[Original article]

iMP Banner subscribe iMP contents -- September 2000 September 2000
The Perverse Economics of Information: An Extended Conversation with Paul A. Strassmann

"The exceptionally favorable results delivered by U.S. IT firms should not be a source of complacency and certainly not a reason to believe that the currently favorable U.S. position makes it possible to maintain sustainable superiority forever."

Paul A. Strassmann
publisher@infoeconomics.com
 

This essay maintains the format of an interview -- questions and answers -- but these took place in a series of e-mail exchanges over a series of days. We have implemented Gordon Bell's notion of telepresence where neither time nor place impeded the conversation.

Paul A. Strassmann served as chief information executive from 1961 through 1985 at General Foods, Kraft and Xerox. In 1991 he was appointed Deputy Assistant Secretary of Defense and Director of Defense Information and was responsible for managing DoD's Corporation Information Management program. At present, he is CEO of the Information Economics Press, serves on the Boards of several software start-up firms, acts a Senior Advisor to SAIC and is on the adjunct faculty of the School of Information Warfare, National Defense University. References to his books and publications can be found on [www.strassmann.com]. His combat military service dates back to 1944.


Q: You have recently described a concentration of profits of U.S. firms among global information technology (IT) firms and have warned us of inappropriate complacency. Would you sum up the main conclusions for iMP's readers?

Let me first summarize the facts that define what I mean by concentration of profits in the hands of U.S. corporations.

As a metric of economic power I have taken the firm's profits after taxes. This indicator reveals -- perhaps better than any other measure -- the capacity of a firm to accumulate economic surpluses that can be reinvested into further growth. I am also including total revenues to show the relative importance of IT in the global and U.S. economies:

Table 1.
Global Distribution of IT Firms, Revenues and Profits

Information Technologies

Number of Firms

Total Revenues --
$ Billions

Total Profits --
$ Billions

Total Global Numbers 2,272 $1,153.8 $37.9
U.S. Numbers 1,568 $639.2 $36.3
U.S. % of Global Total 69.0% 55.4% 95.9%

The U.S., with 55.4 percent of the global revenues, collects 95.9 percent of all profits. I found a further breakdown of the financial numbers especially revealing:

The U.S., with 55.4 percent of the global revenues, collects 95.9 percent of all profits. I found a further breakdown of the financial numbers especially revealing:

Table 2.
Sector Shares of Firms, Revenues and Profits

Computers
Number
of Firms
Total Revenues -- $ Billions
Total Profits
--$ Billions
Total Global Numbers 305   $603.5  
$11.8
 
U.S. Numbers 188   $303.9  
$15.3
 
U.S. % of Global Total 61.6 %   50.4 %  
$129.7 %
 
Components
Total Global Numbers 464   $261.9  
$9.9
 
U.S. Numbers 278   $124.8  
$7.7
 
U.S. % of Global Total 59.9 %   47.7 %  
77.4 %
 
Software
Total Global Numbers 1503   $ 288.3  
$16.1
 
U.S. Numbers 1102   $210.5  
$13.3
 
U.S. % of Global Total 73.3 %   $73.0 %  
82.4 %
 

It should be clear from the above tabulation that economic power -- in the form of profits -- has largely shifted from hardware towards software. It is worth noting, however, that Microsoft and Oracle together account for $9.1 billion profits, or 68 percent of the U.S. performance. Without these two firms, the U.S. position would look much weaker. Nevertheless, the relatively huge number of U.S. software firms and their quick rise-or-die operating patterns is likely to safeguard the lead that the U.S. is currently enjoying in this sector.

I also find it interesting that with about one half of the computer hardware sales ($303.9 Billions), U.S. computer firms make more profit than all of the firms in the rest of the world.

The sum of the profits shown in Table 2 does not reveal that the total global profits represent the sum of positive minus negative financial results. An examination of the statistical distribution of profits and losses will display the pattern of how many of the firms are winners and how manyare losers:

Table 3.
Distribution of Profits for Global Computer Firms

Computer Firms Profits -- $000
Top Three U.S. Profitable Firms $11,279,00
80 Other Profitable U.S. Firms $7,490,166
66 Other Global Profitable Firms $2,635,530
Total Profits $21,404,696
110 Unprofitable U.S. Firms $-3,423,316
46 Other Global Unprofitable Firms $-6,148,911
Total Losses $-9,572,227

The top three U.S. firms -- IBM, Hewlett-Packard and Dell -- by themselves deliver 96 percent of the net total global profit collected by the entire industry. The remaining 146 profitable and 156 unprofitable firms largely offset their respective gains and losses. When one examines the structure of the computer business from this point of view, one must conclude that in terms of economic value, the computer industry is highly concentrated and is dominated by U.S. firms.

