Adam Smith

Image is by Hal R. Varian

Information Revolution and Economics: Part I, Innovation and the New Economy by Steve Lee

I wanted to do arts but thought I ought to do science . . . Economics seemed about halfway in between. -- Mick Jagger

If the "Information Revolution" is the building up of an 'empire,' then we should be able to agree with Silicon Valley writer Michael Cringsly when he called this empire an "accidental" one. After all, when the early vacuum tube computers, such as the ENIAC, were first invented, no one thought of spreadsheets, word processing, desktop publishing, or the Internet. These early computers were intended for breaking German Enigma codes, calculating artillery trajectories, and, when World War II was over, perhaps to help solve a myriad of problems in science.

Even with the invention of the transistor and the silicon microchip, few people dreamed of the actual potential that computers could unleash. The Altair, the Sol, the Apple II, the IBM PC -- in the early days, these gizmos were for hobbyists, kids playing games, and a few adventurous types that had the courage to use it for business and personal affairs. Little did these people know that the computer would launch a revolution that is changing the very nature of our lives. Who could have imagined that the current richest man in the world -- Bill Gates -- could build an $18 Billion fortune with computer code -- essentially information -- rather than with oil fields, massive industrial concerns, or real estate.

What does the Information Revolution mean for our economy? Why do we see some of the spectacular growth that we are seeing in the markets that are a part of the revolution? In this two part series on Community Based Computing, we will use some simplified lessons from Economics to analyze what is happening now and to open up the window to what might happen in the future.

In part I, we look at whether what is happening with computers and the Internet is a substantial shift in the course of the world's economy. In part II, we will analyze how the internal structure of companies inside and outside Silicon Valley has changed dramatically due to the introduction of the computer and other related innovations.

Part I: Innovation and Fundamental Shifts in the Nature of the Economy

Is what we are seeing today with computers and the Internet a dramatic shift in the worldwide economy? Or, is the "Information Revolution" a 'flash-in-the-pan' -- a notable but relatively short-lived and insignificant footnote in the history of man?

Using the ideas of an early 20th century Austrian economist, Joseph Schumpeter, we will see that the Information Revolution is no 'flash-in-the-pan.' Instead, it is as significant a change in the overall economy -- and the course of human existence -- as the Industrial Revolution and the Gutenburg printing press.

Schumpeterian Economics: The Effects of Innovation

The key to Schumpeter's economics was innovation. By innovation he did not just mean a technical breakthrough. In Schumpeter's idea of innovation, technical advances could only be considered an "innovation" if those advances could be sold on a relatively large scale. For example, the Graphical User Interface (GUI) was developed in the 70's at Xerox. However, it was not developed into a product until the introduction of the Macintosh in the mid-80's. So in Schumpeterian Economics, the innovation did not happen in the 70's at Xerox but in the 80's at Apple, because Apple's GUI was being sold on a relatively large scale.

Another important idea from Schumpeterian Economics was his idea of the entrepreneur. The common definition of entrepreneur is someone who builds a business based on his or her ideas. Schumpeter's definition -- while not excluding the commonly held view of the word -- was considerably different. Schumpeter's entrepreneur could best be described as an "innovator" -- the person that brings the innovation about. The entrepreneur is the chap that comes up with an idea and finds a way to make it into a sellable product or service. The Schumpeterian entrepreneur does not have to own his or her own business. The entrepreneur can exist within an existing firm or create a new firm. To use a computer example, if a programmer at Microsoft come up with an intelligent agent but develops it within Microsoft instead of striking out on his own, he is just as much an entrepreneur as if he had left Microsoft to start his own software firm.

To Schumpeter, the entrepreneur and his innovation was the key to understanding economic systems. It was up to the entrepreneur to move an economy from one state of general equilibrium (a stable state in an economic system) to another one. The entrepreneur and his innovation is responsible for growth in the economy. Conversely, without the entrepreneur and his innovation, the economy can go into a tail spin.

The Schumpeterian Entrepreneur is a special individual. According to Schumpeter's 1939 book Business Cycle, the ability to come up with an innovation was distributed in a Gaussian/Normal fashion (i.e., a 'Bell Curve' distribution). Like IQ, only half the population could claim to have above average innovative abilities. The successful entrepreneur -- who needed to possess a truly great ability to come up with an innovation -- would be considerably less than 50% of the population.

What is the reward for the entrepreneur that could seemingly move mountains? By introducing an innovation, the entrepreneur (and/or his firm) could temporarily capture most of the potential profits that exist in that market. For example, before Microsoft introduced Windows 3.0, Apple was able to earn a high premium on each unit of Macintosh computers sold. Why? Because Apple's easy to use GUI operating system was an innovation. It was able to garner most of the profits that were available for the market for easy to use GUI operating systems. This advantage, however, was temporary. When Microsoft developed a "comparable" GUI, Apple's profit margins began to fall. According to Schumpeterian Economics, the only way for Apple to increase their profit margins would be to come up with a new innovation.

It goes without saying that most of the firms involved in the Information Revolution are trying to be innovative/entrepreneurial in the Schumpeterian sense.

