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Business News/ Opinion / The digital economy: three questions
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The digital economy: three questions

The emerging digital economy presents several economic paradoxes to which there are no clear answers as yet

Photo: iStockphoto Premium
Photo: iStockphoto

It is now almost two decades since the initial share sale by browser pioneer Netscape in August 1995 sparked off the first dot com rush.

Much has happened since then. The dot com bubble inevitably popped six years later. Companies such as pets.com with vacuous business models went up in flames. So did a few others such as Nortel that hoped to build the telecommunications backbone of the emerging digital economy. The ambitious $164 billion merger between America Online and Time Warner was a disaster; this deal marked the last phase of the frenzy just as the Netscape share sale began it all.

A handful of firms such as Amazon and eBay managed to emerge unharmed from the rubble of the spectacular dot com collapse. New champions such as Google and Facebook emerged. Companies such as Apple effectively destroyed the business models of traditional music companies.

The emerging app economy is a game changer. Taxi aggregator Uber has had to deal with a backlash across the world precisely because it has overturned the traditional taxi market.

The world is now in the midst of a fresh bout of enthusiasm about digital enterprises. The valuations of various online companies definitely look stretched (and look at some of those Indian valuations), but what perhaps distinguishes the current times from what happened then is the fact that business models are slightly more robust than the airy hope of being able to monetize eyeballs.

Yet, what is beyond doubt is that the two digital gold rushes have changed the way we work, buy, sell and interact with one another. The doubts are elsewhere. The emerging digital economy presents several economic paradoxes to which there are no clear answers as yet. Here are three important ones.

What effect does the new economy have on productivity?

The origins of this problem can be traced back to a famous statement made by Nobel laureate Robert Solow way back in 1987: “You can see the computer age everywhere but in the productivity statistics."

Solow was the right person to ask the uncomfortable question: his neoclassical standard model of economic growth taught to students underlines the importance of productivity growth as a driver of economic expansion.

There are two interesting issues raised by the Solow paradox.

First, our current way of measuring economic output perhaps fails to capture the benefits of the new digital economy. New research on hedonic price sets may eventually help economists better capture the benefits of products such as computers that change very rapidly. Second, it is not yet clear whether new digital enterprises benefit the economy as a whole or merely shift demand from one provider to the other. For example, what Uber gains equals the loss of traditional taxi drivers or what Airbnb gets is at the cost of hotels. The aggregate effect on productivity could be nil. Economists have as yet not been able to provide a definitive answer to this paradox.

Do network effects inevitably create digital monopolies?

Take a look at a social media company such as Facebook: It gets more users because it already has lots of users. The same logic works with eBay: You will want to put your goods on sale on the site because lots of buyers visit it while the buyers will come in droves because there are lots of sellers. Growth in one side of the market leads to growth in the other.

Such a snowballing effect can lead to market dominance, if not outright monopoly.

Users will naturally gravitate to the biggest companies. The special attributes of some digital products—especially zero marginal costs—add to the problem. Many of these issues were highlighted in the landmark case between Microsoft and Netscape in 2001. The former was accused of using its dominance in the operating system market to unfairly promote its browser at the expense of Netscape Navigator. The real competitive challenge to dominant digital enterprises will then come from innovation rather than price.

Are there good bubbles and bad ones?

This may seem to some as almost as ridiculous as the question asked about the good and bad Taliban, but it is yet worth considering. The first dot com boom did a lot of damage, but we can say with the benefit of hindsight that it also lowered the cost of capital for digital entrepreneurs as well as funded the massive expansion of telecom networks that have made our digital lives possible today.

Compare the dot com bubble with the global housing bubble that ended in tears in 2008. There is little long-term good that has come out of it, because it saw a massive misallocation of capital to build housing stock that provides no permanent benefit to most economies. This is not a defence of bubbles. Policymakers need to be wary of them. The more limited point is that some bubbles can have positive effects in the long term while others have no such benefits.

Niranjan Rajadhyaksha is executive editor of Mint.

Comments are welcome at cafeeconomics@livemint.com. To read Niranjan Rajadhyaksha’s previous columns, go to www.livemint.com/cafeeconomics

Follow Mint Opinion on Twitter at https://twitter.com/Mint_Opinion

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Published: 30 Jun 2015, 11:52 AM IST
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