sophisticated capital markets has
provided important support for the technological advances of the last
decade, although whether they will continue to do so in the next decade
remains to be seen. The flourishing venture capital market and the dynamic
IPO market are unique features of the U.S. economy and may help explain
why the New Economy emerged here rather than in Europe or Asia.

R&D in the New Economy

As the economy has become "lighter," shifting toward products that
embody more knowledge capital and less physical capital, R&D--the
principal means by which knowledge capital is created--has risen
dramatically. The entire R&D process today is in the midst of a
transformation away from the vertically integrated model pursued by
large R&D laboratories and toward a more decentralized model involving
more small-firm R&D and increasing collaboration between firms to
bring products and services to market.

Between 1995 and 1999, real R&D spending in the United States grew
at an annual rate of nearly 6 percent, evidence of a substantially
increased commitment to innovation. Private sector R&D accounts for
most of this growth, having increased at a remarkable 8 percent annual
rate over the same period. In this era of budgetary restraint, real
Federal support for R&D remained approximately constant but shifted
somewhat away from defense R&D toward civilian applications (Chart 3-8).
Other key indicators offer corroborating evidence of an increase in R&D
activity. The number of scientists and engineers doing R&D rose 34
percent between 1995 and 1999. Immigration has been an important source
of engineers and scientists in the United States, not only in R&D but
in many other activities as well. Foreign-born persons make up only
about 10 percent of the U.S. population, but about 13 percent of
scientists engineers.

Private sector support of basic research also increased rapidly in
the 1990s, growing at an astounding 17 percent annual rate since 1995.
Indeed, one survey observes that ``industry is doing more long-range,
high-risk, discovery-type research than ever before.'' This is somewhat
surprising, because economists have typically argued that private firms
will tend to focus on applied, rather than basic, research. Because
basic research may not produce commercially exploitable results, and
because firms fear that competitors will free-ride on their basic
research investment if it does bear fruit, private firms are thought
to invest little in basic research. In the early 1990s, in fact, several



large firms famous for supporting basic research scaled back their
research budgets after experiencing sharp declines in earnings, raising
concerns that private sector support for basic research would dwindle.

Why, then, did private sector support for basic research increase in
the 1990s? A recent study shows that patent applications increasingly
cite scientific research, and not just existing patents; this suggests
that basic science is becoming more important for technological change.
(This trend has been particularly strong in information technology and
in biotechnology.) For this reason, firms that employ individuals skilled
in performing basic R&D may be better able to take advantage of the
scientific research performed by universities, the national laboratories,
and other firms. Furthermore, as a recent study of postdoctoral
biologists' job choices suggests, allowing researchers to pursue basic
science and publish their results helps firms attract high-quality
researchers and reduces the financial compensation that researchers demand.

The Organization of Innovation

Small firms have been responsible for much of the growth in private
R&D. Between 1993 and 1998, real spending on R&D by firms with more
than 25,000 employees increased by 8 percent, but R&D conducted by firms
with fewer than 500 employees nearly doubled. In 1998 R&D conducted by
firms with fewer than 500 employees accounted for 18 percent of all
industrial R&D spending (Chart 3-9), and firms with 500 to 4,999
employees accounted for an additional 16 percent, compared with 12 and
14 percent, respectively, in 1993. More than 40 percent of all privately
employed scientific researchers now work in these small firms.

The increasing importance of small-firm R&D is consistent with an
observed shift, in a number of industries, toward the distribution of
innovative activity across multiple independent firms. For example,
in the 1950s and 1960s, computer firms usually sold fully integrated,
proprietary systems comprising both hardware and software. They
developed and manufactured the majority of the components for these
systems inside their own company. Today, in contrast, the most popular
systems are based on modular architectures. Production of software and
hardware is separated, and hardware manufacturing typically involves
components designed and developed by dozens of different firms. Many of
today's semiconductor design companies own no manufacturing facilities
and focus exclusively on creating the intellectual property--the design
itself. Still others perform contract production for dozens of these
design companies.

Important changes have also occurred in pharmaceuticals. Before the
1970s the discovery of new drugs relied on what was called the random
screening approach, which drew mainly on medicinal chemistry and
pharmacology. Large, established pharmaceutical firms were the primary
innovators.



innovators. Today, in the wake of the molecular biology revolution, firms
use a more profound understanding of the biological basis of disease to
guide their search for drugs. Biotechnology has also become a technology
for producing new drugs as well as discovering them, and
the industry has seen the large-scale entry of firms that do both. In
today's pharmaceutical industry, collaboration among major pharmaceutical
firms, biotechnology firms, and academic institutions has become
commonplace. The large drug companies have recognized that it is difficult
to acquire all of the capabilities necessary to do modern pharmaceutical
R&D they must rely to some extent on external partners. The new
biotechnology firms, for their part, have formed partnerships with the
large drug companies that possess skills in conducting clinical trials
and marketing that they themselves lack. Many biotechnology startups are
closely linked to universities, and universities now routinely enter into
licensing agreements with firms to commercialize the patents they hold.

In another departure from traditional R&D patterns, service firms
also account for a considerable share of the recent growth of private R&D.
The most recent data from the NSF show that service firms have stepped
up their performance of R&D over the past few years. R&D by engineering
and management services firms, for example, doubled between 1995 and 1998,
to $8 billion, and in the same period R&D by business services firms
increased by 69 percent, to $15 billion. Consistent with today's more
decentralized approach to R&D, these service firms provide essential
software for data processing and product development for their clients
in manufacturing and other sectors of the economy.

Recent attention has focused on the management of innovation within
and between firms. The design of incentives offered to researchers is
important here. Incentive schemes must be carefully designed, particularly
when multiple tasks--for instance, both basic and applied research--
compete for a researcher's time and attention. Studies have suggested
that firms seeking to develop promising but immature technologies with
the potential to challenge their current business should establish
separate, independent business units to develop these technologies.
Otherwise the incentives of researchers and others within the
organization could come in conflict.

Developments in information technology, meanwhile, have made possible
entirely new R&D processes that further challenge the traditional
centralized models. ``Open-source'' software design, which encourages
users to modify the source code of a program and to share these
improvements with others, has become increasingly widespread. Tens of
thousands of programmers in the United States and abroad have
contributed to open-source programs for such widely used products as
Internet server software, e-mail routing software, and even some
personal computer operating systems. Widespread Internet access has
led to a dramatic acceleration in open-source activity, despite the
fact that open-source programmers typically do this work without pay and
distribute their source code for free. They may be motivated by
reputation, which can lead to better future job offers and greater
respect among peers, or by the sheer pleasure of solving the problem.

Another key feature of innovation and R&D in the New Economy is
geographic concentration. Such concentration persists even in a world
where declining telecommunications costs and improved software have made
it easier for researchers in distant parts of the globe to collaborate.
Knowledge spillovers between firms, and between firms and academic
institutions, are particularly important in the technology sector. One
study that looked at patent citations as a measure of these spillovers
suggests that they are geographically localized; this finding remains
even after controlling for pre-existing research activity. Spillovers
involving what economists call tacit knowledge--knowledge that is not
easily codified or communicated except through close interaction--may be
even more geographically localized, since they are likely to be mediated
through social ties (for example, between an entrepreneur and a venture
capitalist) or face-to-face contact. This creates geographic clusters
of firms in a set of related industries. Many of the Nation's high-
technology clusters benefit greatly from proximity to major research
universities; besides Silicon Valley, examples include the Research
Triangle in North Carolina, Route 128 in Massachusetts, and Austin,
Texas. Aside from the benefits from research spillovers, firms may
choose to locate in these clusters to have better access to
sophisticated customers, to benefit from the presence of supporting
industries, and because startup costs--particularly the costs of hiring
employees with a specific type of expertise--are lower. Clustering has
been pronounced in industries where university R&D, private R&D, and
skilled labor are particularly important.