The disparity between the profit performances of the U.S. firms as compared with the results delivered by all other countries' computer firms is remarkable. The ratio of profitable vs. unprofitable firms for the U.S. is 5.5 to 1. In the case of all other countries, that ratio is a highly unfavorable 0.43 to 1. This disparity clearly demonstrates the present advantages enjoyed by the U.S. in the computer sector of the information technology business.

An examination of the statistical distribution of profits and losses for the global software firms will also display the pattern of how many of the firms are winners and how many are losers:

Software Firms
Profits -- $000
Top Three U.S. Profitable Firms
$11,170,758
 
408 Other Profitable U.S. Firms
$12,111,063
 
283 Other Global Profitable Firms
$4,455,119
 
Total Profits
$27,736,940
 
691 Unprofitable U.S. Firms
$-9,970,551
 
118 Other Global Unprofitable Firms
$-1,617,894
 
Total Losses
$-11,588,444
 

Again, the net total global profits are what remain from the total global profits realized by the winners after they are offset by total global losses by the losing component firms.

The aggregate profitability of software firms does not reflect adequately the extraordinary effects of profits realized by Microsoft, Oracle and Cisco. These three firms alone account for 69 percent of the total net profits for the entire global software industry and 84 percent of the total profits for the entire U.S. software industry.

Policy Implications

Information technologies are emerging as the engines of economic growth of the 21st century. They deserve increased attention as one of the primary sources of U.S. global economic power. It is quite possible that the rapidly surfacing complaints and antagonism about the alleged American political dominance in global affairs may be, to a significant extent, a reaction to U.S. primacy in everything that is related to information technologies. The suddenly rising national anxieties which are now vented against McDonald's hamburgers, Coca-Cola drinks, biogenetically controlled crops and anti-missile defenses may serve as proxies for articulating deeply seated apprehensions that most countries are not in a good position to compete with computer-intensive U.S. corporations.[1]

The exceptionally favorable results delivered by U.S. IT firms should not be a source of complacency and certainly not a reason to believe that the currently favorable U.S. position makes it possible to maintain sustainable superiority forever. A study of industrial history will reveal that retaining a number one position is always precarious and never defensible with any sense of assurance. When the fall from a position of exceptional economic advantage occurs, its first cause comes usually from self-inflicted wounds. The rising number of enemies just administer to the ultimate demise.

And what is the vulnerability of the U.S. Maginot Line? It is the arrogance by the leaders of the software industry -- the readily perceived bearers of U.S. hegemony in information technologies -- who have leveraged their rising economic muscle to seek and to obtain legal exemptions from accountability for faulty products. If there is any single cause for anxiety about the continuation of the economic prosperity of U.S. information industries, it is such self-serving actions that will give a good reason to hitherto obedient customers to seek out more economical sources of supply or to stop in their arms-race like pursuits of investments that have a poor payoff.

From a policy standpoint, the last thing that one needs at this point is more government regulation or direction of information technology investments. The present policies that yield to information industries unfair economic advantages (such as the recent Y2K legislation exempting information vendors of liabilities and the UCITA legislation which offers to software vendors protection against legal suits to an extent that is unprecedented for any other sector of the economy) suggests that government policies should enforce a strictly market neutral position and leave to the marketing forces to resolve any questions of competitive viability.[2] Any opportunistic attempt by the leading U.S. information technology firms to leverage their economic power for predatory and restrictive purposes -- including violation of privacy rights or jeopardizing national security of any nation -- would ultimately work against long term U.S. national interests. Under such circumstances, the legitimate role of government is to act as a counter to a predatory corporation's short-term opportunism. Making such corporations liable for economic damages (such as in the cases of tobacco and asbestos firms) would be thus much more effective than the questionable remedies that can be obtained by anti-trust actions.

Q: You have done substantial research in the concept of knowledge capital (KC). Would you define this concept for iMP's readers and summarize for us (1) what role KC has for corporate development, especially for the success of the handful of profitable IT firms, and (2) the implications for U.S. economic and national defense priorities?

(1) It is no longer a matter of debate that information and its management constitute both a primary cost and the most valuable asset of corporations in the new economy. However, traditional accounting practices offer no consistent method for incorporating a measure of this vital ingredient. In 1988, I formulated a set of metrics to surmount this shortcoming and to permit executives, information managers and investors to make informed decisions and project into the future likely consequences of past performance. Incidentally, Strassmann, Inc. has now received and successfully defended its formulation of Knowledge Capital as a Registered Trade Mark. Knowledge Capital (KC) now provides an operational means of comparing the economic health of the world's corporations from routinely reported financial data.

