[Economic Report of the President (2005)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 6

Innovation and the
Information Economy


Innovation is a primary engine of economic growth. Many commonplace
features of modern life, such as personal computers, the Internet,
e-mail, and e-commerce, have developed and diffused throughout the
economy within a short span of years. Our Nation's growing
prosperity depends on fostering an environment in which innovation
will flourish.
The innovative process involves the invention, commercialization,
and diffusion of new ideas. At each of these stages, people are
spurred to action by the prospect of reaping rewards from their
investment. In a free market, innovators vie to lower the cost of
goods and services, to improve their quality and usefulness, and--
most importantly--to develop new goods and services that promise
benefits to customers. An innovation will succeed if it passes the
market test by profitably delivering greater value to customers.
Successful innovations blossom, attracting capital and diffusing
rapidly through the market, while unsuccessful innovations can
wither just as quickly. In this way, markets allow capital to flow
to its highest-valued uses.
This engine of growth can falter, however, if government policies
distort the market signals that guide innovative activity. Well-
meaning policies to promote the diffusion of a service or foster
entry into new markets can have unintended consequences. A policy
to subsidize an existing service so that more people will consume it
can deter development of innovative new services that people might
otherwise prefer. In addition, pioneering investors forced to share
the fruits of their investment with new entrants would find it less
profitable to invest in the first place, and a new market may never
be developed. When government regulation, instead of a competitive
process, "picks the winners," people tend to lose.
This chapter provides an overview of recent developments in one
especially innovative sector of the economy: information technology.
The main points in this chapter are:
  Information technology is a key contributor to economic
growth and productivity, and its importance to the economy
is growing.
 Competition drives the broad diffusion of innovative low-cost,
high-quality information services. This has held true in
markets for mobile wireless telephones, satellite
television, and dial-up and broadband Internet services.
 As circumstances change and industries evolve, existing
government regulations may need rethinking. In particular,
economic regulations aimed at correcting an absence of
competition may lose their rationale when competition from
new technologies emerges.
 People are motivated to invest by the prospect of earning
returns on their investment. Government thus has an
important role to play in defining and protecting property
rights in intellectual and physical capital so that
entrepreneurs will be spurred to innovate.
Growth of the Information Economy
Information technology (IT) has made enormous contributions to
recent economic growth. IT comprises four categories of industry:
(1) hardware (such as semiconductors and computers), (2) software/
services (such as prepackaged software and data processing), (3) communications equipment (such as household audio and video
equipment), and (4) communications services (such as telephone
services and cable and other pay television services).
IT has made many workplace tasks easier, boosting people's
productivity. One recent study finds that labor productivity in the
nonfarm business sector grew at an annual rate of 2.4 percent from
1996 through 2001, and attributes nearly three-quarters of this
growth to the accumulation of IT capital together with improvements
in how people use this capital. IT has likewise contributed
significantly to growth in our prosperity. Real gross domestic
product (GDP) grew 2.9 percent in 2003, of which 0.8 percentage
point was attributable to IT (Chart 6-1).
Growth in Computer and Internet Use
A key part of the growing information economy is that more people
are using computers and communicating over the Internet. At the time
of an October 1997 survey, 37 percent of households owned a computer.
The corresponding figure for an October 2003 survey was 62 percent.
Internet use from home nearly tripled over these six years from 19
percent of households in 1997 to 55 percent in 2003. In the
workplace, recent growth in Internet and e-mail usage has also been
dramatic. A survey found that in August 2000, 26 percent of employed
persons aged 25 and over used the Internet and e-mail at work, while
an October 2003 survey found the figure to reach 45 percent.
Explosive growth in Internet use has been a nationwide phenomenon.
In 2001, only one state had more than 70 percent of its population
using the Internet from any location. In 2003, five more states had
reached the 70 percent level, and only one state fell below the
50 percent mark. At 57.2 percent, Internet use in 2003 among people
living in rural areas was virtually on a par with the national
average of 58.7 percent. Demographically, Internet use increases
with both income and educational attainment.