Government Funding for R&D

The Federal Government continues to supply over half of all basic
research funds in the United States, as it has since World War II (Box
3-1). Between 1993 and 1999, Federal funding for basic research increased
at a 2 percent annual real rate. This funding increased a further 9
percent in fiscal 2000 and is budgeted to increase an additional 7
percent in fiscal 2001. Many New Economy technologies, such as the web
browser and the Internet, have their origins in federally funded basic
research. Other important technologies such as bar codes, fiber optics,
and data compression also benefited from public funding in their early
stages.

This Administration has increased basic research funding for many
important technologies, computer science and biotechnology in particular.
In 1999, 20 percent of the Federal research budget went toward health
and human services research, and 50 percent of Federal basic research
funds went toward the life sciences. Recently, Federal funding for basic
research in information technology has increased. The Administration has
established the Information Technology for the 21st Century Initiative,
a basic research initiative targeted at software development,
supercomputing, and networking infrastructure and examining the societal
implications of the information technology revolution. This program had a
budget of $309 million in fiscal 2000 and $704 million in fiscal 2001.

Any discussion of the Federal role in R&D requires careful consideration
of whether public R&D complements or substitutes for private R&D. Some
forms of R&D performed by the Federal Government are clearly complementary
to private R&D spending. For example, providing information about the
genetic basis of disease could increase the productivity of private R&D
efforts to design new drugs. However, public R&D may at times crowd out
private R&D if firms perceive that they can free-ride on government-
supported projects, particularly those that focus on developing specific
products. Time considerations may also be important. Today's Federal
spending may support tomorrow's private spending but reduce the incentives
for the private sector to do research today. Partly because of these
considerations, the focus of Federal R&D spending has typically been on
basic research, where underinvestment by private firms is thought to be
most likely, and on R&D related to the missions of government agencies.

Encouraging Private Research and Collaboration

Besides providing direct funding, government policy has created a
favorable climate for private R&D through the tax code and through
encouraging collaboration among private sector firms. According to the
Organization for Economic Cooperation and Development (OECD), the tax
treatment of

____________________________________________________________________________
Box 3-1. Federal R&D and Commercial Technology:
Licensing, Cooperation, and Partnerships

A significant fraction of federally funded R&D supports the needs
of Federal agencies pursuing public purposes such as national defense.
However, the technology created by this research often has potentially
valuable private sector applications as well. A series of new laws in
the 1980s encouraged the realization of this potential by making
technology transfer an explicit mission of the Federal laboratories.
These laboratories were also given the authority to grant licenses on
their patents to U.S. businesses and universities, and Federal
agencies were allowed to enter into cooperative research and
development agreements (CRADAs) with private firms to conduct research
benefiting both the government and the CRADA partner. In the 1990s
these technology transfer mechanisms took root and flowered in the
Federal research enterprise. In 1998 Federal laboratories granted
licenses for nearly twice as many inventions as in 1993, and nearly
three times as many as in 1990. Not surprisingly, income from these
licenses has risen dramatically. The number of active CRADA projects
has doubled since 1993, with most such projects in the defense and
energy spheres.

The missions of some Federal agencies target commercial applications
specifically. The Advanced Technology Program (ATP), administered by
the National Institute of Standards and Technology, supports research
projects that focus on the long-term technology needs of U.S.
industry, by sharing the cost of peer-approved, high-risk projects.
Over 460 ATP awards--many of which have gone to cooperative ventures
between firms and universities--have been made in fields as diverse
as photonics, manufacturing, materials science, information
technology, and biotechnology.

Founded in 1993, the Partnership for a New Generation of Vehicles
(PNGV) is another example of how Federal agencies and industry have
joined forces to pursue mutual interests. The PNGV brings together
the three major U.S. automakers, over 300 automotive suppliers and
universities, and seven Federal agencies to develop technology for
environmentally friendly vehicles. The vehicles developed under this
program promise to achieve up to triple the fuel efficiency of today's
vehicles, and very low emissions, without sacrificing affordability,
performance, or safety.
-----------------------------------------------------------------------------


R&D in the United States is one of the more favorable among OECD
nations. Federal policy has also encouraged the formation of strategic
technology alliances, which are particularly important for new
modes of R&D. Two hundred and fifty-five domestic U.S. technology
alliances were formed in 1998, up from a mere 51 in 1980 (Chart 3-10).
The number of alliances formed between U.S. and foreign firms climbed
from 88 in 1980 to 222 in 1998. This growth in new alliances was driven
largely by agreements between firms in information technology and
biotechnology.

One particularly intensive type of technology alliance is the research
joint venture. Research joint ventures allow participating firms to take
advantage of their different and often complementary capabilities, to
spread the risk of a project, and to pool resources. For example, two
major firms working on computer memory technology recently announced a
joint effort to develop magnetic random access memory (MRAM). This
technology promises more efficient computing--machines using MRAM will
start up instantly, for example. One company has created the early MRAM
technology itself, whereas the other brings to the venture additional
expertise in complex semiconductor memory. Combining the efforts of some
80 engineers, the firms hope to develop commercially viable MRAM by 2004.

Research joint ventures limit wasteful duplication and are particularly
important for projects whose payoffs are likely to be years away. Most
important, they allow firms to internalize some of the benefits of
knowledge



spillovers; the difficulty in capturing these externalities
is presumably a reason why firms are thought to underinvest in R&D in
the first place.

Although technology alliances existed before the mid-1980s, U.S.
antitrust law created some confusion about the extent to which firms
could cooperate on R&D. With passage of the National Cooperative Research
Act in 1984, the treatment of research joint ventures under antitrust
law was modified in two important respects: the application of antitrust
law to such ventures was clarified, and the maximum penalty that could
be assessed in a successful private lawsuit was reduced. The 1993
National Cooperative Research and Production Act further liberalized the
environment for cooperation by extending these provisions to include the
application of technologies developed by joint efforts. Seven hundred and
forty-one research joint ventures were registered under this act through
1998, with most occurring in the communications, electronics, and
transportation equipment industries.

Intellectual Property Protection

Perhaps the chief incentive for innovation is the potential financial
reward from owning a unique resource, product, or service. Innovators
often profit simply by being first to market, but legal protection for
their discoveries provides an additional attraction. U.S. law provides
particularly strong intellectual property protection. For example, it
allows the patenting of most biological material that occurs as a result
of substantial human intervention, and this protection has contributed
to the rapid innovation in the U.S. biotechnology industry. European case
law for biotechnology patents is evolving but inconsistent, and the
European Union does not currently grant patents for plant varieties.
Japanese law for the patenting of living material is similar to that
in the United States, but Japan prohibits the protection of biotechnology
inventions related to the human body for the purpose of diagnosis or
treatment of disease.

In addition, the United States grants clear protection to a variety of
computer-related innovations, an area that Japanese and European laws
protect more loosely. The European Patent Convention specifically notes
that computer programs as such are not to be regarded as inventions.
Although court rulings have interpreted this as requiring that software
inventions make a technical contribution to be eligible for a patent,
considerable misunderstanding remains in the European Union about the
extent of patent protection for software, particularly among small and
medium-size enterprises. In Japan a software patent claim can only be
expressed as a claim on the process, whereas in the United States claims
can cover a product or a process. This means that, in Japan, many more
patents may be required to fully cover a new software package; this
increases the possibility of a gap in protection that a competitor
can exploit. In both the European Union and Japan, a software patent is
substantially narrower than one granted in the United States.

