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Information Superhighway Robbery

Electronic commerce is ready for explosive growth, but the
threat of global piracy continues to delay the rewards.

Thomas H. Lipscomb




The "through the looking glass" world of the digital economy, like its central nervous system-the Internet-doesn't change anything; it just changes everything. And the sheer speed of that change and its impact on all areas of the economy is accelerating so rapidly that it is easy to lose our bearings. Trends and industries we think we understand have already changed radically beneath their familiar outward appearances.

Barely a decade ago, the United States seemed to have evolved naturally into a manufacturing and service economy. Computerization looked like just another tool supporting the basic economy, like mass production or advertising. It allowed significant savings in operating costs by eliminating middle management positions, and innovations in connectivity made possible efficiencies such as "just in time" inventory. But few saw the immense change in the American economy that was underway

For what appeared to be an evolution was the most massive, basic change in our economy since the Industrial Revolution. Information technology (IT) has made intellectual property (IP) the largest industry in United States. Since 1996 our leading area of foreign trade has been IP in its many different forms, from computer products and software to entertainment. In the past decade in the U.S., employment in intellectual property-based industries has grown nearly three times as rapidly as in the overall economy.

IT is spreading over the entire developed world with incredible rapidity. Ireland-a decade ago the poorest country in the European Community (EC), with the highest unemployment-now leads the EC countries with a more than 8 percent increase in annual GDP and low unemployment. This shift has been based largely on IT. Companies based in Ireland now produce 60 percent of all packaged software and a third of all PCs sold in Europe, while stagnant giants like Germany and France endure historically high unemployment and export their conventional manufacturing production-and the jobs associated with it-to more-hospitable foreign locations.

Not since sixteenth-century treasure galleons, returning with gold and silver plundered from the Americas, turned dusty, impoverished Spain into a world power has there been such a rapid change in the status of participants in the world economy. Microsoft Corporation, a company barely twenty-five years old, is challenging venerable GE for the position of largest corporation in the United States, at more than $260 billion. Microsoft's founder, Bill Gates, is the richest man in the U.S., with more than $58 billion according to the new Forbes 400 list, more than twice as wealthy as the runner up. Gates has far more than the $25.6 billion accumulated by the great monopolist John D. Rockefeller according to the new biography by Roy Chernow.

Antiquated Ideas

Few of us really know what to make of an economy in which people buy more computers than television sets. Thus our political leaders remain fixated on issues like crime, Social Security, the environment, and the loss of industrial manufacturing jobs, which are not nearly as critical as protecting U.S. IP in the global economy. Policymakers continue to view key issues such as encryption and high-speed computer sales in familiar but antiquated Cold War terms.

In the developing world, it has long been popular to regard intellectual property protection as just another means of exploitation by more prosperous countries. But, as a recent World Bank survey of international executives has shown, the two most important factors influencing multinational corporations' siting of major foreign investment are tax rates and intellectual property protection. Flagrant offenders such as India suffer severely. After adopting patent protections in 1994, Mexico now receives more than twelve times what India receives from foreign investment. The establishment of strong IP protection in Korea has generated a highly innovative local base for technological development with growing exports.

But hard though it may be to believe after the extraordinary burst of wealth from information technology industries in the past quarter-century, the information product that has not yet been introduced into the global marketplace represents by far the largest opportunity in the world economy today. And Divine Providence who, we are assured, protects children, drunks, and the United States, has given the U.S. the largest potential share of this burgeoning world market in films, music, games, and spinoffs from print media. With the past decade's paradigm-shifting improvements in computer processing power, miniaturization, storage, and data handling, the U.S. has been building and improving what is in effect a vast railway system with faster engines, higher-capacity freight cars, and better roadbeds and rights of way. The result is so impressive that we have forgotten a fundamental truth: the greatest profits lie in what the railway carries. It is the freight-and not the rolling stock, tracks, and yards-that has the highest value and will represent the largest share of continuing business.

