Program

Events

The Coming Bust of the Knowledge Economy

June 26, 2003 // 9:00am11:00am

The Woodrow Wilson Center's Project on America and the Global Economy and the Athena Alliance cosponsored a policy forum with Steven Weber of the University of California-Berkeley to examine how the open-source software phenomenon is remaking the economics of a significant piece of the information technology (IT) industry. Weber argued that the development of open-source software is not unique but illustrates more generally how new production processes are affecting the creation and value of complex knowledge goods. Ultimately, the evolution in the development and production of complex goods shifts the value chain and turns some typically expensive, specialty products into commodities. He predicted that proprietary operating system software would become an old-fashioned, "quaint" notion in as soon as ten years.

These changes in the knowledge economy's methods of development and production closely resemble Schumpeter's process of creative destruction that drives economic progress, and should therefore be viewed in a positive light. Nevertheless, Weber cautioned that this evolution entails risks that must be defined and prepared for, the largest being the destruction of business models that largely depend on provincial and antiquated notions of what is proprietary and what can be controlled. The repercussions for these business models would be substantial: the destruction of huge amounts of invested capital and stock valuation. Current users of these models will "fight tooth and nail" to halt the economic and technological progress that would lead to such ends.


The Lasting Influence of the Technology Bubble

A difficult but inevitable truth is that there is no viable business model that guarantees the return of IT stocks to their valuations before the bursting of the technology bubble. Some companies over invested in the 1990s and are left with unused capacity and a significant burden of debt. For instance, telecom companies invested heavily in network capabilities just as the Internet began to replace them. Some of these same companies and others built out huge amounts of bandwidth on the erroneous assumption that there would be enough content and demand to justify such a huge supply. Substantial capital was borrowed to build these cables and fiber-optic bandwidth that are now at most, an inexpensive commodity.

Other industries are still struggling to adapt to the digital revolution. The music industry also faces a substantial decline in CD sales and revenue. Unlike the "meltdown" in the telecommunications industry, the music industry faces a "corrosive loss of legitimacy and confidence."

§ Napster and Intellectual Property Rights (IPR)

Weber argues that it is not just a dramatic technological change but rather a shift in mindset that fuels economic revolutions. He reminded the audience that Peter Drucker argued in the nineties that new ideas, not a fascination with technology, fuel economic growth. Drucker compared the nineties to the Industrial Revolution where it was not the steam engine but the major innovations in the organization of factories, corporations, daily newspapers, and trade unions that led to the rapid growth during and after that period.

Napster, a relatively simple piece of technology, profoundly changed how people thought about the music industry by making the record companies' business model transparent to their end users/customers. Weber asked 150 students in one of his classes last year if it was legitimate to pay for music. Only three students (the slightly older ones) raised their hands. He believed that this was a mind shift that would not easily be changed.

Weber felt that intellectual property politics led to legally inconsistent and problematic solutions in the Napster case. Under the non-circumvention clause of the Digital Millennium Copyright Act (DMCA), it is not only illegal to break an electronic lock on a protected digital good, it is also illegal (with few exceptions) to build a software tool that can be used to open an electronic lock, regardless of the builder's intentions. As a result, technologies posing any threat to the copyright regime are being constrained instead of punishing conduct in violation of copyright law.

This preemptive law undermines a major source of innovation for the economy to protect the $12 billion dollar music industry and more fundamentally troubling, it gives more protection to a single piece of intellectual property (in this case a song) than it currently gives to much more personal information such as information encoded in one's DNA. He argued that while another song might be written at any time, once someone's DNA has been decoded and made public, the harm that might be done is irrevocable.

Weber also referred to a proposal by Pam Samuelson (U.C. Berkeley) and the Electronic Frontier Foundation that would levy a tax on hard drives or broadband connections and distribute the tax-generated funds to copyright holders as compensation for file-sharing. He considered this to be a "bizarre, stunningly inefficient, and dysfunctional," idea.


Software and Pharmaceuticals

The software and pharmaceuticals industries are both fundamental to the knowledge economy. The debate on the current IPR regime revolves around the breathtaking evolution of software and its related products and services. Meanwhile, the pharmaceuticals industry represents a large percentage of the U.S. GDP and exports and also has the potential to dramatically affect society with a groundbreaking treatment for cancer and other life-threatening illnesses. Still, Weber maintains that it is a "strange and discomforting time" to be involved with either industry.

Weber has detected two distinct views on the future direction of the IT market. Many people optimistically believe that the current fall in stock prices are temporary setbacks and that the markets will return to their mid-nineties positions after a few years, but without an equity bubble that proved to be a distorting distraction. The second theory, which Weber agrees with, sees the current economic conditions as a major period of industrial reorganization that will fundamentally change the way the markets value these industries.

§ Software

The software industry represents about two and a half percent of U.S. GDP. Although the whole IT sector was affected by the bubble economy of the 1990s, Weber distinguished between the grossly overvalued dot com companies and less irrational over valuations of traditional software companies that create products with a measurable value for their investors and consumers.

The challenge in the IT world comes from open-source software, a different animal developed under a business model and an IPR regime that is directly opposite of the proprietary software companies' strategies. It has three basic characteristics:
- the source code that allows people to understand and modify what the software is doing is distributed freely with the software,
- anyone can redistribute the software without paying royalties to the author of that software, and
- anyone can modify the software and distribute that software under the same terms.