As more new technologies emerge, challenges to incorporating these
innovations into the intellectual property framework will continue to
surface. As it did with earlier innovations, the existing intellectual
property framework is adapting to accommodate today's new technologies.
For instance, the increasing use of software has blurred the line
between a physical transformation, which is traditionally covered by
the patent system, and a concept, which is not. Court rulings have
consistently upheld the patent protection of ``business methods''--
financial techniques or software programs that suffuse technology and
concept. However, the legal rulings in favor of business methods patents
have generated controversy, as illustrated by the debate surrounding a
large Internet retailer's patenting of its website ordering process.
Critics argue that patents of business methods are of low quality and
overly broad, and that they might stifle innovation. In response, the
Patent and Trademark Office announced the Business Methods Patent
Initiative in early 2000. The initiative establishes new procedures for
reviewing such patents, including a second layer of patent review,
enhanced training for examiners, and expanded searches for prior work.

The proliferation of new technologies has also raised issues related
to copyright and trademark law. ``Peer-to-peer'' file-sharing systems
permit the easy exchange of copyrighted media, including music,
software, video, and texts. The Administration has supported the
extension of copyright protection to the digital realm and has worked
to establish an international standard of copyright. One achievement in
this area was the passage of the Digital Millennium Copyright Act
(DMCA), which implements the Copyright Treaty and the Performances and
Phonograms Treaty of the World Intellectual Property Organization. Among
other provisions, the DMCA limits the extent to which Internet service
providers can be held accountable for copyright infringement by their users.

As biotechnology, the Internet, and other innovative technologies
become more widespread, important legal challenges will continue to
emerge. For example, e-signature legislation recently took effect,
providing standards under which legally binding signatures can be
created and sent electronically. This advance brings with it important
new challenges in contracting.

A Favorable Alignment

Why, then, is the U.S. economy awash in technology? The evidence
suggests that the combination of increased, competition-driven demand
for technology, thriving financial markets, increased public and private
R&D, and legal protection have created a uniquely favorable climate for
entrepreneurship in the technology sector. As this chapter has emphasized,
it is not any one of these factors in isolation but rather the convergence
of these favorable conditions that has led to the recent surge in
technological innovation. Technology flourishes when markets are allowed
to work, and where government policy provides essential support.

Doing Business in the New Economy

How has growth in technological innovation affected the economy as a
whole? Chapters 1 and 2 of this Report detailed the effects of
information technology on economy-wide productivity. Here the focus is
on the effects of technology, along with complementary organizational
practices and increased global competition, on the behavior of
individual plants, firms, and industries. The remarkable productivity
of the information technology sector itself over the last several
decades has already been discussed. This part of the chapter turns
to other sectors of the economy, to show how the technologies and
business methods of the New Economy have spread beyond the information
technology sector.

Chapter 1 presented aggregate evidence that the New Economy has
diffused outside the information technology sector to the service-
producing industries. Between 1989 and 1999, labor productivity
accelerated in retail and wholesale trade and in finance and business
services (Table 1-2). These industries are heavy users of information
technology, and this technology may have contributed to these gains.
However, the aggregate statistics do not provide the whole picture.
Productivity gains in these industries are difficult to gauge:
measuring output and prices is an imperfect exercise, and the
productivity numbers do not incorporate important changes in quality.
To understand and extend these findings, then, it is essential to look
at evidence within firms and industries. This section focuses on the
underlying mechanisms by which performance gains might arise.

These performance gains come mainly from two sources. First, the
level of investment in information technology has increased sharply,
in both the manufacturing and the services sectors. As discussed in
Chapters 1 and 2, only since 1995 has investment in information
technology grown to the point where the stock of information
technology capital can itself have a noticeable effect on aggregate
productivity. However, computers are more than just another factor of
production. As this section will emphasize, another important driver
of productivity growth is the way computers and electronic
communications together enhance the efficiency of labor and other
factors, as firms adapt these technologies to their own unique
business applications. It is these increases in the productivity of
all factors that explain the economy-wide gains documented in Chapters
1 and 2.

Information technology has made inputs more productive by changing
the way firms do business. In manufacturing, increasing computing power
and decreasing cost have brought about performance gains through
automation, numeric control, computer-aided design, and other channels.
Information technology has also facilitated changes in job design,
giving manufacturing workers more decisionmaking authority on the shop
floor and placing a premium on technical skills. Firms are also
relying increasingly on performance-based pay, including profit-sharing
and stock option plans.

Supplier and customer relations have also changed. Supplier contacts
that were formerly kept at arm's length have become more closely
integrated and coordinated, thanks in part to automated procurement
systems. Data that used to be kept proprietary are now increasingly
shared between business partners. Inventories have shrunk. Firms use
databases of transaction histories to target products and services to
individual customers, while setting up telephone call centers and other
operations to improve service.

The structure of many markets has changed. In some sectors high fixed
costs and low marginal costs, combined with first-mover advantages and
network effects, have led to highly concentrated markets. Other sectors
are populated by smaller, newer firms. Firm boundaries are also shifting
more rapidly as firms move toward flexible, collaborative relationships
such as strategic alliances with suppliers and even potential rivals.

Finally, competition in the New Economy is more vibrant, more dynamic
than ever before. Many markets have become more ``entrepreneurial'' as
new business starts--and business failures--have increased. The increase
in global trade brought about by trade liberalization along with lower
communications and transportation costs has led to improved performance.
This section outlines the effect of technology, organization, and other
factors on performance.

New Developments Inside Plants and Firms

Many people associate the New Economy with semiconductor plants or
biotechnology research laboratories. Those are, of course, important
drivers of recent performance improvements. However, information
technology has had significant effects on old-economy industries as well.

Applying Computing Power Outside
the Information Technology Sector

As computing power has gotten cheaper and firms have made greater
investments in information technology, they have learned to apply that
greater power to improving the performance of the firm. Manufacturing
firms have done this by investing in information technology that is
embedded in much of the new machinery they install, and by investing
in information technology in their business processes. Service firms
have used the new technologies to introduce new products and processes
as well. Although the case studies presented below do not add up to an
economy-wide measure of the impact of information technology, they do
show clearly that it is improving productivity in many sectors of the
economy--even old-economy industries such as steel, transportation,
and banking.

In the manufacturing sector, computers allow the automation of many
tasks, improving the flexibility, speed, and reliability of the
production process. The machine tool industry provides an example
(Box 3-2). These improvements in the production process are also combined
with the use of new software that governs scheduling mechanisms, to
reduce work in process and shorten lead times for order fulfillment. In
the services sector, the availability of information and the increased
ability to process that information have enabled retailers and service
providers to respond more quickly to changing customer demand and to
provide more customized service.

The changes witnessed in the steel industry exemplify these changes in
production processes and management practices. The fundamental processes
of steelmaking remain much as they always were: melting raw material,
forming it into an intermediate product, and shaping and treating that
product into final goods. But a number of technological advances, many
incorporating information technology to measure, monitor, and control
these processes, have affected almost every step in steel production.

As recently as 10 or 15 years ago, steelmaking involved extensive
manual control and setup and relied heavily on operators' experience,
observation, and intuition in determining how to control the process.
Computer processing of data from sensors, using innovative software,
has improved the ability to control the process, allowing faster, more
efficient operation, in addition to more uniform product quality. For
example, the availability of computing power to quickly process data
has enabled steelmakers to combine sophisticated software decisionmaking
algorithms (called neural networks) with precision sensing devices to
continuously monitor and adjust the ever-changing conditions in the
electric arc furnaces widely used for melting steel. This closer
control reduces both energy consumption and wear and tear on the
equipment. The setup to cast the molten steel into an intermediate
product has changed from a process in which several operators would
``walk the line,'' setting the controls for every motor and pump, to
one in which a single operator uses an automatic control system that
synchronizes and sets the equipment. The rolling process now incorporates
sensors that constantly inspect for deviations from the desired shape,
allowing the operators to make corrections before material is wasted.
Operators can remotely control the speed and clearance of the rolls
using computer-controlled motors to correct problems as they develop.