E-mail is the most common online activity, with more than 87
percent of Internet users aged 15 and over sending and receiving
e-mail in 2003. The next most popular online activity, at more
than 76 percent of Internet users in 2003, is searching for
information about products and services. Two-thirds of Internet
users obtained news, weather, and sports information online, and
more than half made purchases online in 2003.
E-Commerce Tops $1 Trillion
Transactions conducted online--e-commerce--exceeded $1.1 trillion
in 2002. Business-to-consumer e-commerce, reckoned as the sum of
transactions in retail trade and in selected service industries
(such as publishing, broadcasting, and telecommunications), reached
$85 billion in 2002 (Chart 6-2). Retail trade e-commerce alone
amounted to $44 billion in 2002, with nonstore retailers--those
selling primarily through "clicks" rather than "bricks"--
accounting for nearly three-quarters of this total. Online retail
sales have continued to grow rapidly. In the third quarter of 2004,
retail trade e-commerce was more than 21 percent higher than in the
third quarter of 2003.

Consumers have gained from shopping online in at least two ways.
First, comparison shopping has become quicker and easier online. A
consumer can visit a succession of retail Web sites at virtually
zero cost. Collecting a similar amount of information by visiting
brick-and-mortar retail stores would be far more time-consuming and
costly. A consumer need not even canvass retail Web sites
individually; "shopbot" sites can gather such information on the
consumer's behalf. As the cost of comparison shopping has fallen,
price competition has intensified, both among Internet retailers
and between Internet retailers and brick-and-mortar stores.
A number of recent studies have attempted to gauge the consumer
benefits from such intensified competition. Studies of the markets
for books, automobiles, and life insurance have generally found
that comparison shopping online helps consumers obtain significantly
lower prices, resulting in savings estimated to be in the many
hundreds of millions of dollars per year. Intensified competition
between online retailers and brick-and-mortar retailers means that
even consumers who do not shop online may be reaping rewards from
the spread of e-commerce.
A second way in which consumers have benefited from e-commerce is
in the greater variety of goods available online. For example, the
number of book titles available at one major online bookseller is
23 times greater than the number of titles stocked in a major chain
retail superstore. Greater variety means that consumers can match
purchases more closely to their individual tastes. A recent study of
book sales suggests that the consumer gains from greater variety
online are even larger than the gains from intensified price
competition.




Changed circumstances, such as new retailing methods, can pose
challenges to existing regulatory frameworks, or even undermine the
original rationale for regulation. As the Internet changes how we
live and work, government should be attuned to these changes and
adapt. The Internet is having an impact on regulation given the
growth of e-commerce, as illustrated in Box 6-1, and the growth of
broadband voice and data services, as discussed in a later section.
Although business-to-consumer online sales have captured much
popular  attention, these are dwarfed by business-to-business
e-commerce, which in 2002 accounted for more than 90 percent of all
online transaction volume. Manufacturing shipments transacted online
were $752 billion in 2002, a 3.8 percent increase over 2001 (Chart
6-3). Online merchant wholesale trade increased by 11.7 percent
from the 2001 level, to reach $320 billion in 2002.
______________________________________________________________________

Box 6-1:  Airline Computer Reservation Systems

In the first half of 2004, the Administration deregulated airline
computer reservation systems (CRS), which travel agents have used to
book airline flights for travelers. Regulatory restrictions imposed in
the 1980s became obsolete as people gained new information sources over
the Internet. CRS centralize flight information across carriers and
provide easy booking capabilities to travel agents. Following airline deregulation in the late 1970s, travel agents came to depend on CRS for
the latest schedule and fare information. At the time, CRS were largely
owned by individual airlines. This ownership raised concerns that
CRS-owning airlines might put rival airlines at a disadvantage in the
system so that travel agents would book a greater share of flights with
the CRS-owning airline. CRS suppliers might also lock travel agents in
by requiring long-term contracts and by structuring the programs to
raise switching costs. To address these issues, the Civil Aeronautics
Board instituted a series of regulations in 1984, which prevented a
CRS-owning airline from setting up its systems in a way that
disadvantaged other airlines or other CRS.
While the CRS rules may have been beneficial two decades ago,
subsequent industry changes have made the regulations largely
anachronistic through ownership changes and the development of travel
search engines on the Internet. The airlines have completely divested
the CRS, so concerns about discrimination against unaffiliated airlines
are no longer warranted. Equally important, the advent of the Internet
has provided carriers with an alternative avenue for disseminating their
fare and schedule information to consumers. The growth of the travel
search engines has also enabled consumers to quickly compare rates
across airlines. The development of these direct-to-consumer channels
has reduced the need for travel agencies and has reduced travel
agencies' need for CRS, because they too can use the Internet. These
changes work to place greater competitive pressure on the CRS vendors,
which reduces the concern about their market power. In light of these
changes, the Administration acted to deregulate the CRS market in the
first half of 2004. Deregulation already appears to be having a
positive effect--industry news reports indicate that CRS prices have
fallen and are expected to continue to fall as old contracts expire and
new ones are negotiated.

