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 COLUMN
The economics of innovation WHAT IS DRIVING INNOVATION today, and how does it compare with other periods of hyperinnovation in the past? What happens when the party ends in these kind of technology booms, and what are the best strategies for survival?
Marty Weitzman, an economist at Harvard University, describes these periods as "recombinant growth." The idea is that every now and then a set of components combines in lots of different ways to produce new sets of goods and services. That recombination is the source of innovation in these periods. Let's look at some historical examples and bring it up to the present. In 1801, Eli Whitney conducted a demonstration for President Thomas Jefferson. He took apart 10 muskets, scrambled the parts, and had people put them back together. To everyone's amazement the muskets worked. Whitney demonstrated his uniformity system, a method of machining parts to a high degree of standardization. Recombining parts was novel, and that episode set off the North American industrial revolution. Flash forward to the 1960s and the development of the integrated circuit. The integrated circuit is a wonderful example of a flexible component. The decades that followed brought a huge variety of devices that were constructed from integrated circuits, including, of course, personal computers and routers, the basis for information technology today. In the last couple of years, we've seen a somewhat different kind of recombinant growth. The components aren't pieces of hardware, they're things such as HTTP and XML. All of these protocols and pieces of software and standards have been combined and recombined to create all sorts of innovations: Web pages, chat rooms, online auctions, exchanges, search engines, and so on. What is interesting about this particular burst of creative activity is that the components are software and protocols: collections of bits that can be sent around the world in fractions of seconds, so there's no time needed to manufacture, no inventories, and no delay. Recombination can now occur far more rapidly than in previous periods of innovation. Bursts of financial speculation surrounded all these technology developments. A good example is the railroad. In the 1880s more miles of railroad were built than in any other period in American history. Then in the 1890s more companies were going bankrupt than in any other period of American history. The cause was very similar to the problems facing some types of technology today: huge fixed costs and very low variable costs. If you look at the fixed cost of operating a railroad in 1880, it was about two-thirds of the total cost. If you look at the cost of long-haul fiber, it has the same structure: a big cost for putting the technology in place and lighting the fiber. The operating costs are very small compared to those large, fixed costs. With that kind of cost structure, it's easy to get into price wars. One competitor cuts his price, everyone has to follow, and there isn't enough revenue to cover debts. Right now we're seeing a telecommunications price war. They have much the same cost structure as the railroads. It's hard for the telcos to find a floor to these price cuts because the operating costs are so small compared to the fixed costs. Economists aren't known for their optimism. Our motto is: There's a cloud behind every silver lining. But there are reasons to believe that the economic impact of the technology hangover won't be as bad as some of those other episodes. One reason is that information technology is highly fungible. You can put it to lots of different uses, even after the capacity is in place. Think back to those railroad tracks. The only thing one could do with those railroad tracks was carry trains. It would have been fantastic if the miles of excess railroad tracks could have been transformed into highways to service the new growth industry coming on in the next decade: the automobile. But today, if you have fiber you can carry voice, data, audio, video, transactions, whatever. You can set up a database for MP3 recordings, and it's not so hard to repurpose that to handle supermarket transactions if the MP3 business doesn't pan out. Communication technology and information technology can often be transformed reasonably quickly to support other innovative activities. That's a prime capability of computers. It means you're less likely to end up with an oversupply in the classic sense, which we saw in these other historical periods. The technology boom and bust cycle isn't eliminated, but it will have less of an effect than in prior decades. Hal Varian is dean of the school of information management and systems at University of California, Berkeley. Join him for a live online forum, "Building the IT workforce," Thursday, Dec. 12, at 11 a.m. PST, at http://forums.infoworld.com/WebX?230@@.ee7684b.  RELATED SUBJECTS  Enterprise ApplicationsSPONSORED WHITE PAPERS 
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