It is difficult to see this, considering the Internet we use today. By far the largest percentage of information technology sales on the Internet and through other consumer outlets remains in hardware and software products. Intel now reports a billion dollars a month of revenues from the web, comprising 65 percent of its sales. Current government estimates predict that Internet commerce in the United States will exceed $300 billion by the year 2002, but less than 10 percent of these sales are expected to involve pure digital information products. Ironically, the vast majority of what is being sold over the Internet requires physical warehousing and fossil fuel-powered vehicles for delivery.

The world's economic and legal systems do not require much retooling to cover such sales. After all, whether used to sell a router from Cisco Systems or a laptop from Dell (companies now grossing millions of dollars a day over the Internet), or a book from Amazon.com, the Internet today is just a glorified subsector of the $84 billion direct-mail catalog business, not really a new medium. It is true that "wired" consumers are the cream of the potential customer base: the youngest, most highly educated, highest-income target market in the world. But web users can only buy a limited amount of computers and software.

The real Internet sales opportunity is in the ability of millions of customers to buy digitally, pay digitally, and receive digital products through digital media, instantaneously, all over the world. This market can generate literally trillions of dollars of sales annually, but firms have done very little to access it. They have some good reasons for concern. Much-heralded projects such as Time-Warner's Pathfinder-which has now consumed three CEOs in three years-have been tremendous failures. Only a few print publishers such as Consumer Reports and The Wall Street Journal are showing even small profits on their Internet presence. For all their brand-name power, companies such as The New York Times, CBS, Disney, and Pearson still cannot figure out how to make money on the Web. Bertelsmann, the largest publishing empire in the world, with 110 commercial websites operated by almost a thousand employees, loses money on the less than 3 percent of its revenues accruing from these sales.

Slow Growth

Technology experts with no experience in communications media or information products have often hyped the Web's economic potential, and its poor showing has mystified them. But there is no mystery here. Anyone with real media experience understands that a medium's delivery mechanism determines what it can carry at a profit. Progress in this area has been slow, purely because of technological delivery problems.

A computer expert may be enthralled by a speech-recognition program that can convert spoken information to print with 90 percent accuracy, but the ordinary consumer cares only whether it works well and is easy to use. A 10 percent failure rate is too high for him. Thus it is hardly surprising that the painfully slow screenfills of today's Internet do not impress consumers. What is available on the digital Internet "superhighway" today looks Stone Age compared to the rapid, jump-cutting music videos on analog TV sets based on 1960s technology.

There is no doubt that slow data rates have depressed adoption by home users, who are far more normal consumers than the early adopters or "industrial strength" computer users willing to deal with Windows crashes, online connect problems, browser tinkering, plugins, and the like. It still takes almost an hour to download a fairly small program such as Excel, so it is obviously impossible to sell something as data-heavy as a movie. And with no real financial incentives to provide faster service, telecoms and media companies have let the improved delivery opportunities they had available, such as ISDN, wither on the vine.

This is about to change radically. New high-speed connections through ADSL teleconnect and cable modems will soon offer data transfer speeds faster than 1.3 megabytes per second (almost thirty times as fast as a 56K modem). This will enable Internet providers to deliver full-motion video, and it is only the beginning. With the deregulation subsequent to the Communications Act of 1996, long distance carriers, Baby Bells, cable companies, broadcasters, satellite delivery companies, and others will be racing into one another's markets to exploit what only recently seemed a limited medium-bandwidth. And John Sculley's "digital convergence"-which is now bringing into direct competition products and services that were once entirely separate lines of business-will only accelerate the process and the level of affordable service. As Jay Samit, the head of new media at Universal Studios, put it, "This is a world where telco, media, software, and hardware manufacturers are all 800-pound gorillas in their own forest and suddenly they're all thrown together."

