Business Operations

The growth of the information economy is associated with many powerful developments:

• Information technology can dramatically reduce the cost of some activities, among them searching for information and collaborating with partners.
• In some cases information technology makes efficient operation possible for much smaller producing units or individuals, as occurs with desktop graphics and analysis and reaching large audiences through Web sites.
• Information technology makes widespread and instantaneous communication possible, involving speech, documents, video and transactions. This facilitates many kinds of interaction.
• Information technology can speed up business processes and let organizations react quickly to changes in the economy.
• Rapid technological change produces intense competition, often for a long time. If the market is growing fast enough, new competitors may be able to successfully challenge even large, well-established firms.
• Rapid technological change intensifies the process of "creative destruction" in which firms are displaced by competitors. Competitors may enter that have greater understanding of the new environment and technologies and/or are better able to adapt ¾ in an environment that requires decisive and appropriate responses for survival as well as for success.

Effects on Products and Markets

• New technologies often create important new markets by offering products that make it possible to do things more efficiently or in new ways, and sometimes to do things that it was not possible to do previously.
• Information technology is making it possible to efficiently produce a much larger number of varieties of goods and services and to access niche markets that have demands for those products.
• For many information and software providers the cost of producing additional units of each product is zero or near-zero after the initial fixed costs are met, facilitating rapid growth of markets.
• Many information products exhibit "network externalities" or "demand-side economies of scale." Such economies arise because the value to each user of participating in the network increases exponentially with the number of participants ("Metcalf’s Law" – see text box).

Network externalities are evident in services such as telephone, fax and e-mail. Of course, network externalities are at the heart of the growth of the Internet. Demand increases as more people are using the same product and because when they do the markets become more attractive to suppliers. For example, as viewers increased, more TV programming came in, leading to even more viewers. Bandwagon and other social effects can further reinforce demand as well.

Network externalities make demand for products more price-sensitive since lower prices that add customers lead to even more customers. Economies in production, especially those from low costs of adding users, can interact with demand economies from network externalities to produce rapid growth in the number of users. They also can bring about major changes in ways of doing business.

Concentration and Competition

Some analysts have been concerned that the concentration of markets that results from the benefits of a large network can lead to monopoly. When technological change is strong and growth is rapid, competition may be great enough to prevent substantial monopoly effects from developing. Challengers may invest heavily in seeking to attain the efficiencies of large size and preserve competition in the process ¾ what Hal Varian calls "competing for monopoly." Eventually, however, as a technology becomes mature and/or growth slows down, and as less successful competitors are weakened, the possibility of monopolistic effects increases.

In a period of rapid technological change, several technologies often emerge that can perform some of the same functions, such as a use of telephone, cable and wireless for Internet connections. Competition among technologies can greatly lengthen the period of time during which strong competition persists as long as owners of one technological franchise do not become the dominant owners of competing technological franchises.

Rapid technological change has been associated with pressures to reduce regulation and lower trade barriers to increase competition and efficiency. Rapid technological change, especially in information technology, has been a major contributor to the global increase in reliance on markets. As firms have globalized in the processes, that has brought some movement toward international convergence in the structure of firms and important changes in the relationships of firms to governments.

December 10, 2002

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The following was written after the 2000 stock market collapse:

The speculative boom of the late 1990s and its aftermath were the result of intense emphasis on income in the form of capital gains that built-up since the 1980s. The emphasis on capital gains was encouraged by the double taxation of corporate profits at the company and individual levels. Once started, in too many quarters it evolved into an effort to achieve extraordinarily large incomes in a short period of time.

Devices

One impetus to the shift to capital gains income was the 1993 IRS ruling that the maximum tax-deductible salary a company can pay and employee is $1 million per year. Above that level, compensation had to be performance-related for the company to be able to deduct the cost. The ruling led to a grat expansion in the use of stock options to meet the "performance-related" criterion.

The reduction in the top capital gains tax rate in 1997 also contributed to emphasis on income in the form of capital gains. However, the change itself reflected attitudes that had been building for a long time.

Many devices we used by executives to convert income into capital gains. Among them were:

• Paying little in dividends to build up retained earnings so they would be capitalized in higher stock prices
• The company buying back its stock to raise earnings per share
• Increasing leverage
• Making numerous acquisitions to create the appearance of rapid growth
• Making highly speculative investments in telecommunications licenses and equipment, fiber optics, energy trading and other areas
• Paying a larger share of executive compensation in the form of options.
• Widely using pro forma accounting and ebitda (earnings before interest, taxes, depreciation and amortization) instead of GAAP accounting (generally accepted accounting principles)
• Overstating projected returns on pension investments to reduce contributions or shift funds into profits
• Loading costs into special write-offs so they would not reduce ongoing earnings
• Increasing use of off-balance sheet special purpose entities and transactions
• Making loans to officers so they could buy stock
• Delaying reporting of executive stock transactions
• Misrepresenting earnings and prospects in public communications
• Incorporating in Bermuda and other offshore areas to avoid taxes

Others succumbed to the frenzy. Analysts were pressured for favorable ratings by the lure of investment banking business. Accounting firms were blinded by the desire for lucrative consulting contracts.

The public got equally caught up in the capital gains chase. Stock ownership grew to unprecedented levels, as did the share of portfolios invested in equities. A rising share of equity portfolios was in more speculative investments. The highest stock prices got, the more people jump in. Investment analysts and others on Wall Street both help to create the crescendo and joined in.

Consequences

The results of the capital gains chase have become painfully clear. They include:

• Erosion of ethics
• Greater divergence of interests between managers and shareholders
• A focus on short-term gains even when contrary to stakeholders’ long-term interests
• Dramatically higher price/earnings ratios
• Far greater compensation of executives relative to others
• Worker loyalty becoming more of a one-way street
• Collapses of companies operating on the edge, with losses for employees and suppliers and disruptions of service
• Increased debt for both companies and households and increased defaults
• Setbacks in retirement savings
• Prolonged recession

Responses and Prospects

Some important changes are taking place in accounting and reporting, in attitudes and leadership. The changes are incomplete and there are overreactions as well.

As a result of the capital gains chase we can expect longer recovery in capital investment and in the economy. The growth of stock prices is likely to be slowed as people remain wary and as high valuations adjust. Rebuilding confidence and trust will take time.

Can it happen again? Yes, more readily than the responses to recent problems would suggest, but not in so widespread a way or with such intensity for a long time.

Excesses resulting from the capital gains chase could arise in new ways. They can manifest themselves in a premature stock market boom or real estate speculation, in risky international investments or in speculative uses of derivatives and other financial innovations.

Double taxation of dividends remains. So does the use of share repurchases, which require less discipline than meeting dividend payments. Accounting has further to go to address issues of hidden liabilities and valuation of business assets whose worth can change abruptly. The underlying attitudes that produced the excesses have subsided but, contrary to the conventional wisdom, they are still with us.