__________________________________________________________________________
Box 3-2. Information Technology in the Machine Tool Industry:
The New Economy Helps the Old

The machine tool industry, one of the oldest and most basic of U.S.
manufacturing industries, appears to have experienced accelerated
performance in the 1990s as a result of improvements based on
information technology. Because this industry makes the machines
used in the rest of the manufacturing sector, improvements in the
quality of its products can result in productivity gains for the
entire sector. The annual productivity growth rate for this industry
rose to 2.5 percent from 1990 through 1998 after more than a decade
of decline. But even this figure underestimates the performance gains
that have arisen from improvements in such factors as reduced
inventories and higher product quality.

The use of computerized, numerically controlled machines in this
industry has had a major impact. Although developed in the 1970s,
numerically controlled machines made up only 5 percent of the
machining base by 1983. By 1997, however, this share had risen to 68
percent. These machines increase operating speed: one study found
that as of 1987 they had already reduced unit production time by 40
percent relative to manual production. They also increase output
quality and reduce setup times, so that products can be switched more
frequently and inventories can be kept smaller.

One industry that uses these production methods is valve production:
valves are seen in virtually every industrial environment, where they
are used in pipelines to control the flow of liquids or gases of
various kinds. Data described below from a typical valve-making firm
document pronounced productivity gains in three primary areas of the
firm: new product design, production, and inspection. To envision
these phases, imagine that the firm is making a complicated valve
part starting with a chunk of steel, then boring a hole in the middle
for liquid flow, turning grooves on the end, and finally drilling and
tapping additional holes and turning protrusions that permit control
devices to be attached.

New Product Design

New product design is a primary element of production, because valve
production is often very specialized; small numbers of valves must be
produced that are unique to the new application for which they are
ordered. In the 1990s the computer-aided design software used by
valve-producing firms became capable of displaying three-dimensional
images, showing the valve as a solid model rather than as a flat
planar representation. This change speeded design time enormously.
The new software also allows all the properties of the valve, such as
stress loads and the center of gravity, to be calculated automatically,
thus eliminating the need for extensive manual calculations. It also
eliminates the need for a demonstration model and significantly
improves design quality. One firm estimates that the new software has
reduced design time by more than 50 percent and cut the required number
of engineers and draftsmen on a typical job by 30 percent. Thus,
although at least 84 percent of all manufacturers had introduced
computer-aided design in some form by 1997, the very recent move to
three-dimensional design is likely to have a particularly strong
impact on performance.

New Production Methods

Numerically controlled machines were introduced 25 years ago, but
the recently developed computer numerical control (CNC) machines can
produce valve parts much more rapidly. These machines are run by
sophisticated software with a simple graphical user interface that
enables the operator to produce a typical complicated part in one
day, compared with the four days it would have taken previously.
Moreover, the CNC machine is much more versatile. Two CNC machines
are enough to produce a new valve that might have required eight of
the earlier-generation machines 10 years ago.

New Inspection Techniques

A complicated valve often must be machined in each dimension to a
tolerance of 1/1000th of an inch. Therefore inspection is a critical
part of the production process. For many years inspection was done
with manual measuring devices, which was very time consuming.
Inspection machines developed in the last few years instead use a
probe technology, so that the operator simply touches each surface
of the valve with a probe, which then generates a three-dimensional
image and measures all dimensions. The new device can cut inspection
time for a typical complicated valve part from 20 hours to 4.

The Importance of Information Technology

The machines that make today's complicated valves are run by
sophisticated software programs that require high-speed computing and
extensive data storage. These new machines are now available and
affordable because the costs of computing have plummeted, and because
capital goods makers have had time to learn how to harness cheap
computing power by developing the applied software needed to run the
machines. Thus the performance improvement in valve production has
come about partly as a result of high levels of new investment, but
also because the information technology imbedded in all new
machinery enables these machines to perform at rates previously
unachievable.
-----------------------------------------------------------------------------


The result of this integration of computers into steelmaking has
been a significant improvement in performance. Together with other
technological changes, such as larger furnaces and improvements in
casting practices, and the closing of older, inefficient plants, the
new technologies have also contributed to higher product quality and
productivity. Steelmakers today use less than 4 worker-hours to produce
a ton of steel, down from about 6 worker-hours in 1990. The best-
performing mills have achieved results of less than 1 worker-hour
per ton.

Service industries, too, have harnessed information technology to
change the way they do business. The trucking industry is using the
new technology to better serve its customers' logistics needs. To be
efficient, trucking firms must satisfy customers with prompt pickup
and delivery of loads while minimizing unused capacity in the form of
both idle equipment and empty and incompletely loaded trips. By
coordinating information from many shippers and consignees in a
geographical area, firms can reduce wasted movement. To track and
dispatch trucks efficiently, they use sophisticated locating technology,
such as the satellite-based global positioning system; real-time
traffic, weather, and road construction information; computers on
board the trucks themselves; complex software and algorithms; and
supporting hardware to organize customers and loads. The ability to
effectively use information to manage shipments not only contributes
to efficiency but also enables other innovative processes such as
automated exchange of information.

Banks have also used new technologies to improve their processes.
In the mid-1990s retail banks introduced imaging technology to process
checks more efficiently. Digital images of checks are stored on a
central computer and scanned by software that reads the amounts on
the images. Checks are then balanced against deposit slips
automatically. Introducing this technology has freed employees from
having to record check amounts manually, lowered transactions costs by
eliminating the need to move checks physically, and allowed banks to
reorganize their workflow around a more extensive division of labor.

Complementary Changes in Organizational Practices

To fully realize the performance gains from the applied use of
information technology, firms often must make complementary changes
in organizational practices. For example, the information that the
new technology puts in the hands of production line operators is
valuable only if those operators have the authority to use it to
make decisions about the operation of the line. The move to place
greater decisionmaking authority in the hands of line personnel is
one key example of an organizational change that complements the
adoption of information technology and enhances its value. Another
complementary change is in the incentives that operators and other
employees have to use information to make better decisions.

There is evidence that in the last 10 years more firms have placed
greater decisionmaking authority in the hands of the average employee.
The growth of processes to increase employee involvement and the
delegation of decisionmaking to the shop floor, for example through
off-line problem-solving teams or self-directed work teams, indicate
how line employees are performing functions that used to be retained
as management prerogatives. A survey of manufacturing establishments
found that the share of establishments adopting at least one employee
involvement practice (defined as quality circles, job rotation, teams,
or total quality management) rose from 65 percent in 1992 to 85
percent in 1997. The share of establishments reporting the use of
multiple employee involvement practices rose from 37 percent to 71
percent over the same period. As employees take on more responsibility
and are involved in more complex production processes, a greater
premium is placed on skills and cognitive ability. One study showed
a rapid increase during the 1980s and 1990s in the proportion of the
labor force engaged in tasks requiring interactive or analytical
skills, as opposed to tasks based more on following prescribed rules.
Thus firms have an incentive to undertake more extensive screening
of prospective employees and provide more continuing education and
training to those on the payroll. Job rotation can serve as another
way of improving employees' understanding of the firm's processes,
thereby enhancing their ability to solve problems and improve productivity.

Much of this shift in decisionmaking authority to production workers
began before the recent surge of investment in information technology.
In the 1980s the high performance of Japanese manufacturing and the
competitive threat it posed led many U.S. firms to experiment with
or adopt Japanese-like practices. These practices have become even
more valuable as firms have made large investments in information
technology that complement their human resource investments.