Classical economic measures of productivity (Return-on-Assets, Return-on-Investment, Return-on Equity) focus on accounting profits generated from financial capital and ignore the intangibles associated with information (e.g., relationships, knowledge, management, employee turnover), although the latter set constitutes the true source of wealth in the information economy. The KC metrics incorporate these elusive foundational elements by focusing on economic profit instead of accounting profit. When economic profit is calculated, financial capital is treated as a readily obtainable commodity rented at a rate that the firm pays for its borrowings. Thus, the definitions of Economic Profit and Knowledge Capital are:

Economic Profit = Accounting Profit minus Financial Capital multiplied by Cost of Capital

Knowledge Capital = Economic Profit divided by Cost of Capital

I have calculated Knowledge Capital for approximately 20,000 of the world's publicly listed companies and have used Knowledge Capital Assessments in consulting engagements (see [http://www.Strassmann.com/d4]). That demonstrates the practical applicability of the metric as a benchmark for comparing players within an industry, effective use of knowledge between industries, mean employee valuation and factors of socio-geographic importance.

(2) As "information" and "knowledge" become the primary levers of economic power in the global economy, comparisons based on Knowledge Capital instead of revenues, assets or even GNP (Gross National Product) become less revealing and relevant.

I have used the 1998 Knowledge Capital valuations of global and listed public corporations to portray the economic power of the U.S. as follows:

Table 5
Knowledge Capital Valuations

Knowledge Capital % of Total Global KC
U.S. US $6.8 trillion
57 %
5 Countries with GDP greater than US $1 trillion US $1.4 trillion
12 %
Rest of World US $3.8 trillion
31%

 

On account of favorable interest rates in the U.S., its premium priced dollar and relatively high profitability of U.S. corporations, the Knowledge Capital comparisons reveal a remarkable concentration of economic power. If used effectively, the accumulated Knowledge Capital can be then used to compound U.S. wealth at rates, which cannot be matched, by any one or even any combination of other countries.

Policy Implications

The overwhelming U.S. dominance in the possession of Knowledge Capital is both its strength as well as its weakness. KC is not only vulnerable to sudden devaluations whenever the fiscal (e.g., currency and interest rates) health deteriorates. The inherent riskiness of the KC component as related to corporate profitability has been a topic of my recent article in my monthly editorial that I write for the Knowledge Management magazine ["Expecting Too Much of Knowledge"].

At present much of the attention at the national policy levels is concentrated on matters of information security and information infrastructure protection against attacks that are aimed primarily at the destruction or compromise of physical or software assets. Though such precautions have tactical merit, they totally miss the point that the greatest vulnerability of the U.S. comes from the inherent risk to its Knowledge Capital assets. These can evaporate either as result of sudden economic disruptions (such as currency depreciation, rise in interest rates, inability to protect intellectual assets) or through rapid erosion in the ability of leading U.S. corporations to retain their technological lead.

Any student of history will recognize that all prior attempts at hegemony (whether regional or global) have failed not because of physical or geographic failure but because of internal economic collapse preceding the inevitable demise of national power. I have demonstrated in a number of papers that the wealth of the U.S. is now based primarily on KC and not on land or financial assets. How to protect U.S. Knowledge Capital against the inevitable threats to its viability is certainly the new agenda item that needs a thorough discussion. My own contribution in this regard will remain in providing the analytic background that will continue to shed light on the magnitude of this challenge.

Q: John Chambers of Cisco has argued that the transformative technology is networking rather than just IT, broadly construed. In the centralization and concentration of economic power that you have described, what is the relative contribution of the technology? That is, are there distinct properties of IT and/or of IT networking, as opposed to other technologies that contribute to the processes you have identified?

I am not surprised that the CEO of Cisco -- the most profitable vendor of communication equipment -- would argue about the preeminent influence of his products. Without denying the enormous importance of making available low-cost and high-bandwidth communications links, I would certainly not assign to these technologies the decisive role in shaping the future shifts in global economic power.

The largest economic gains in the next decade in global commerce will come from the global streamlining of procurement in the manufacturing value-added chains. (see my article in Computerworld, which quantifies this opportunity, [http://www.strassmann.com/pubs/cw/netprofits.shtml]. Most of these gains have nothing to do with telecommunications as an enabler but with the politics of barrier-free world commerce. What is nowadays trumpeted as a Business-to-Business (B2B) Internet-based procurement is really old hat and was conducted on a global basis as early as in the 1960's -- where politically feasible.

Q: Given your analysis, that economic power in information technologies concentrates, is it, therefore, appropriate for government to intervene in response to a perceived market failure and artificially break up these concentrations in the name of protecting the consumer? Or is that approach tantamount to swimming up Niagara Falls? That is, the effort is doomed because the logic of the technology is such that another firm or cartel will simply replace the one that has been forced to fragment?

Having served in the government in a key information technology position and after observing recent attempts by the government to carry out a number of technology-based initiatives I am convinced that government intervention in matters of technology is not practical.