After a huge increase in online subscribers in the past five years, the number of U.S. home Internet users has begun to stabilize at approximately 27 percent of households. The average Internet consumer spends approximately twenty-five hours per month online. Just as an astronomer sees little difference in the appearance of a distant star whether he views it at one-power magnification or one-thousand-power, the slow march of data rates from 1200 baud to 56.6 kilobytes per second over the past decade has been insufficient to broaden the user base substantially.

Yet in a remarkable statement, AOL's Steve Case, the CEO of the largest online service in the world (with fifteen-million low-end subscribers), recently forecast that there will be one-billion Internet users in the next five years. Why? Because of the improvements noted earlier: consumers will soon be able to use the Internet quickly and easily to download music, video programming, films, and video games anywhere in the world. And because information transmitted digitally does not degrade like information in analog media, it is possible to deliver mirror-image quality in an infinite universe of replication. IP proprietors will be able to make the highest-quality products available to the largest marketplace ever at the lowest costs in history. They are facing a truly unprecedented explosion in sales and profit margins.

Potential for Piracy

That is the good news. The bad news is that we are about to place America's most valuable and fastest-growing industry sector in an international marketplace in which theft is more common than legitimate purchase. Counterfeiting physical objects such as a Cisco router or Dell laptop costs far more than buying them, and it takes a lot of time and effort. Making a copy of a digital product, however, takes less than a second and costs pennies. The incentives for massive digital media piracy are so obvious that it will not make sense for firms to send their products into the new marketplace without a binding international environment of law, protocol, and industry standards.

The potential financial losses from this media vulnerability are as immediate and immense as the profits and economic expansion accrued to date by IT. The Business Software Alliance has estimated that in New York state in 1997, software piracy cost more than 7,800 jobs and almost a billion dollars in wages, tax revenue, and retail sales. This includes only software piracy, an esoteric exercise that requires considerable expertise, and only one, not very significant, part of the U.S. market. The impact of global piracy in easy-to-use digital media will be immense.

Last year, the federal government took its first serious steps to protect intellectual property, implementing a government-wide ban on illegal copying of software and signing into law the Digital Millennium Copyright Bill which extends current copyright protection and criminalizes attempts to defeat systems designed to protect intellectual property. The Clinton administration has also been working quite effectively through the European Community and the World Intellectual Property Organization (WIPO) to protect digital data.

Unfortunately, much work remains, and many influential organizations in the U.S. are opposing the extension of protection for digital products at the very time we need it most urgently. One reason for this opposition is the libertarian and almost hacker-friendly attitude of many important persons in the digital world. Because their own experience is oriented more toward computer technology than information, they tend to be nonchalant about the rights of information providers and IP owners. And it does not help when major figures such as Esther Dyson and John Perry Barlow (of the Electronic Frontier Foundation), declare that "information wants to be free."

This is a particularly dangerous attitude for the U.S., because many nations in the developing world have a long tradition of stealing and mass-producing videotapes, computer programs, CDs, and other IP assets. This piracy was damaging enough before true digital IP, but mirror-image replication may soon turn a major annoyance into an international catastrophe, particularly for U.S. companies, who create more than 80 percent of the current world output. And if we have a weakening sense of IP owners? rights in our own country, our government's protection of those rights abroad will almost certainly be weak.

Understandably, many information and entertainment providers have simply kept their products out of the Internet marketplace, limiting their websites to corporate background, promotion, product advertisements, and some free material. To return to the railroad analogy, it matters little how excellent the railroad and trains are if their delivery route is threatened by millions of train robbers. No one in his right mind will put any freight of real value on board.

Immense Opportunity

Just when the digital marketplace appears ready to take off, it may be about to implode because piracy makes it impossible to make a profit on digital intellectual property. A proper network of policy and support, however, can open the medium to global sales opportunities reaching billions of consumers at very low cost. Creating this network is clearly in the best interests of the U.S. and the rest of the world. Recent national and international agreements on issues from digital IP enforcement to relief from Internet taxation have greatly improved the prospects for such a scheme, and commercially effective systems for payment and product encryption are now available to speed the transition.