A second major complementary change is the greater use of
performance-based pay. Various incentive pay schemes--from
production-based pay to profit sharing to stock option plans--
have been designed to improve employee motivation. A 1998-99 survey
found that 63 percent of respondent firms used some form of variable
pay for nonexecutives. Between 1987 and 1999 the use of profit
sharing and other performance-based incentives at Fortune 1000 firms
increased from 26 percent to over 50 percent. These incentives
perform two functions. First, they motivate employees to improve firm
performance, because the employees share in the resulting monetary
rewards. Second, they provide a screening function, as more highly
skilled and more motivated employees are more likely to be willing
to work in firms where pay is based on performance. One study of
finishing lines in the steel industry found that lines with a set of
supporting innovative work organization and incentive practices
reduced downtime by 7 percentage points.

Stock option grants are a particularly important form of incentive
pay. They have been a part of executive compensation for years, but
grants for nonexecutive personnel are a relatively new phenomenon.
Although only 5 percent of all nonexecutive employees in publicly
held firms received stock option grants in 1999, the proportion rises
to almost 27 percent for those earning more than $75,000 a year.
Moreover, the use of this compensation vehicle appears to be diffusing
rapidly. A 1998 survey of 415 firms found that 34 percent had some
type of stock option plan for nonexecutives. Although this was not
necessarily a representative sample of all U.S. firms, other studies
reach similar findings. This study also found that, of the 88.4
percent of firms that reported the use of any type of variable pay,
17.7 percent indicated that they had introduced a stock option plan
within the past 2 years (Chart 3-11); 8.2 percent reported introducing
profit sharing, and 13.8 percent offered bonuses. Eligibility for
stock options was also broadened more rapidly than were plans for
profit sharing or bonuses. A study of 125 firms that accounted for
about 75 percent of 1997 market capitalization of firms in the
Standard & Poor's 500 index estimated the value of these grants
at about 4 percent of total compensation in 1998.



The use of stock options appears to be highly concentrated in the
high-technology sector. Stock options might be a preferred method of
compensating workers in high-technology firms because they allow firms
with low current (but high expected future) cash flows to offer
higher compensation than they otherwise could. Stock options may also
elicit greater worker effort and productivity by tying the worker's
compensation to the firm's long-term performance. There is little
actual evidence, however, on the performance effects of stock options.
One study did find that the presence of an employee stock ownership
plan or a stock option plan increases labor productivity at the
establishment level, after controlling for other aspects of workplace
practices and establishment attributes. Another study found that,
after controlling for firm size and industry classification, sales
per worker in 1997 were higher in firms that had implemented a
broad-based employee stock option plan. However, it is too early to
draw firm conclusions on the net effects of options on compensation,
especially because the expansion in their use came at a time when
stock prices, and hence the value of stock options, were increasing.
The effect of employee stock option plans may be substantially
different when stock prices are flat or falling.

Significant changes in human resource practices have been documented
in several other industries, including steel, automobiles, apparel,
and customer call centers. These changes have allowed firms to make
better use of the new information technology that has recently become
available.

Changes in Firm Boundaries

Information technology, along with the complementary human resource
practices just described, has also had important effects on firm
boundaries in many industries. (A firm's "boundary" is simply the line
between the set of activities a firm performs for itself and the set of
activities that it pays other firms to perform for it.) Vertical
boundaries describe the firm's relationships with its suppliers and
its customers: vertically integrated firms manage their own supply
lines and have their own marketing and distribution networks, whereas
firms that are not vertically integrated prefer to purchase supplies
from independent dealers and to contract out their marketing and
distribution to retailers. Horizontal boundaries describe the firm's
relationships with its rivals: some markets are dominated by a few
large, horizontally integrated firms, whereas in others many smaller
firms compete for customers.

Information technology has frequently led to tighter, more closely
integrated relationships between firms and their suppliers and between
firms and their customers, without necessarily leading to full vertical
integration. Indeed, the declining cost of exchanging information
between firms has led many firms to outsource functions previously
performed in house. At the same time, information technology has led to
substantial consolidation in industries such as telecommunications and
financial services, representing an increase in horizontal integration,
although in some cases changes in regulation and competition have been
more important motives for consolidating.

Supplier Relationships

Today's consumer goods pass through complex supply chains, which the
application of information technology can make more efficient. In many
industries today, the supply chain involves a number of firms performing
a variety of distinct functions, all of which are necessary to bring a
product to market. These firms may create or extract primary materials,
design and assemble those materials into more complex components,
transport intermediate and finished products, or offer them for sale
to the consumer. The efficiency of this system depends on the speed
with which it delivers final products to consumers, the amount of
inventory that is locked up in the supply chain at any given time,
and, of course, the efficiency of each firm in the chain.

Information technology, combined with changes in business practices,
has enabled firms to reduce costs and increase efficiency in their
supply chains, as is evident in retail trade. In the retail sector,
sharing of point-of-sale data between a firm and its suppliers, a
practice that received considerable attention in the 1980s, has become
increasingly widespread, improving the flexibility and efficiency of
distribution systems and lowering costs for consumers. For example,
over 97 percent of grocery stores now use scanners to collect point-
of-sale data. Efficient customer response (ECR) systems that share
this point-of-sale data with suppliers to improve the efficiency of
the supply chain were introduced in 1992. These systems take into
account customer demand in an individual store as well as the complete
economics of the supply chain. One recent study showed that ECR
adoption was associated with higher productivity: firms that had gone
further in their efforts to adopt ECR had higher sales per labor hour
and per square foot and turned over their inventories more often than
other firms. The study was not able to establish the direction of
causation, however. In many industries these changes have redefined,
or promise to redefine, the relationship between a firm and its suppliers.

More drastic improvements in efficiency, driven by Internet
technology, are occurring in other industries. In some cases, new firms
have entered the market to simplify complex purchasing processes. For
example, in the highly specialized life science research supply business,
scientists at tens of thousands of different laboratories in hundreds
of firms and universities purchase over 1 million distinct products
manufactured by hundreds of firms to conduct their experiments. For a
laboratory scientist, ordering these products has traditionally
involved searching through 500-page catalogues from multiple suppliers,
filling out forms to send to the purchasing department, and faxing or
phoning in an order. The typical cost of processing orders in this way,
including paperwork and employee time, has been estimated to be around
$100 per order. Using the Internet, one firm has created an on-line
marketplace with over 1 million products and has streamlined the
ordering process and the interface between the purchasing department
and the scientist. This technology promises to reduce the total cost
of placing an order to about $10.

On-line business-to-business (B2B) exchanges have emerged to seek
even greater efficiencies in the industrial procurement process. Some
of these exchanges are industry-specific, whereas others offer a broad
range of industrial products, commodities, and services to multiple
industries. B2B exchanges offer a range of transaction tools, such
as auctions, centralized clearing for payments, credit information
about trading partners, and other custom services that allow greater
efficiency in procurement. One on-line exchange claims to have saved
customers $2 billion during its 5 years in operation. An on-line
exchange for the steel industry boasts a clientele of 220 mills, 647
service centers, 909 fabricators, 352 distributors, and 626 trading
companies.

One market research firm estimates that B2B sales over the Internet
rose to $200 billion in 2000, from about $40 billion in 1998.
Projections vary widely but tend to agree that this dramatic growth
will continue in the near future. The efficiencies of B2B commerce
are likely to extend the performance gains already realized in
aggregate inventory statistics. Inventories in a wide range of
industries have fallen steadily over the past decade, with significant
declines in apparel and department stores and among manufacturers of
industrial and electronic goods. For example, in the early to mid-
1990s, firms in the apparel industry reduced their inventories by an
average of 1.2 percent per year, and their inventory-to-sales ratios
by an average of 5.2 percent per year, by adopting information
technology and a modular, team-based system of production that
improved flexibility.

Many firms are outsourcing, or contracting out, functions they
previously performed themselves. Indeed, outsourcing has grown
rapidly. Between January 1993 and October 2000, employment agency
payrolls grew 99 percent, and management consulting services grew
about 94 percent (Chart 3-12), while economy-wide employment growth
was a much smaller 20 percent. Firms routinely outsource strategic
development and the management of their information technology, human
resources, and facilities operations to firms that specialize in
these functions.