______________________________________________________________________





In 2002 online transactions among businesses were larger than
business-to-consumer e-commerce not only in absolute terms, but also
as a fraction of total value. Only 1.4 percent of retail trade
revenues were transacted online in 2002. By contrast, 11.7 percent
of all merchant wholesale trade and nearly one-fifth of all
manufacturing shipments were transacted online in 2002.
Illegal Acts on the Internet
The Internet provides tremendous opportunities to improve the way
we communicate, learn, entertain ourselves, and buy and sell goods
and services. Unfortunately, theft, vandalism, and fraud are also
moving online. From an economic perspective, these activities are
costly because they violate the property rights of people, reducing
their incentives to create new goods and diverting resources from
productive uses as people spend time trying to undo the damage
caused by computer viruses and Internet worms. More fundamentally,
the growth in such activity could threaten public confidence in
using the Internet for productive purposes. As in the offline world,
where locks and inventory control tags deter property right
violations, private sector responses can make cybercrime more
difficult. Government must also act to protect property rights and
ensure that the Internet and other new technologies are safe venues
for commerce.
Cybersecurity
The growing reliance on the Internet means that computer users are
exposed to new threats. Viruses and Internet worms impair computers
and prevent authorized users from gaining timely, reliable access to
data or a system. Attacks in cyberspace can maliciously modify,
alter, or destroy data or a computer system. Attackers access
computers without authorization to view or copy proprietary or
private information, such as a credit card numbers or trade secrets.
At a deeper level, concerns have grown about how unauthorized
control over large numbers of systems by those with malicious intent
can pose threats to the security of sensitive information or to the
functioning of critical infrastructures. In terms of prevention, the
private sector is best equipped to take steps against evolving cyber
threats. The private sector owns most of the computer systems and
networks and can, in many cases, capture the benefits from
investments in improved security. Private sector surveys suggest
that organizations are spending increasing amounts on IT security.
The President's National Strategy to Secure Cyberspace also makes
clear the Federal government's important role in promoting
cybersecurity.
Fraudulent Spam and Spyware
Scams to defraud people are another type of property rights
violation. The Federal Trade Commission (FTC) has found that spam
(unwanted, typically commercial e-mail), in addition to being a
nuisance, is mostly deceptive and fraudulent. Of 1,000 pieces of
spam examined by the Commission, 84.5 percent were deceptive on
their face or advertised an illegitimate product or service. As in
the offline world, consumer awareness online is the first line of
defense in combating fraud. The anonymity and scope of the Internet
can make it difficult for law enforcement agencies to track down
sources of fraudulent spam and spyware (which collects information
from the victim's computer). Such activity is growing quickly and
posing significant costs to victims and companies. The President
signed into law the Controlling the Assault of Non-Solicited
Pornography and Marketing Act of 2003 (CAN-SPAM Act), which
establishes a framework of administrative, civil, and criminal tools
to help America's consumers, businesses, and families combat
unsolicited commercial e-mail. The problems associated with spam
cannot be solved by Federal legislation alone, but will require
market responses in the development and adoption of new technologies.
The Federal government has also stepped up the pursuit of purveyors
of fraudulent spam and spyware. For example, in a joint law
enforcement initiative, the FTC and the Department of Justice (DOJ)
have brought actions to shut down operations that hijacked logos
from online businesses to con hundreds of consumers into providing
credit card and bank account numbers. December 2004 saw the formation
of a new public-private consortium that includes financial services
firms, Internet service providers, IT vendors, and law enforcement
to fight Internet-based fraud.
Copyright Infringement
Copyrights encourage the development of goods such as books, songs,
and videos that are much costlier to produce initially than to
replicate. Digital technologies and the Internet have made possible
high-quality reproduction of music and video at nearly zero cost,
and facilitated extensive unauthorized use through mechanisms such
as file-sharing networks. Industry is exploring technological
remedies to combat theft, but the Federal government is also playing
a role. The Attorney General has made enforcement of intellectual
property laws a high priority of the DOJ. The DOJ has expanded its
Computer Crime and Intellectual Property Section and created the
Cyber Division of the Federal Bureau of Investigation. In 2004, the
DOJ launched Operation Digital Gridlock, the first Federal
enforcement action ever taken against criminal copyright theft on
peer-to-peer networks (that allow groups of computer users with the
same networking program to interconnect and directly access files
from one another's hard drives).
Competition Versus Economic Regulation
An overly high price or low quality by a supplier opens the door
to profit opportunities for the supplier's rivals. Rivals can expand
their sales by undercutting price or offering superior quality or
service. In this way, competition drives suppliers to provide
customers the greatest possible value consistent with covering costs.
Pursuit of profit opportunities also draws firms to enter or develop
new markets, which can lead to quantum leaps in consumer welfare. A
pioneering firm that develops a new service, for example, may for a
time reap high returns on its investment. But the high returns tend
to draw other firms to enter and thus intensify competition in the
new market. As competition drives down the innovative service's
price, the service will become more broadly adopted by consumers.
This pattern has unfolded time and again in diverse sectors of the
economy.
The promise of competition might not be fulfilled, however, if
scale economies in an industry are so great that only a single firm
can supply the market cost-effectively. A firm operates under
economies of scale when its average cost of supplying a good falls
as the firm expands its scale of operations. Economies of scale can
arise, for example, if the up-front costs of setting up a business
are large. Once the groundwork of the business has been laid, the
incremental cost of the good--the cost of supplying each additional
unit--may be low. Examples of industries in which suppliers compete
in the midst of scale economies include automobiles, software, and
pharmaceuticals. Prices in such markets can fall over time, as firms
enter the market and competition drives prices down toward the
good's incremental cost. But a firm will only enter a market if it
expects to earn enough of a margin above its incremental cost on
enough sales to cover its ongoing overhead costs and recover its
up-front costs of entry. In rare cases, up-front costs may be so
large, and competition after entry so intense, that no entrant
could profitably challenge the incumbent supplier's monopoly. Such
industries are called natural monopolies.
Natural monopolies are a rare exception to the competition that to
a greater or lesser degree characterizes most markets. Industries
commonly given the natural monopoly label have tended to have a
highly capital-intensive infrastructure, such as the telephone
system, cable television, railroads, and the electricity distribution
grid. A rationale for the economic regulation of these industries
has been that competition and its benefits would not naturally arise.
A monopolist has an incentive to restrict output and raise price
above the competitive level. In the absence of competition,
regulation may offer the prospect of a substitute, although a poor
one, for the competitive process. Ideally, the aim of economic
regulation would be an industry outcome of low prices and high
quality that approaches what competition would have accomplished,
had competition been possible.
However, natural monopoly does not necessarily mean economic
regulation is needed to protect consumers from monopoly prices.
While natural monopoly means that competition in the field is
unlikely to arise, there could still be vigorous competition for
the field--that is, competition among firms to attain the position
of monopolist. Municipalities can and do exploit competition for
the field, for example, by auctioning a monopoly franchise, to
extract concessions from the winning monopoly provider.
Traditional, Rate-of-Return Regulation
Under traditional, rate-of-return regulation, the regulator
estimates the firm's capital base and incremental cost. This
approach allows the firm to charge prices just high enough to yield
a rate of return that would have attracted capital to the industry,
had the industry been open to competitive entry.
The traditional approach to regulation presents several
difficulties. First, measuring a firm's capital base and
incremental cost involves substantial auditing effort and
uncertainty for the regulator. Judging the appropriate rate of
return is also difficult, as it involves gauging the riskiness of
capital investments in the industry. An especially problematic
aspect of traditional regulation, though, is its effect on
incentives. A firm in a competitive industry, and even an
unregulated monopolist, has an incentive to trim its costs to a
minimum so that it can capture the highest possible profit. A firm
subject to rate-of-return regulation has no comparable incentive to
keep costs down. The higher the firm's incremental costs, the higher
the prices the regulator will generally allow the firm to charge to
cover those costs. A key problem is that the firm has an incentive
to choose overly capital-intensive technologies, because this
increases the capital base to which the regulator applies the firm's
allowable rate of return.