Unfortunately, our traditional understanding of the media business conceals the vast magnitude of the coming changes. Telecoms, for instance, should no longer be under the regulatory standards used when their principal business was voice transmission. They are moving into the transportation business, routing billions of digital products from owners to consumers. In fact, the telecoms are developing the ability for entertainment we expected from the cable companies, and they have far more reach than cable firms, far more capital, and can provide phone service as well.

The high-speed data conduits rapidly becoming available from telecoms and other broadband servers allow them to offer fully interactive, customer-defined "pull marketing" services that cable and broadcast can only dream about. The disastrous Orlando experiment by Time-Warner and Silicon Graphics established all too clearly just how expensive it would be to duplicate this environment through cable. John Malone saw that clearly enough and folded debt-ridden TCI into cash-rich AT&T in the nick of time, trading a losing medium's stock for a far better option for the future.

Rest assured, the "railroad business" will continue to grow. PricewaterhouseCoopers recently estimated that small high-tech businesses in the United States were forecasting revenue growth in 1998 of 23.7 percent and larger firms 17.8 percent, with international sales comprising more than 25 percent of the total. And 72 percent of these businesses plan to add new employees in the next year.

But the truly immense opportunity still lies in the freight. IP providers are about to enjoy a medium that radically reduces their production and distribution costs and time to market. Imagine what profits print publishers like McGraw-Hill and Harper/Collins might make if they could slash their media and distribution costs and obtain instant access to a worldwide market. And consider the boost in value for a film company like Universal or SONY/Columbia if shrinking per-screen revenues, growing publicity and advertising costs, and a sluggish video market were dwarfed by rising digital-media revenues. And think about the potential for a music company that could reach a world market instantly without having to weave through a distribution system that often looks more like a criminal conspiracy than a legitimate business. Then ponder Steve Case?s prediction of one-billion Internet consumers in five years and consider the possibilities.

The high-speed digital marketplace will make the fixed, hundred-channel cable systems of today look as restricted as a crystal radio set. Like a far-bigger version of the NASDAQ electronic market, it will enable instantaneous settlement of trillions of customer-defined purchases, all based on market prices that fluctuate in fractions of a second. In this environment, the most successful industries will be those with the lowest fixed costs of production as a percentage of sales. And those costs will be very low indeed: huge amounts of digital inventory cost only pennies to store while providing an enticing range of selection.

Offering Internet access to a maximum range of inventory choice, Amazon.com stock rose in 1998 from under $50 a share to more than $300. Because it is still physically delivering books to its customers, Amazon has yet to make a profit. Imagine what it will be worth when it no longer has to waste time and money shipping books. The greatest winners in the coming marketplace will be the most effective proprietors of digital intellectual property through digital media.

But with everything in place for an explosion in global sales of intellectual property already available through other means, the owners of that property continue to hesitate. Arthur C. Clarke framed their predicament perfectly: "As the century that saw the birth of both electronics and optonics draws to a close, it would seem that virtually everything we would wish to do in the field of telecommunications is now technically possible. The only limitations are financial, legal and political."

Without legal and binding international conventions for the protection of digital distribution of intellectual property, this immense opportunity in the global marketplace will continue to sputter even though the technology is now available to support it. And mistaken policies that tolerate the wholesale theft of intellectual property by the developing world will continue to deny it what it will need most in the new millennium-open access to the electronic marketplace for intellectual property, the key to success in the global economy.

Breaking through this impasse may well be the most critical factor in the long-term expansion of the global economy and America's share of it.

Thomas H. Lipscomb is the Chairman of the Center for the Digital Future in New York. He was a founder and CEO of two public companies in digital technology and holds five patents. He has been an executive in several media companies, most recently as CEO of Times Books, and he has written articles for publications such as The New York Times, The Washington Post, and The Wall Street Journal.


Copyright © 2000 by Hudson Institute.

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