Firms choose to outsource for any of several reasons. Contractors
that specialize in a particular function may have competitive
advantages in performing these functions relative to in-house staff
and service groups, and reducing operating costs is one of the most
frequently cited reasons for outsourcing. Contracting out can
contribute to a firm's productivity in other ways. By letting others
provide services that are ancillary to the company's



primary business, outsourcing allows management to focus its effort
on doing its core business better. In addition, outsourcing provides
firms with access to expertise that would be costly and time-
consuming for the firm to recruit and bring on staff. This expertise
can also bring in new ideas and innovations learned from other firms
in the industry or beyond. Finally, firms can use outsourcing to
achieve greater flexibility: they can quickly access capabilities as
needed and with less investment in physical plant and less overhead.
At the same time, however, outsourcing carries risk for firms and for
their employees. Management may lose control of key operational
functions or skills. And some temporary employees may be paid less
than regular employees and be less likely to receive benefits such as
health insurance.

Firms have other choices besides outsourcing and in-house
production. They can engage in strategic alliances, which are
long-term agreements between firms to share facilities, expertise,
and other resources to accomplish joint goals. U.S. firms have been
particularly active in this area, accounting for about half of all
alliances among firms based in OECD countries during the 1990s.
Strategic alliances, like other long-term contracts, allow firms to
combine some aspects of their operations without incurring the costs
of full integration. For example, an alliance with a key supplier can
help stabilize the supply chain, whereas a marketing alliance may
allow firms producing complementary products to pool their resources
for greater joint gains. (A movie studio might form an alliance with
a fast-food restaurant chain to promote a new release, for example.)
Also, as discussed earlier in this chapter, firms may ally in order
to develop a new technology or to exchange existing technical
capabilities.

Customer Relationships

Information technology has also enabled firms to communicate more
closely with their customers, and thus to be more responsive to
customer preferences and to produce goods and services that reflect
those preferences. Firms are using information technology in a number
of ways to improve marketing and customer service. As the costs of
computing and data storage have fallen, firms' efforts have shifted
away from mass marketing, in which each potential consumer receives
the same message, to more interactive marketing (sometimes called
micromarketing). Interactive marketing uses information about a
customer's prior purchase behavior, credit history, location, and
income to provide that customer with information about products he
or she might be likely to purchase. Database technology has made this
type of marketing feasible on a broad scale. On-line book and music
retailers now provide their customers with real-time recommendations
for additional purchases based on the customer's purchase history,
and grocery stores use customer data to tailor the choice of cents-
off coupons offered at checkout. The same database technology,
combined with reduced costs of communication, has enabled firms in a
number of industries to provide customer service at lower cost over
the phone. Firms in industries from telecommunications to financial
services to consumer goods have established telephone call centers
to handle customer questions and to provide product support.
Information technology allows these centers to be based almost
anywhere in the world, and service representatives at these centers
to access the entire history of a customer's account during the call.
The ability to store and retrieve these data quickly has made customer
information a strategic asset, one that firms are increasingly
looking to take advantage of.

The Internet is radically altering how producers and sellers of
consumer goods interact with their customers. A manufacturer or
retailer can now communicate with customers anywhere in the world at
relatively low cost. A number of firms have taken advantage of this
capability, offering products and product information via the
Internet. Consumers with access to the Internet can now do comparison
shopping at very low cost before leaving the house or placing an
on-line order. Internet sales to consumers reached $17.1 billion in
the first three quarters of 2000 (but still account for less than 1
percent of all retail sales). The Internet has also created whole new
trans-action mechanisms, such as on-line auctions. A significant
fraction of all Internet consumer auctions are for secondary goods and
remainders. This suggests that total trade in these goods may be on
the rise.

Market Structure

Technology has also affected the structure of many markets, making
some more highly concentrated while leading others to become more
fragmented. Markets for many software products and information
services, for example, have been dominated by big players with large
market shares. Ownership of a particular technology standard is
often an important source of competitive advantage if that technology
cannot be imitated, and this can lead to market concentration. In the
United States, information technology standards are often established
in a decentralized manner, through the free play of the market,
rather than through a centrally coordinated effort. Markets with
strong network effects are often characterized by "tipping." When it
becomes apparent that one technology has a large enough lead, the
market may "tip," with nearly all new consumers from that point
forward adopting the dominant technology. In such winner-take-all (or
winner-take-most) markets, a firm faces crucial decisions about
whether to make its product compatible with past and future
generations of products, and whether to base its product on open or
proprietary technology. Intense early competition to build a base of
loyal users may result. Firms may also use strategic product
preannouncements to establish a stake in a new market and head off
competition.

This propensity of markets with network effects to tip poses
challenges for regulators and antitrust authorities as one or a few
firms begin to dominate. It also encourages cooperation among
competitors within an industry to promote a standardized technology.
In cases where formal alliances or joint ventures are created, the
costs of developing intellectual property are often shared, as are
marketing expenses. As the U.S. legal code and U.S. antitrust
authorities have recognized, such collaboration need not preclude
vigorous competition in the product market.

In industries such as telecommunications, energy, and financial
services, many markets have become more concentrated as firms combine
their operations through mergers and acquisitions. In financial
services the primary sources of structural change have been
information technology and deregulation. For instance, ever since
passage of the Bank Holding Company Act of 1956, geographic
restrictions on banks have been slowly lifted, enabling them to
expand gradually across State lines. Although barriers to interstate
banking were not completely removed until the enactment of the Riegle-
Neal Interstate Banking and Branching Efficiency Act of 1994,
regional and interstate pacts enabled bank holding companies to
operate across State lines. One study estimates that, by 1994, a
bank holding company in a typical State had competitive access to
nearly 70 percent of U.S. gross domestic banking assets.

As banks have expanded, they have also begun to consolidate. Over
a third of all banking organizations nationwide disappeared between
1979 and 1994, even as total banking assets continued to increase.
Between 1988 and 1997 the numbers of stand-alone banks and top-level
bank holding companies both fell by almost 30 percent, while the
share of U.S. banking assets held by the top eight banking
organizations rose from 22.3 percent to 35.5 percent. In 1998, 4 of
the top 10 U.S. "mega-mergers," based on market value, occurred in
financial services. These changes are not confined to the United
States: two Japanese bank mergers currently pending will create the
two largest banks in the world, with about $2.5 trillion in assets
between them.

Deregulation is thus an important spur to geographic diversification
and consolidation. Past geographic restrictions on competition may
have allowed inefficient banks to survive, and consequently the
gradual removal of these restrictions has transformed the structure
of the industry. One study shows that bank efficiency improved
substantially as restrictions on intrastate branching and interstate
banking were removed. As a result, the share of deposits held by
subsidiaries of out-of-State bank holding companies increased from 2
percent in 1979 to 28 percent in 1994. Meanwhile, the Glass-Steagall
prohibition on combining commercial and investment banking in the
same enterprise is slowly being lifted. In 1987 the Federal Reserve
Board began permitting bank holding companies to engage in limited
nonbank activities through so-called Section 20 affiliates. Section
20 activities were originally limited to 5 percent of a subsidiary's
total revenue, but the limit was raised to 10 percent in 1989 and 25
percent in 1996.

In 1999 many of the Depression-era restrictions on banks were
formally removed with passage of the Financial Modernization Act
(also known as the Gramm-Leach-Bliley Act). This legislation lifts
these regulatory barriers by creating a uniform regulatory framework
governing affiliations among different financial services
institutions, and by expanding the range of investments available to
these firms. The new law allows banks, security firms, and insurance
firms to affiliate under a new rubric, that of a financial holding
company. By November 2000, 456 such companies had been formed, with
assets totaling 13 percent of all U.S. financial sector assets.