Price-Cap Regulation
Many Federal and state regulators have turned from traditional
regulation to price-cap regulation of industries considered to be
natural monopolies. Prior to 1984, all states regulated telephone
service on a rate-of-return basis. By September 2004, 37 states
had switched to some form of price-cap regulation. Under price-cap
regulation, the regulator sets an initial price or basket of prices
that the firm can charge for its goods. The price caps are then
updated over time, by a positive factor to account for inflation and
a negative offset to account for the firm's perceived ability to
trim its costs through productivity improvements. If the regulated
firm succeeds in trimming costs by more than than the productivity
offset in the price cap, its profits will increase. The hope is that
price-cap regulation may avoid some of the perverse incentive
effects of traditional regulation, by de-linking the regulated
firm's returns from its costs. Several recent studies have found
that, in comparison with rate-of-return regulation, price-cap
regulation is associated with improvements in the technical
efficiency of telecommunications providers, as well as greater
investment in modernizing switches and deploying fiber-optic cable.
Price-cap regulation is far from ideal, however, and in fact
faces problems similar to those of traditional regulation. In
setting the initial price cap, the regulator must measure the firm's
capital base and incremental costs, as well as determine a rate of
return that the capped prices should yield. This is identical to the
process in traditional rate-of-return regulation. In setting an
inflation factor for the price cap's growth, the regulator must
assess both the rate at which the firm's input costs are likely to
grow and the rate of productivity growth the firm is capable of
achieving. Given difficulties in gauging these rates, the regulator
must make periodic adjustments to the price-cap mechanism in light
of industry outcomes. But if the regulated firm underperforms, is it
because the regulator miscalculated, or because the firm failed to
pursue productivity improvements diligently?
Both rate-of-return and price-cap regulation suffer to some degree
from information problems. A regulator cannot know with precision all
of the economic factors relevant to setting prices. In practice,
these types of regulation can lead to shortages, high costs, slowed
innovation, or a combination of all of these shortcomings. Where
vigorous competition is feasible, market forces can guide firms to
deploy their resources in ways that benefit customers far more
effectively than could a price-setting regulator.
Advancing technology is providing competitive inroads to a number
of industries once considered natural monopolies. Satellite
television offers a competitive alternative to cable television
service (Box 6-2), and wireless telecommunications are competing
with wireline telephone services. Such technology-induced
competition can be expected to increase as cable companies begin to
offer voice communications and telephone companies roll out video
services.
______________________________________________________________________

