Trillion Dollar Economists_How Economists and Their Ideas have Transformed Business

by Robert Litan

  The Energy Revolution as a Platform Technology

  While most commentators have focused on the major impacts of the fracking revolution on the oil and gas industry, the effects on other sectors may be even more important. Oil and gas are inputs, directly or indirectly (for example, as fuel for electricity), in virtually every other sector of the economy. So it stands to reason that the benefits of any major technological change in oil and gas discovery, like innovations elsewhere in the economy, are going to be captured to a significant degree by the consumers of the products and services that depend on the innovation. Indeed, one well-known study by Yale University economist Bill Nordhaus (who is profiled in Chapter 14) documented that just 4 percent of the benefits of the invention of the lightbulb were captured by the inventor, and the other 96 percent by purchasers of lightbulbs.8 Nordhaus argued that this was likely to be a general phenomenon, because in competitive industries, as most industries are, any reductions in cost get passed through entirely or nearly so to consumers.9

  I will not be surprised if many readers are shocked, or even in a state of disbelief, over this result. After all, isn’t the reason for our patent, copyright, and trademark system to give strong incentives to inventors and innovative entrepreneurs to come up with and commercialize innovations by granting them some of the monopoly rights to their inventions? What about the fabulous riches earned by the founders of Microsoft, Apple, Google, Intel, and so on? Doesn’t that prove that most of the benefits of innovation accrue to inventors and entrepreneurs?

  Actually, the answers are no. Even for firms that have temporary or moderately long-lasting monopolies in the industries defined by their inventions, they only get rich by selling massive quantities of their inventions to the consuming public. Think about Microsoft for a moment, which has sold billions of copies of its operating system and key applications software programs to consumers throughout the world. While these consumers fork over $100 to $500 or more for copies of this software, the benefits to purchasers and society as a whole surely exceed these costs.

  Individuals use the software on their PCs, and more recently tablet computers, to organize their daily lives, and in many cases, to work at home, either for the companies that employ them or for their own startups, in ways that simply would not have been possible before the PC revolution (for which companies like Microsoft, the PC manufacturers, Intel, and others are responsible). For business users, or those who buy PCs, tablets, and related software in bulk, the information technology (IT) revolution has fundamentally transformed the way businesses operate. Organizations are flatter, which speeds up decision making, while supply-chain management, customer service, human resource departments, and virtually any other cross-cutting function of the modern corporation operate in ways that corporations in the pre-PC wouldn’t even recognize.

  To be sure, the IT industry has some large firms that in their niches have had either large market shares or market power (the ability to influence price as firms in competitive industries cannot), but even the firms in these industries cannot capture all of the gains from their innovations. In the IT sector, this is probably an understatement, since there are intangible ease-of-use benefits that individuals or companies realize from the use of Microsoft or Apple software, or the mobile apps enabled by Apple or Google, that are not necessarily captured in the productivity statistics.

  In any event, the discovery of oil and gas, as a distinct activity or industry, is certainly a more competitive activity than the niche IT sectors where some firms still have dominant positions. Many oil companies either have the ability in-house, or can hire it from drillers, to deploy directional drilling and fracking technology to find oil and gas in tight formations, which makes the production end of the oil and gas industry highly competitive. One widely cited study, by IHS Global Insight, a leading economic and energy consulting firm led by, among others, the energy expert Daniel Yergin, confirmed this by calculating in 2013 the total benefits of fracking shale oil and gas. The study’s verdict: In 2012 alone the energy revolution had saved the average household $1,200 per year, which is equivalent to increasing take-home pay by the same amount, or about 2.5 percent.10 For the whole economy, McKinsey has estimated that the oil/shale gas boom will have increased GDP economy-wide by $380 to $690 billion by 2020, representing a 2 to 3.7 percent increase in annual GDP by that year (an estimate in line with IHS estimate for 2012).11

  These are enormous figures, since annual productivity growth has been in the neighborhood of 2 percent per year over the last decade, which makes the gains from the shale oil/gas boom alone as much as one to two years’ worth of economy-wide productivity growth.

  Industries and sectors of the economy vary considerably by how much energy they use. But clearly, those industries that are more energy intensive, and especially those using natural gas or petroleum products as feedstock for other products, such as the chemicals industry, have especially benefited from the energy revolution.

  Lower costs are analogous to platform effects, since they reduce costs and encourage investment by users of innovations elsewhere in the economy. The shale and oil gas revolution also created important geographically based platform effects. North Dakota, one of the most sparsely populated states in the United States, has experienced rapid growth in both population and incomes because of the discovery of oil in tight shale formations. To attract men willing to work in the harsh climate, oil-drilling companies are paying high wages coupled with bare-bones residential quarters. The men use some of the money to buy gas, food, and other items locally, while sending much of the rest home to their families. This multiplier effect may be less innovative than the new apps that software developers create for new operating systems for computers and mobile devices, but the economic effects are similar. The initial innovation—in this case, new drilling technologies—becomes the equivalent of a platform on which other industries and firms either expand or are created.