The only failures I have observed so far were those that were initiated by governmental regulatory or legislative measures -- with the exception of a few noble attempts at standardization in the past, which are now defunct anyway. The promulgation of standards in order to enable commerce is one of the few administrative functions of the federal government that is explicitly mentioned in the Constitution. Instead of regulatory meddling -- with demonstrably questionable consequences -- the U.S. government would serve the economy much better by doing well one of the few tasks, which are prescribed, and necessary.

It is intrinsic in the nature of information technologies to give a few firms an enormous, but temporary advantage in the market place. So far, each of the dominant firms -- once deemed to be unassailable -- have lapsed into competitively inferior positions. There is no inherent reason why the current leaders will not repeat such a fate. First and foremost, it behooves the government administrators not to stand in the way of verdicts that will be delivered by the competitive marketplace. Contrary to current pretenses, it is precisely such unwarranted protection against damages and liability that buttresses the otherwise weak positions of the current information technology leaders -- and especially that of Microsoft. Second, the government should be guardian of its own interests, not try to interfere. Here, I find that the government's persistent adherence to purchasing Microsoft software, though demonstrably counter to its national security interests, is a particularly questionable approach to policymaking (see [http://www.strassmann.com/pubs/cw/ms-security.shtml]).

Q: Finally, what is the role of demand? In a tradition that goes back to Adam Smith (as you well know), the natural monopoly argument has tended to focus on the producer side (e.g., high threshold costs, conditions in which competition leads to waste rather than optimal use of resources). However, more recent studies of the historical diffusion of telephony in the early 20th century have concluded that demand-pull accounted for standardization on a common provider rather than production push. Is the concentration of power you have identified at least partly a function of demand?

If you study the erosion of economic power of AT&T, IBM, Xerox, Burroughs, etc. -- to give a few examples only -- the evidence will show that it was neither demand pull and certainly not supply push that diminished the economic power of these giants.

In each case it was technological innovation by complete outsiders that hacked away at already rotting foundations of what appeared to be an impregnable corporate fortress.

As long as the U.S. can maintain and afford to waste enormous amounts of money in making venture investments, and as long as we have a highly motivated elite of highly motivated innovators, we will be reasonably safe against unwarranted concentration of economic power. As long as our market system functions well, someone, somehow, will create enormous economic value which will then free as yet unsatisfied demand for goods and services. If that would ultimately lead to their becoming the leading, common and standards-bearing common provider, so be it. Latent demand will remain latent until somebody is smart (or lucky enough) to meet it. At the current stage of development in information technologies it is not demand that leads to marketing success, but innovative supply that suddenly discovers new customers!

Notes:

[1] Rodman, P.W., The World's Resentment -- Anti-Americanism as a Global Phenomenon, The National Interest, Summer 2000

[2] Barbara Simons, ACM's former president summarizes the impact as follows (in Communications of the ACM, August 2000):  UCITA is writing into state law some of the most egregious excesses contained in shrink-wrap software licenses. These include statements that disclaim liability for any damages caused by the software, regardless of how irresponsible the software manufacturer might have been. Shrink-wrap licenses may forbid reverse engineering, even to fix bugs. Manufacturers may prohibit the non-approved use of proprietary formats. They can prohibit the publication of benchmarking results. By contrast, software vendors may modify the terms of the license, with only email notification. They may remotely disable the software if they decide that the terms of the license have been violated. There is no need for court approval, and it is unlikely that the manufacturer would be held liable for any harm created by the shutdown, whether or not the shutdown was groundless. The mere existence of such mechanisms is likely to enable denial-of-service attacks from anywhere.

Since local contractors probably will have a contract that holds them liable for damages, the contractor may be forced to pay for damages resulting from buggy commercial software. The business owner may be unable to sell the software portion of the business to another company, because most shrink-wrap licenses require the permission of the software vendor before a transfer of software can occur.

Very few manufacturers of other products have the arrogance to disclaim all liability for any damage whatsoever caused by defects in their products, and most states restrict the effectiveness of such disclaimers. Software vendors base their non-liability claim on the notion that they are selling only licenses, not `goods'. Consequently, so the argument goes, U.S. federal and state consumer protection laws, such as the Magnuson-Moss Warranty Act, do not apply.  As noted by a State Attorney General: "We believe that UCITA puts forward legal rules that thwart the common sense expectations of buyers and sellers in the real world. We are concerned that the policy choices embodied in these new rules seem to almost invariably favor a relatively small number of vendors to the detriment of millions of businesses and consumers who purchase computer software and subscribe to Internet services . . . . [UCITA] rules deviate substantially from long-established norms of consumer expectations. We are concerned that these deviations will invite overreaching that will ultimately interfere with the full realization of the potential of e-commerce."

Released: September 22, 2000
iMP Magazine: http://www.cisp.org/imp/september_2000/09_00strassmann.htm

Copyright 2000. Paul A. Strassmann. All Rights Reserved.