Box 6-2:  Satellite Television

Virtually all cable system operators hold franchise monopolies over
cable television service within their local service territories. Only a
few communities have issued multiple franchises, allowing for
``overbuild'' competition between cable system operators in the local
market. A number of studies have found that cable rates in the 1980s
were roughly 20 percent lower in markets with cable overbuild
competition than in comparable markets served by cable franchise
monopolists.
The rise of satellite TV services since the mid-1990s has also put competitive pressure on cable system operators. A study of thousands of
cable systems across the United States finds that, controlling for a
variety of other factors, a cable system's penetration rate (cable
subscribers as a ratio of homes passed by cable) tends to be lower in
areas where satellite reception is better. This is consistent with
satellite TV providing more competition to cable TV where a larger
fraction of households has access to satellite reception. While
satellite TV has taken market share away from cable TV, the overall penetration of pay TV services among U.S. households has grown as
satellite TV services have grown. As of June 1998, 78 percent of
households with televisions subscribed to pay TV service. By June 2003,
this had grown to 88 percent. A recent study indicates that the
introduction of satellite TV led to substantial gains for consumers.
However, ongoing antitrust oversight of the pay TV industry remains
important. In 2002, both the FCC and the DOJ acted to block the merger
of the two primary satellite TV providers to prevent a loss of
competition in pay TV services.