Expansion, consolidation, and diversification can bring about
performance improvements by allowing financial institutions to
realize economies of scale. These scale economies are largely driven
by innovations such as new financial instruments, new risk management
techniques, automatic tellers, improved back-office operations, phone
centers, and Internet banking. Recent evidence indicates that bank
efficiency has indeed improved, particularly when new banking
organizations have been created through mergers and acquisitions.
Large banks have also made significant improvements in their
abilities to manage risk; the costs of financial distress,
bankruptcy, and loss of charter have been reduced. Moreover, despite
fears that large banking organizations would focus exclusively on
large customers, bank mergers and acquisitions have not adversely
affected small business lending. The Department of Justice's Antitrust
Division, along with the Federal Reserve Board, is careful to consider
the impact of mergers on the communities to be served before approving
any reorganization.

Explaining Changes in Firm Boundaries

As these examples have shown, firms are tightening some supplier and
customer relationships, outsourcing other aspects of their operations,
and in many cases consolidating business activities with former rivals.
These and other changes in firm boundaries are best understood within
the contractual framework associated with the Nobel Prize-winning
economist Ronald Coase. Coase was the first to explain that the
boundaries of an organization depend not only on its productive
technology but also on the costs of transacting business. In the
Coasian framework, the decision whether to organize transactions
within the firm or on the open market--the make-or-buy decision--
depends on the relative costs of internal and external exchange.
Use of the market mechanism entails certain costs: discovering the
relevant prices, negotiating and enforcing contracts, and so on.
Within the firm, entrepreneurs may be able to reduce these
transactions costs by coordinating these activities themselves.
However, internalizing brings other kinds of transactions costs,
namely, problems of information flow, preserving incentives,
monitoring effort, and evaluating performance. The boundary of the
firm, then, is determined by the trade-off, at the margin, between
the relative transactions costs of external and internal exchange.
In this sense a firm's boundaries depend not only on technology but
also on organizational considerations, that is, on the costs and
benefits of various contracting alternatives.

The above examples suggest ways in which information technology
may alter these boundaries by influencing transactions costs. In the
case of supplier relations, communications and coordination with
suppliers is facilitated by e-mail, automated information exchange,
and particularly by B2B Internet use, all of which should reduce
firms' tendency to be vertically integrated. However, at the same
time, information technology also reduces the costs of coordinating
activities within the firm, so the net effect on vertical boundaries
is ambiguous. Moreover, information technology may lead to expanded
horizontal boundaries, as high-speed communications across plants in
different countries now allows firms to grow as they exploit their
comparative advantages in global markets. Perhaps for these reasons,
it is difficult to detect any economy-wide changes in vertical or
horizontal boundaries, although distinct patterns are discernible
within particular industries.

Competition and Strategy

Firms face a variety of strategic decisions. So far this chapter has
discussed the decisions surrounding the adoption of information
technology, reorganization of the workplace, and the fixing of the
firm's vertical and horizontal boundaries. These and other decisions
are made with the goal of outperforming rivals, that is, of achieving
what the strategic management literature calls sustained competitive
advantage. An important source of sustained competitive advantage is
the possession of unique resources, such as firm-specific knowledge
or capabilities, an installed base of users, valuable patents, or a
popular proprietary standard. In the new, knowledge-based economy,
such intangible resources have become increasingly important.

Intangible Capital

Success in the New Economy relies on intangible capital. In a market
characterized by intensified competition (driven by globalization and
deregulation) and rapid product and service innovation, corporations
must innovate continuously--creating new products or services and
producing them with new, more efficient processes--to stay
competitive. Thus, intangible assets--organizational practices, human
resources, R&D capability, and reputation--are now much more prominent
features of a firm's competitive strategy, because they are the
foundation for innovations that lead to success. New organizational
practices provide the ability to respond quickly to new opportunities.
Appropriate human resource practices, such as an emphasis on training
and the design of appropriate incentives, provide firms with employees
who are able and eager to recognize, create, and develop opportunities.
An R&D program that is good at conceiving ideas and converting them
into products provides a stream of innovations. A favorable
reputation, embodied in brand names, trademarks, and customer
loyalty, can provide the trust on the part of customers that
encourages their acceptance of a firm's latest product innovations.

One indicator of the importance of intangible capital is what
economists call Tobin's q, which is the ratio of a firm's market
value to the cost of replacing its underlying tangible capital. One
interpretation of a high q is that a large part of the firm's value
derives from intangible capital. As Chart 3-13 shows, Tobin's q for
publicly traded U.S. firms rose throughout the 1990s. This is
consistent with an increasing importance of intangible capital.

Information Goods

It is said that information, not tangible products, is the most
important economic good in the New Economy. Of course, so-called
information goods, from books, music, and television programs to the
yellow pages and real-time stock quotes, have long been important to
the U.S. economy.



During the last decade, however, innovations in duplication,
storage, and transmission have sharply reduced the cost of delivering
information goods to consumers. These falling costs have led to
increased entry by firms seeking to deliver new information products
and have led incumbent firms to revisit their strategies for
maximizing the value of the information they create and distribute.

The production of information tends to be characterized by high
fixed costs and low variable costs; computing and the Internet reduce
the latter nearly to zero. When consumers' preferences are relatively
similar, markets for information goods may be highly concentrated.
For example, few markets are served by more than two yellow pages
providers. However, when consumers' preferences vary widely, multiple
producers may enter the market and find it profitable to focus on
small groups of consumers. For example, although the major television
networks still account for over half of viewership in prime time,
hundreds of other cable television channels now cater to specific
viewer tastes.

The low cost of distributing information via the Internet has led
information providers to rethink yet again their strategies for
reaching consumers. Many magazines and newspapers now offer free
on-line versions of their paper products. Some of these firms offer
additional unique on-line content for free; others offer premium
services such as customized content for an additional fee. Some
information providers have integrated with distribution channels such
as cable operators and even Internet access providers, whereas others
have chosen to remain independent.

Internet Retailing

For retailers and manufacturers of branded consumer goods, the
Internet has created a whole new distribution channel. This has raised
significant issues about how to compete, especially for firms with
investments in physical distribution infrastructure. For manufacturers
that have traditionally sold through intermediaries such as department
stores or specialty retailers, the Internet makes direct sales to
customers possible. However, for these firms to sell directly through
the Internet, they must undertake activities that are new to them,
such as retail billing, order fulfillment, delivery, and handling of
individual returns. The potential profits from additional sales at
retail prices must be measured against the cost of developing these
new capabilities and against potential loss of sales through existing
channels. A major sports apparel producer now sells through four
different channels: sporting goods stores, department stores,
company-owned stores, and the Internet. For traditional bricks-and-
mortar retailers, on-line sales may compete directly with their own
retail business. This has led some firms, such as one large book
retailer, to separate their on-line and bricks-and-mortar operations
in order to offer greater flexibility to both. Other retailers have
chosen hybrid strategies, allowing customers to buy on line but
funneling all returns and customer service through existing stores.
Some bricks-and-mortar retailers have forged partnerships with
on-line retailers to satisfy the needs of on-line shoppers.

Understanding Performance Gains

This chapter has documented the extensive changes in firm
organization and strategy brought about by technological change.
Ultimately, however, to explain the effects of information technology
on the aggregate productivity gains reported in Chapter 1, these
technological and organizational improvements must be linked to
realized performance gains. Fortunately, new studies are beginning
to document the performance effects of information technology and
associated organizational changes at individual plants and firms.
This evidence strongly supports the idea that the new technology,
when combined with the appropriate organizational structures, has
improved performance, and did so especially in the 1990s.

How Do Technology and Organizational Change
Improve Performance?