  In addition, eastern states in the Marcellus shale gas formation also have experienced benefits, or really revivals, in many areas that were headed on their way down: portions of Ohio, West Virginia, and Pennsylvania in particular. New York is also in this gas region, but its policy makers have limited drilling out of fear of the environmental impacts of fracking on underground water supplies and the release of methane that sometimes accompanies the fracking process. At this writing, the Environmental Protection Agency has also been looking at the water contamination issue, and there is the possibility that the federal government will issue minimum standards drillers must meet to ensure underground water quality in states where fracking is taking place. Research about the methane problem, at least at wells operated by larger companies, suggests that it has been overstated.12 Few energy experts believe that any new environmental requirements the federal government may set will significantly slow the fracking boom.

  The Bottom Line

  In sum, free markets, encouraged by economists, have had much wider benefits than those limited to looking for oil and gas. We can thank a number of economists in the 1960s and 1970s for that, as well as those of recent vintage who stood ready to counsel against any attempts to impose the oil and gas controls of an earlier era in the 1990s and 2000s, when prices soared (but since have come down).

  Accordingly, when you think about the U.S. oil and gas boom remember the economists. Of course, there were powerful political forces pulling with them, unlike airline and trucking deregulation. But the intellectual case helped.

  Notes

  1. For a more elaborate, quantitative history of oil prices and their regulation since the end of World War II, see “Crude Oil Price History and Analysis,” WTRG Economics, www.wtrg.com/prices.html.

  2. This brief history is based on a combination of sources, including Stephen G. Breyer, Regulation and Its Reform (Cambridge, MA: Harvard University Press, 1982) and “The History of Regulation,” NaturalGas.org, www.naturalgas.org/regulation/history/.

  3. See, e.g., Paul W. MacAvoy
and Robert S. Pindyck, “Alternative Regulatory Policies for Dealing with the Natural Gas Shortage,” The Bell Journal of Economics and Management Science 4, no. 2 (1973): 454–498 and Stephen Breyer and Paul W. MacAvoy, “The Natural Gas Shortage and the Regulation of Natural Gas Producers,” Harvard Law Review 86, no. 6 (1973): 941–987, www.jstor.org/discover/10.2307/1340084?uid=309668551.

  4. Breyer, Regulation and Its Reform.

  5. Jonathan Rauch, “The New Old Economy: Oil, Computers, and the Reinvention of the Earth,” The Atlantic Online, www.theatlantic.com/past/docs/issues/2001/01/rauch.htm.

  6. See “U.S. Field Production of Crude Oil,” U.S. Energy Information Administration, www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=pet&s=mcrfpus1&f=a.

  7. See “U.S. Imports of Crude Oil,” U.S. Energy Information Administration, www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=MCRIMUS1&f=A.

  8. William D. Nordhaus, “Schumpeterian Profits and the Alchemist Fallacy,” Discussion Paper Number 6, Yale Working Papers on Economic Applications and Policy (2005), www.econ.yale.edu/sites/default/files/Working-Papers/wp000/ddp0006.pdf. On a personal note, Bill is a close friend who has been a lifelong mentor and was the coauthor of my first book, Reforming Federal Regulation (New Haven, CT: Yale University Press, 1983).

  9. Elsewhere I have used this 4 percent finding to extrapolate how many new scale firms (those reaching $1 billion in sales) must be founded each year to generate a permanent increase in the overall U.S. economic growth rate of one percentage point: roughly 30 to 60 such firms a year. See Robert Litan, “Baseball’s Answer to Growth” in The 4% Solution: Unleashing the Economic Growth America Needs, ed. Brendan Minter (New York: Crown Business, 2012), 127–143.

  10. The study itself is only available to the company’s subscribers, but the bottom-line result has been quoted widely. Two examples are in editorials by the Wall Street Journal, September 10 and September 14–15, 2013.

  11. Susan Lund, James Manyika, Scott Nyquist, Lenny Mendonca, and Sreenivas Ramaswamy, “Game Changers: Five Opportunities for US Growth and Renewal,” McKinsey and Company, www.mckinsey.com/insights/americas/us_game_changers.

  12. Russell Gold, “Fracking Leaks Overstated, Study Says,” Wall Street Journal, September 16, 2013.

  Chapter 11

  Economists and the Telecommunications Revolution

  Perhaps no sector in modern economies has been more transformed by technological change than telecommunications. Young readers of this book surely take this for granted because they have known no other world: the ability to talk, text, watch videos, listen to music, and access an almost unlimited amount of information via the Internet, anytime over mobile phones or on landline connections. There are so many television channels available it is hard to keep track of them.

  But this state of affairs is all relatively new, and is nothing like what older readers of this book will remember. Before the Internet, communications in modern countries consisted of voice and data messages routed largely over wire-based telephone networks. Poor countries were hardly wired, while most countries had only one or a few television channels, owned by the state or a wealthy connected few.

  In this chapter, I focus on the contributions of economists to the sea change in the telecommunications landscape over the past several decades. As I tried to avoid with the energy revolution, I am also not going to overreach here. Certainly, the lion’s share of the credit for the changes goes to the inventors, engineers, and computer scientists, among others, who developed and commercialized the multiple technologies that characterize the modern telecommunications industry.