______________________________________________________________________

Telephone Service: A Natural Monopoly?
Natural monopoly arguments have traditionally offered a
rationale for economic regulation of telephone service. It can be
costly for entrants to reproduce the incumbent local networks of
copper wires or "loops" that connect nearly every U.S. household to
telephone service. Over the past two decades, however, the wireline
(land line) telephone monopoly has yielded to encroaching competition
from the entry of alternative suppliers of long-distance service in
the 1980s, the explosive growth in mobile wireless telephone service
over the past decade, and the recent introduction of voice
communications over the Internet. Such proliferating competition has
posed challenges to the economic regulation of telephone services.
Long-Distance Services
Prior to 1984, both local and long-distance telephone service in
the United States was supplied primarily by a single firm, AT&T. As
part of a 1982 antitrust settlement with the DOJ, AT&T was broken up
in 1984 into a number of regional exchanges providing local service
and one long-distance provider that retained the AT&T name. The
breakup separated local telephone service, which remained rate-
regulated because of its natural monopoly characteristics or for
jurisdictional reasons, from long-distance service and equipment
manufacturing--businesses viewed as potentially competitive.
Thereafter, competition in long-distance service progressed with the
entry and expansion of alternative providers.
Between 1984 and 2002, per-minute long-distance prices fell by
more than 80 percent after adjusting for inflation. This resulted
in part from the FCC lowering per-minute access charges on long-
distance calls, savings that were passed through to long-distance
customers as a result of the emerging competition among long-
distance providers. At the same time, the proportion of U.S.
households connecting to local telephone service grew from 91.4
percent in 1984 to 93.3 percent in 1990. A study of telephone
demand over this period found that much of this increased
penetration in telephone service could be explained by the drop in
long-distance prices. This reflects the fact that consumers value
connecting to the local telephone network for the ability to place
long-distance calls as well as local calls.
Goods tend to be supplied efficiently when prices reflect costs.
If a price is higher than the true cost of supplying an additional
unit of a good, too little of the good will be consumed relative to
what would yield the greatest net benefits to consumers and
producers. Telephone charges pegged to the volume of call traffic
tend to discourage call volume. This can lead to less than efficient
utilization of the telephone network, if price exceeds the network
costs of putting through an additional call or minute of calling. By
the same token, price reductions toward unit cost encourage more
efficient utilization of the network and increase the value
consumers derive from connecting to the network.
Mobile Wireless Telephone Services
Whatever the prospects for competition in telephone service may
have been in decades past, substantial competition has emerged in
recent years, and more is on the way. Mobile wireless telephone
service has grown by nearly 26 percent annually, from 16 million
subscribers in the United States in 1993 to more than 158 million
in 2003 (Chart 6-4). Nationwide, 54 percent of the population
subscribed to wireless service at the close of 2003. In contrast,
nationwide wireline telephone penetration was nearly 95 percent in
2003, but the number of wireline telephone lines peaked in 2000, at
192.5 million lines, and fell by about 5 million lines over the next
two years. Some of this decline likely reflects consumers choosing
to switch from wireline to mobile wireless telephone service.
Compared to wireline service, wireless service offers the
convenience of mobility and accessibility. Growing wireless
penetration has been driven by a rapid drop in wireless prices. The
average price per minute of mobile wireless telephone service fell
from 47 cents in 1994 to about 11 cents in 2002 (Chart 6-5).
Sharpening competition has helped drive the falling average price
per minute of mobile wireless telephone service over the past
decade.
Wireless telephone services are carried over radio spectrum.
Spectrum generally refers to a broad range of frequencies of
electromagnetic radiation, which encompasses visible light.
Frequencies higher than those of visible light include
ultraviolet light and x-rays, while lower frequencies include
first infrared light and then, as wavelengths grow longer, radio
waves. Radio spectrum refers to the lower range of frequencies,
which carry broadcasting and mobile communications services. If
two transmitters at the same geographic location were to use the
same frequency at the same time, they would interfere with each
other,