Upswings in the Kondratieff Long Cycle or Why Bill Gates has $18 Billion (as of 1996)

In the early days of Microsoft, Bill Gates reportedly told his colleagues that he hoped that there would be a computer on every desk and Microsoft software running on every one of those computers. This statement -- if we ignore the statement about Microsoft software -- is the key to why the Information Revolution is so revolutionary and why its visionaries -- which as we have already discussed is equivalent to saying entrepreneur/innovator -- are so wealthy in such a short time.

Is there an explanation for this? Is there a guide to what may happen in the future? As it turns out there is a guide to what is happening: Schumpeterian Economics.

It turns out that standard Economics -- while good at explaining some of the things that are happening in the Information Revolution -- is inadequate to explain what is happening right now with the explosion of technological revolution. Therefore, some economists have been turning to the ideas of Joseph Schumpeter -- a man who wrote most of his works when computers is any form did not exist.

Why is Schumpeter so important? Because -- unlike other economic theories -- Schumpeter's theories made the introduction of innovations central to how he modeled economic systems. The most relevant theory to our discussion is his ideas about the business cycle.

GDP from 1948

The chart above was created by Christian Zimmermann of the University of Quebec at Montreal

The business cycle is the idea that the economy moves up and down depending on the changes of a variety of variables. If the business cycle 'swings' upward, that means we are in a period of growth. If it swings downward, we are in a recession or, in extreme cases, a depression.

Schumpeter's business cycle theory had three major components that distinguished it from other business cycle theories.

1.) Schumpeter's business cycle theory had a long term cycle called a "Kondratieff." Most business cycle theorists have business cycles that are relatively short term: anywhere from a few days to a few years. The Kondratieff, however, ranged from a period of 50 to 60 years (or even longer). In other words, upswings and downswings in the Kondratieff were not going to be "flashes-in-the-pan." Changes to the Kondratieff Long Cycle were going to be fundamental shifts in the nature of the economy and were likely to last for a long period of time.

2.) Schumpeter's business cycle (including the Kondratieff) were non-linear. Although a business cycle is almost always non-linear, other theories had business cycles that essentially behaved in a linear fashion. Other business cycle theories had cycles around linear long term trends or treated business cycle curves as if they were an aggregate of linear data. So either by artifact of econometric statistics or by design, most of the business cycles are thought to behave in essentially linear ways.

There is a serious problem with the essentially linear thinking in these other business cycle theories. For example, if the Information Revolution experienced linear growth, people like Bill Gates could not possibly make so much money in so short a time. In Schumpeter's models, the Information Revolution could experience non-linear (almost exponential) growth. With non-linear business cycle theories, we can easily explain how a 19 year old Harvard dropout can earn $18 Billion in less than two decades.

3.) Changes in the Kondratieff Long Cycle is primarily caused by changes in the levels of innovation. If there is an upswing in the Kondratieff Long Cycle (i.e., a long period of growth and a fundamental increase in the level of economic well-being in the economy) it is caused by a "swarming" -- Schumpeter's way of saying a large increase -- in the activity of entrepreneurs and the increase in the level of their innovation.

For example, the last time we had an upswing in the Kondratieff Long Cycle was the heyday of the Industrial Revolution in the mid to late 19th century and into most of the 20th century. The introduction of machinery as both products an as aids in the manufacturing process, as well as the introduction of the products associated with heavy industrialization, created a large fundamental increase in the level of economic prosperity in the industrialized economies.

We can relate this to the Information Revolution by saying that the last two decades has seen a "swarm" of innovation. Bright young minds came together at a particular point in time to create a massive increase in the level of innovation. By doing so, they not only benefited themselves but also have begun a process to increase the level of economic prosperity (relatively speaking) in the economies in which the are active in.

We can conclude several things from our discussion. We can expect that, as long as the good innovative ideas are there, both the innovator and the economy in which they exist will benefit. The Information Revolution is not an exaggeration, it really is a revolution. We can expect meteoric rises in the markets involved in this revolution for at least another decade. The average investor should not worry that technological stocks are just a "fad." They can safely adopt the strategy of investing in tech stocks for the foreseeable future. (However, I should add a note of caution. Not all tech stocks are profitable. For exempla, there are many ideas out there that are really not innovations (i.e., sellable). Also some investors are better or luckier than others.)

Another observation we can make is that we should expect a shift of wealth from economies and sectors of any particular economy that the Information Revolution is a threat to. Just as the train and automobile made horses drawn buggies obsolete, so the computer and the Internet will make its less innovative "competitors" obsolete. Sadly, many areas within a country and in other countries will face the same kinds of problems that underdeveloped regions had to face during the Industrial Revolution.

In part II of this series, we will explore what the role that financing (stock market, venture capital, loans, et al.) has on the way high tech firms are organized. We will also look at how the innovations of the Information Revolution creates a sort of positive "feedback" which reduces costs and also has an effect on how Silicon Valley firms (and firms that do similar things outside of that geographic area) are organized.

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