As a result, open-source software is working under and thus pioneering a fundamentally different IPR regime, characterized by an owner's "right to distribute, not to exclude" under only one condition: other users cannot be constrained in how they alter the code. It is the exact opposite of the current IPR regime where "the core notion" holding together the existing proprietary software model and justifying its valuations is that the software code's owner can rightfully exclude others according to its own terms. At a basic level, open-source software turns expensive, protected, service-intensive products into commodities. Since the computer code is open and inexpensive, it also broadens the system maintenance market. "Open-source software is not just a fluke. It is a fundamentally different kind of production process for complex knowledge goods."

Companies such as Microsoft, Oracle, and SAP are thus directly challenged by the open-source method of software creation. Weber strongly emphasized that along with the possible destruction of the traditional software behemoths' old monopoly profit generation, open-source creation of software directly implies new methods of innovation and new sources of value. As about forty percent of businesses have overwhelmingly turned to Linux software on inexpensive Intel chips to run the same kinds and magnitude of operations as they would on much more costly software, Sun Microsystems (Solaris) and Microsoft have identified Linux and other open-source programming as the main threat to their business models.

Traditional software companies face open-source threats share in virtually every market. Apache, an open-source software program that runs Internet servers, owns 65 percent of the server market. Linux also now runs supercomputer clusters, thereby cutting high performance computing costs by 30 to 50 percent. Globis is an open-source software program that utilizes the entire Internet's computational ability to solve problems. TiVo, Sharp PDAs, and household goods are either using or will soon use Linux.

Weber maintained that this actually helps the IT industry because of the fast rate of hardware development and the slow rate in development of software. Increasing the power of software technology would have a disproportionately huge impact on the IT economy.

More significantly, in the same way that Napster altered the music business, open-source software could even more dramatically remake the software industry because of both its adaptability and its measurable success in the market. Whereas Napster only allowed the distribution and duplication of an existing product, open-source software "is a free-standing production system that overturns the existing rules of intellectual property." For example, companies that invested their resources in writing intellectual capital-intensive, proprietary, specialized software for other industries, such as banking, may face the development a less expensive and more convenient product from open-source that causes their companies' valuations to plummet, leading to the bursting of another financial bubble created by the overvaluation of proprietary software.

§ Pharmaceuticals

Weber also discussed what he viewed as a politically and conceptually fragile IPR regime behind the pharmaceutical and biotechnology industries. He questioned the effectiveness and even misuse of the patent-based system for innovative investment. In his view, these companies face four key challenges:

- The visibility of their business model, as in the music business, foreshadows public pressure and perhaps ultimately, structural changes. Current medicines target a very limited set of human genes while the human genome project's progress allows for possibly groundbreaking medical treatments that will require public-private and intra-industry collaboration and expansion. Even in the U.S., the pharmaceutical industry's current business model and reputation do not have the legitimacy and support to obtain and sustain such partnerships.

- The current debate in developing countries over the price and availability of drugs will soon begin in developed countries as well. Weber pointed out that differential pricing for Africa will lead to pushes for lower drug prices for lower income individuals in the U.S. as well.

- Weber also foresees drug companies being targeted as villains of public health problems, with some parts of the pharmaceutical industry even being compared to the tobacco industry.

- With the September 11, 2001 attacks, the anthrax scare, the U.S. government's threat to take Cipro off patent, and the possibility of a SARS-like outbreak somewhere in the United States, the pharmaceutical industries can no longer rely on the federal government's protection for their intellectual property rights.

The pharmaceutical companies typically focus on the development of one or two major drugs. This results in the constant threat of a "bio-tech bomb" where stock prices collapse as soon as a key drug fails to secure FDA approval or does not prove as effective as initially expected. Weber pointed out that many people in the pharmaceutical industry, while aware of these problems, fear severe repercussions from Wall Street should they be the first to seek a new business model.


Public Policy Solutions

Weber reiterated his belief that the technology economy will not return to the same high valuations of the nineties. He believes that the IT industry faces a period of persistent lower growth and that negative financial shocks will continue, leaving policymakers with difficult choices:

- Pension funds must find different places to invest the capital they had previously put in the technology and pharmaceutical industries.

- Technology outsourcing to India, China, Taiwan, and other countries will become a target for protectionist policies. At the same time, outsourcing will raise national security concerns. Unlike before, technology companies have been politically mobilized.

- Government funded research and development in technology from homeland security initiatives will have a "disproportionate impact on technology trajectories" in areas that were previously driven by the consumer sector (e.g. wireless networking, ubiquitous sensors, distributed supercomputing).

- The creation of commodity infrastructures will lead to new industries that capitalize on these new commodities similar to the way railroads and Sears did in the past and as IBM is positioning itself now as a global services company. Likewise, Weber expects to see the emergence of service providers in the pharmaceuticals industry perhaps following the approach of a cosmetics company that successfully provides specific products to targeted segments of the population.

- Policymakers can either encourage or hinder this process. Weber discouraged "buying time for systems that do not degrade gracefully." He argued against desperation leading to "defensive, rigid, and inefficient" actions such as the hard drive tax proposed by the Electronic Frontier Foundation, eternal copyright, and the non-circumvention clause of the DMCA.

Weber concluded that the government would inevitably subsidize the reconstruction of these industries not because of their size, but because they are too essential to the infrastructure of a modern economy. A good federal subsidy strategy will permit experiments in unlicensed space (ex: Wifi) and simultaneously, give clear boundaries for areas that require regulation in the interests of society (ex: public safety communications bandwidth). Lastly, the government needs to find a solution to the problem of "first-mover disadvantage." At some point, the government must stop protecting the direct stakeholders and accept the reality of industry losses.


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