garbling their transmissions. To limit such interference problems,
the Federal government licenses rights to use specified bands of
spectrum at specified locations. Federal government users of
spectrum are licensed through the National Telecommunications and
Information Administration (NTIA). All other spectrum users are
licensed through the FCC.
In the early 1990s, government-issued spectrum licenses for
wireless telephone service were limited to just two cellular
providers in each cellular market area. A series of FCC-run
auctions beginning in 1995 provided additional spectrum for
digital personal communications services (PCS), enough to support
as many as eight wireless providers. By the end of 1999, 88 percent
of the Nation's population could choose from three or more wireless
providers and 35 percent could choose from at least six. By the end
of 2003, these figures were up to 97 percent and 76 percent,
respectively.
Talking on the Internet: Voice over Internet Protocol
Local exchange telephone networks are facing growing competition
from Internet-based telephone services. Unlike traditional circuit-
switched telephone calls, communications using Voice over Internet
Protocol (VoIP) break the call stream into data packets sent over
the Internet, turning your computer into an alternative to
traditional telephone service. Much of the current volume of VoIP
calls originates and terminates on public switched telephone
networks, by callers using digital subscriber line (DSL) broadband
services. But VoIP services are spreading to other network
facilities, such as those of cable television systems. According to
news reports, several of the country's largest cable system
operators plan to roll out VoIP services within their service
territories, which would make them available to millions of
households. News reports indicate that Wireless Fidelity (Wi-Fi)
broadband service providers are also exploring VoIP services.
Looking ahead, electric utilities that develop broadband over power
lines service could also provide VoIP services. All of these recent
developments, together with the rapid growth in mobile wireless
telephone service, suggest that the monopoly access to household
voice communications that local telephone exchanges have had for
nearly a century is yielding to intensifying competition.
The prospect of growing VoIP traffic has raised concerns in
some quarters that this emerging competition may undermine the
current structure of regulating telephone services. A basic
rationale for the economic regulation of telephone service has
been the natural monopoly argument, that is, that competition for
telephone service was unlikely to arise. Economic regulation then
offered the prospect of an alternative way, although a problematic
one, of achieving some of the benefits of competition that customers
have enjoyed in most other markets. But with competition now
emerging, the natural monopoly rationale for the economic regulation
of telephone service is beginning to fall away. Squelching
competition as a threat to the existing regulatory framework would
turn matters on their head. Regulation should adapt to changing
market realities in ways that allow innovation to flourish and
consumers to choose among alternatives, while ensuring national
security, homeland security, law enforcement and public safety.
Realizing the Promise of Broadband
Broadband services offer download speeds much faster than dial-up
Internet access, enabling innovative features such as streaming
video and VoIP. For example, fiber-optic cable to the home can
provide speeds of more than 100 megabits per second. Broadband
services have quickly been embraced by the public, growing from
2.8 million high-speed lines (defined as connection speeds over
200 kilobits per second in at least one direction) in December
1999 to more than 32.4 million lines in June 2004. This represents
an annual growth rate of 72 percent. In the first few years after
inception, broadband penetration among U.S. households has outpaced
the earlier diffusion of dial-up Internet, mobile wireless
telephones, personal computers, videocassette recorders, and color
television.
Universal, Affordable Access to Broadband
Last March, the President announced a national goal of universal,
affordable access to broadband services by 2007. The
Administration's ongoing efforts to achieve this goal reflect a
belief in the powers of competition and private sector innovation to
bring the benefits of broadband to consumers. As experience in the
telephone industry has shown, competition offers the most robust and
reliable means of broadly diffusing important technologies. The
Administration has taken steps to unleash the power of free markets
to deliver broadband services by removing disincentives to invest,
strengthening property rights, and allowing consumers rather than
the government to choose the technologies that best meet their
needs.
Removing Disincentives to Invest
Competition in broadband service is growing. Already, many
communities have two providers of broadband service. In 1999, 33.7
percent of the zip codes in the United States had at least two high-
speed Internet access providers. By the middle of 2004, the fraction
had risen to 80.5 percent. So far, competition in broadband has
primarily been between DSL services provided by telephone companies
and cable modem services provided by cable television system
operators. Cable's share in high-speed lines has grown from 51.3
percent in December 1999 to 57.3 percent in June 2004. One avenue by
which telephone companies could compete more effectively in
broadband service is through investment in fiber-optic cable, which
offers faster connection speeds than can generally be achieved over
the copper wires of the traditional telephone network. According to
news reports, fiber-optics will allow telephone companies to offer
television in addition to very high-speed broadband services,
similar to the current offerings of many cable television operators.
While fiber-optic high-speed lines have more than doubled between
December 1999 and June 2004, other forms of broadband delivery have
grown at an even faster pace, so that fiber's share in high-speed
lines has fallen. Part of the reason may be that regulatory
uncertainty has impeded fiber-optic investment. The
Telecommunications Act of 1996 requires telephone companies to
provide portions of their network facilities for sale or lease at
regulated rates to competing local exchange companies. This process
is known as "unbundling" network elements. Until recently, it
remained unclear whether the Act's unbundling requirements would
extend beyond copper loops to also cover fiber-optic cable. People
are motivated to invest by the prospect of reaping returns. In
residential neighborhoods, an unbundling requirement that would
force investors to share the fruits of their investment in fiber-
optic cable with competitors could blunt incentives to invest in
fiber-optics. The result might not be more competition, but rather
less innovation. The Administration supported the FCC's decisions in
2003 and 2004 to exempt fiber-optic loops from unbundling
requirements when this technology is deployed to residential
neighborhoods, including fiber-to-the-home, fiber-to-the-curb, and
fiber-to-multi-dwelling-units. According to news reports in the wake
of these rulings, a number of major telephone companies have
announced plans to invest several billion dollars in deploying
fiber-optic cable to reach more than 20 million households within
three years.