  My more modest, though I believe still powerful, claim is that economists played an integral role in shaping the public policies that encouraged these advances. In addition, economists are used by some of the firms in this industry to enable them to compete more effectively. This chapter tells these stories.

  Economists in a Quick History of Communications

  It is useful for the exposition in this chapter to distinguish between two types of communication: person-to-person and one-to-many. For most of human history, people have communicated with each other by talking face to face, or with handwritten messages delivered by humans or birds. “One-to-many” communications were limited to just the audiences who could physically hear the speakers.

  Several technologies have revolutionized both forms of communication. Apart from the development of language and writing, arguably the most important innovation of the modern era was Gutenberg’s invention of the printing press in the fourteenth century. That is the consensus, anyway, of a panel of experts on innovation convened by The Atlantic magazine, one of whose members observed that once books and shorter manuscripts were easily copied and distributed, “knowledge began replicating and quickly assumed a life of its own.”1

  Printed material is an example of a “one-to-many” communication, but is asynchronous because of the time lag between the preparation of the content by the author and its distribution to readers. Synchronized mass communication—radio and television—came much later, in the late nineteenth and twentieth centuries, respectively. Both technologies harnessed the electromagnetic spectrum to transmit signals through the air. Later in the twentieth century, television signals would be sent through cable lines, which permitted a great expansion in the numbers of channels and the range of content that audiences could receive.

  As for personal communications, big technological breakthroughs came earlier, initially in the middle of the nineteenth century, with the invention of the telegraph, and several decades later with the invention of the telephone. For roughly eight decades, telephonic communications could only be transmitted via copper wires or by radio devices. In the 1970s, satellites enabled data and voice signals to be transmitted through the air in combination with the existing landline network to deliver messages to their ultimate destinations. Even then, satellites were used primarily for transmitting television signals and data, not voice. Over-the-air personal communication began to expand greatly with the deployment of microwave communications that replaced copper wire for long distance (more about this later) and the invention of cellular telephone devices and networks in the latter portion of the twentieth century.

  Two things about these different forms of communication have made them interesting to economists. The landline telephone industry was assumed by policy makers to be a natural monopoly, a circumstance calling for price regulation to protect consumers, a topic that has long been of interest to economists. Radio and television broadcasters, meanwhile, made use of a scarce resource—certain parts of the electromagnetic spectrum (see following box) that could handle their signals—another state of affairs about which economists have much to say.

  The Electromagnetic Spectrum: A Quick Primer

  If you slept through your high school physics class, or otherwise have forgotten much of what you once knew, it is useful to briefly recollect how it is that radio, television, and cellular phone signals can travel through the air or other matter and reach their destinations.2

  The spectrum refers to the range of various frequencies and wavelengths (the two are opposites) of radiation or energy that travels through air and space. Radio consists of long waves and low frequencies (and thus low energy) at one end of the spectrum; ultraviolet light and x-rays are short wavelength, high frequency (and thus high energy) forms of radiation. Ordinary light is somewhere in the middle of the spectrum.

  In the telecommunications industry it is most common to refer to frequencies in different parts of the spectrum. They are measured in hertz, with one hertz representing one wave per second, a kilohertz (KHz) as 1,000 waves per second, and a megahertz (MHz) as 1 million waves per second. A typical FM radio station transmits signals at about 100 MHz.

  Broadcast television consists of very high frequency (VHF) or ultrahigh frequency (UHF) bands of spectrum. As discussed later in the chapter, the Federal Communications Commission (FCC) will be auctioning up to 120 MHz of the VH
F spectrum for use in mobile broadband communications.

  That does not mean that they have always been listened to, at least not right away. Perhaps the clearest example of the lag in implementing an economist’s idea relates to the way spectrum licenses have been handed out by the government, which asserted ownership of the airwaves shortly after radio was invented and commercialized in the early twentieth century. The agency making that claim, the Federal Radio Commission (today’s Federal Communications Commission), did what comes naturally to government agencies: It established an applications procedure and handed out the licenses, first for radio and later to television, to those stations whose owners could meet various financial and public interest requirements. As you will learn later in this chapter, if you are not already aware, this is not how most economists think about how to allocate a scarce resource like the electromagnetic spectrum.

  As for the natural monopoly in landline telephony, it took some human hands to make it possible, and then later, when competitors started challenging that notion, it took other humans to ensure that they were allowed to do so in a meaningful way. The monopoly was arranged in the early part of the twentieth century through the settlement of an antitrust case against AT&T (founded as the Bell Telephone Company in 1877, it became American Telephone and Telegraph in 1885). The case was brought largely because of the company’s refusal to interconnect its fledgling network with that of rivals. The settlement cemented AT&T’s monopoly in both interstate and most local telephone transmissions, but prohibited the company from acquiring other telephone companies, while subjecting its rates to regulation. Congress overrode the merger restriction in 1921 by giving the Interstate Commerce Commission (ICC) authority to exempt AT&T’s acquisition of other companies to fill out its nationwide network, a power which in fact the ICC exercised.3