As already emphasized, investments in information technology work
best when combined with complementary changes in business and
production practices. Performance improvements are most likely to be
realized when firms couple these investments with changes in basic
business practices, such as in job design, organizational structure,
and interactions with customers and suppliers, and changes in human
resource practices, such as in incentives and decisionmaking
authority, that are designed to allow employees to use the new
technology most effectively. Differences in the patterns and rates
at which plants adopt these complementary practices may explain why
the productivity effects of investments in information technology
did not come immediately and still have not been realized by all firms.

The lag and variability in productivity gains after investing in
information technology may be due to the time it takes for employees
to adjust to the new technology. Implementing automated equipment
initially causes disruption, as employees must learn new practices
and understand that the operating procedures and priorities in place
under the old technology may not be appropriate with the new
technology. Introducing the newly needed skills into the work force--
either by retraining or by hiring new workers with the appropriate
skills--takes time, and productivity can fall during the transition.
For instance, the introduction of electronic controls into automobile
engines, transmissions, and auxiliary equipment and the development
of computerized diagnostic equipment forced some mechanics to learn
new skills. Several studies note that the disruptions caused by
retraining can be so severe that firms choose to implement new
technologies in greenfield sites--newly built plants with new
employees who do not have to unlearn the old practices.

A second reason for the lag and variance is the need to match
organizational structure to technological capabilities. In
particular, giving employees authority to make decisions on workflow
and machine scheduling, structuring employee compensation systems to
align employees' interests with those of the firm, and implementing
teamwork structures that effectively use employee skills all can
increase the productivity of information technology. Those plants
that adopt complementary human resource practices along with
information technology tend to see greater performance improvements.
For example, precision metal-cutting plants that redesigned work
responsibilities to allow the operators to perform program editing
were found to be 30 percent more efficient than plants where no
production workers were given these responsibilities.

Research on information technology-related productivity at the
firm level is difficult, in part because investment in the new
technology is difficult to measure. However, a few studies have
assessed the impact of such investments at the firm level. These
also suggest that information technology, when combined with
complementary human resource practices, can lead to performance
gains. One study of the use of information technology in a nationally
representative sample of over 1,600 firms found that increasing the
share of the production work force that uses computers from 10
percent to 50 percent increased labor productivity by 4.8 percent.
When increased computer utilization was coupled with profit sharing
and implementation of employee involvement practices such as self-
managed teams, labor productivity rose by another 6 percent in
nonunion plants and 15 percent in union plants. Another study, this
one of service and sales teams at call centers, found that self-
managed teams improved sales productivity by 9.3 percent, and
introducing new technology improved it by 5.3 percent. But when new
technology and self-managed teams were combined, the result was an
additional 17 percent rise in productivity above and beyond the
individual effects. Although these studies cannot establish
definitive causal relationships, the examples described in this
chapter strongly suggest that information technology, when combined
with appropriate organizational practices, can improve performance.

The Dynamics of Market Competition

The New Economy is characterized by both high profitability and
high risk. Over a hundred new e-commerce startups have already shut
their doors. Others, however, have made inroads against the
established firms in their industries, and some have even transformed
their industries.

Competition and Creative Destruction

Market competition is a dynamic process whereby entrepreneurs
constantly launch new companies to challenge existing ones,
occasionally replacing them but just as often failing. This process--
what the economist Joseph Schumpeter called creative destruction--is
apparent in the U.S. economy today. As Chart 3-14 shows, the
remarkable growth of the U.S. economy in the 1990s brought no
reduction in business failures. Throughout the current expansion,
business failures have hovered near their post-1980 average.

As these statistics suggest, today's firms are subject to
remarkably intense competitive pressure, from both domestic and
foreign sources. Nonetheless, corporate profits have exhibited
strong growth, rising in real terms at a 5.7 percent annual rate
from 1993 through mid-2000. This compares more than favorably with
the period between 1980 and 1992, when real corporate profits rose
at a 2.2 percent annual rate, and with the period between 1950 and
1992, when real corporate profits rose at a 3.2 percent annual rate
(Chart 3-15). In short, a high rate of business failure is not
necessarily a sign of economic weakness. Rather, it may simply
reflect the market-driven process of shifting resources and
adjusting the structure of production to meet consumers' changing needs.



The Impact of Globalization

Along with the technological and organizational changes that this
chapter has described, increasing global trade has made markets more
competitive, with dramatic effects on firm behavior and performance.
If a firm is exporting and competing in a variety of markets, it
might be forced to improve its performance in order to penetrate
overseas markets with strong domestic suppliers. Likewise, an
increase in imports may lead domestic industries to search out ways
to be more efficient, ultimately making them better at competing with
foreign producers.

Evidence from the manufacturing sector suggests that good firms
become exporters. Less clear is the answer to the opposite question:
does exporting make a firm better? At the firm level there appears to
be no significant causal link between exports and productivity.
Microeconomic evidence from the Republic of Korea and from Taiwan
reveals few industries where it can be argued that exporting alone
aids performance. However, aggregate data show a correlation between
trend productivity and export demand: an economy that exports more
will likely have higher aggregate performance than one that exports
less. This relationship appears to be stronger for high-technology
industries. Nonetheless, the effect is smaller than that found for an
equivalent increase in domestic demand. It could be that firms find
it difficult to meet a wide variety of foreign regulations and
satisfy a wide range of foreign preferences while maintaining efficiency.

Increased import competition is also associated with an increase
in trend productivity. Combined with the observed link between export
demand and productivity, this suggests that the economy as a whole
allocates resources better when subjected to global competition. In
part, this may be because imports spur imitation and innovation: a
new foreign good introduced into the United States creates new
demand, which challengers then seek to capture or duplicate with
products of their own. Evidence from Japan suggests that it was import
competition, not increased exports, that boosted the Japanese economy
during its high-growth period from 1964 to 1973. A study of the
aftermath of Chile's massive trade liberalization in the 1980s found
that productivity in import-competing firms improved an average of
3 to 10 percent more than that in firms producing nontraded goods.

Conclusion

Technology has been a driving force behind the performance gains
that are associated with the New Economy. With advances in
information technology, firms have accelerated their investments in
the new technology. It appears that sustained investment in
information technology began to pay off handsomely in the 1990s, in
the form of higher productivity within and across sectors. But it
takes time for firms to realize these performance gains. They must
first integrate information technology into their business or
production processes, often through the development of highly
specialized software. They also face important organizational and
strategic choices about the best uses of new technologies and the
increased availability of information. At the same time, increasing
global competition and deregulation have given firms the incentives
and the opportunities to seek ways of accelerating their performance.

Not all firms will be equally successful at implementing
technological and organizational changes, and cyclical factors will
diminish the gains at times. As discussed above, new firms have been
important drivers of change, particularly in the information
technology sector. However, innovation is by nature a risky endeavor,
and many new ventures will fail. Equity values will continue to
fluctuate. Entrepreneurs, investors, and workers must be prepared
for the disturbances that typically accompany economic change.
Moreover, the economy as a whole will continue to experience the
rise and fall of the business cycle, making underlying productivity
trends difficult to discern.

Although the impressive performance of the New Economy is
ultimately due to the creativity and hard work of market
participants, U.S. policies have helped create an environment that
encourages entrepreneurship. The United States places relatively few
restrictions on the movement of capital and labor, so that firms and
individuals can respond when profit opportunities arise. The United
States also imposes relatively low tax rates, so that individuals
can realize the rewards of their innovation and effort. Extensive and
relatively unfettered capital markets in the United States give
entrepreneurs access to the financial resources they need to
innovate. The U.S. government has practiced fiscal restraint, reducing
interest rates and freeing capital for private sector use. And U.S.
policies have provided direct support for R&D, along with indirect
support through tax incentives for private sector investments. These
policies have proved extremely valuable to firms and industries, and
it is essential that they be continued.