Setting Interference Standards
The Administration has also helped to lower barriers to the
development of new competition in broadband service. Broadband
over power lines (BPL) holds the promise of adding a "third wire"
into the home to compete with cable modem and DSL services. However,
BPL generates radio waves that can interfere with the operation of
wireless systems. The Administration has helped the FCC develop
policies to address BPL interference issues. Beginning in 2003, the
Commerce Department's NTIA undertook a detailed technical
examination of interference risks posed by BPL, by conducting
millions of measurements on test equipment. The NTIA submitted a
report and set of specifications to the FCC, which adopted final
rules on BPL technical requirements in October 2004. Setting
appropriate interference standards prevents those who deploy BPL
technology from significantly infringing on the spectrum rights of
others, while allowing the technology to enhance the broadband
service options available to homes and businesses.
Strengthening Spectrum Rights
Another potential source of competition in the provision of
broadband service is third generation, or "3G," wireless
technologies. Wireless technology may revolutionize broadband
competition by eliminating reliance on wires and cables. The
technology may hold particular value for areas with sparse
customers, where wire- and cable-based communications networks
may be particularly expensive to deploy.
The rising demand for wireless services may at some point strain
the limits of available spectrum. Aspects of the Federal government's
system of allocating spectrum licenses can make it difficult for
promising new technologies to displace lower-valued uses of spectrum.
In May 2003, the President established the Spectrum Policy
Initiative to reform spectrum management for the twenty-first
century. In June 2004, the Department of Commerce provided two
reports including policy recommendations to the President, and in
November the President directed Federal agencies to implement the
reports' recommendations. In particular, the President directed the
Secretary of Commerce, in coordination with other Federal agencies,
to develop a plan within one year for identifying and implementing
incentives to promote more efficient and effective use of spectrum,
while protecting national and homeland security, critical
infrastructure, and government services.
One of many issues is the extent to which spectrum currently in
government hands could be released for commercial use. In July 2002,
the Department of Commerce produced a plan in concert with the FCC
and Department of Defense to release for commercial use a broad
swath of radio spectrum, while accommodating critically important
spectrum requirements for national security. In December 2004, the
President signed into law a piece of legislation to establish a
spectrum relocation fund that will compensate government agencies
for putting spectrum they have used up for auction. This will
facilitate making Federal spectrum available when there are higher-
valued private sector uses and provide a better mechanism for
relocating Federal spectrum-dependent systems, with less uncertainty
for both Federal users and industry.
Making more spectrum available for private use is not the only way
to promote the development of promising new wireless technologies
that provide high-speed Internet and other services. Spectrum policy
could also enable spectrum used by the private sector to become
available for higher-valued uses without making incumbent users
worse off. As discussed in Chapter 5, Expanding Individual Choice
and Control, assigning tradable property rights allows providers of
the higher-valued uses to compensate incumbent holders for their
property rights. The Administration has encouraged the FCC to allow
greater use of secondary markets, through which licensees could
sublease their spectrum. The FCC adopted spectrum leasing rules in
October 2003.
Simplifying Federal Rules
To promote widespread deployment of broadband networks, the
Administration has worked to ensure that broadband providers have
timely and cost-effective access to rights-of-way--the legal right
to pass through property controlled by another--including access to
conduits, corridors, trenches, tower sites, and undersea routes.
Such passageways often cross large areas of land owned or controlled
by the Federal government. The Administration has established a
Federal Right-of-Way Working Group under the Department of Commerce
to explore ways to simplify the tangle of Federal agency regulations
broadband providers must navigate in seeking rights-of-way over
Federal lands. The Working Group issued a report with a set of
recommendations. In April 2004, the President instructed Federal
government agencies to implement these recommendations.
Conclusion
The information technology sector has been a vibrant part of our
economy and there is every indication that it will continue to be.
The continued strength of this sector depends on fostering an
environment in which innovation will flourish. In a free market,
innovators compete to lower the cost of goods, improve their quality
and usefulness, and develop entirely new goods that promise quantum
leaps in consumer welfare. People are motivated to invest in
developing new ideas and the infrastructure to enter new markets by
the prospect of earning returns on their investment. Government thus
has an important role to play in defining property rights in
intellectual and physical capital so that people will be spurred to
invest and innovate, as well as ensuring the development of an
environment in which public safety and national security are
protected. Government efforts to hasten the spread of innovative
technologies should focus on lowering regulatory barriers that
impede market provision. But government should avoid ``picking
winners'' among emerging services. Doing so could entrench services
that may become outdated as the marketplace evolves and hinder
people from choosing the services they truly prefer. At this time,
it is hard to predict the range of technologies that will emerge to
deliver high-speed data services, or even what the scope of these
services will be. As people vote with their dollars, the market
winners that emerge will be those technologies and services that
deliver customers the greatest value.