A primer on internet economics: macro and micro impact of the internet on the economy

Business Economics, Oct, 1999 by Albert E. DePrince, Jr., William F. Ford

A recent path-breaking study of the U.S. Internet Economy (I-ECON), concluded that it generated more than $300 billion of revenue and employed about 1.2 million workers in 1998 (CREC). Although those numbers are much larger than other early estimates of the I-ECON's scope, they equate to about 3 percent of 1998's GDP and 1 percent of the labor force. Note, however, that the $300 billion estimate includes sales of business-to-business goods and services, which are not part of GDP. The same study found that the I-ECON is growing at a triple-digit annual rate (175 percent compound annual growth rate) between 1995 and 1998), vis-a-vis the overall economy's 5 to 6 percent nominal growth rate. Therefore, even though the I-ECON's growth rate will certainly decelerate as its base expands, its share of the economy's total output and employment will continue to increase rapidly during the next few years.

The foregoing I-ECON scope and growth conclusions are, of course, being driven by a number of basic demographic and economic forces. [TABULAR DATA FOR TABLE 1 OMITTED] Currently about 70 million of America's 200 million adults are Internet users, and thousands of new users connect to the net every day. Moreover, the share of U.S. real durable equipment spending going into the high-tech sectors rose from 10 percent to 58 percent between 1965 and 1998. Finally, the huge market values now being assigned to as-yet unprofitable Internet companies, such as Amazon.com, clearly reflect the equity market's belief in the I-ECON's future growth and the projected profitable participation in it by such companies.

The Structure of the Internet Economy

Turning to the structure of the I-ECON, the CREC study identifies four major subsectors, as shown in Table 1. The first two are the hardware and software applications providers who are building and operating the Internet's infrastructure. They accounted for about half of the I-ECON's gross 1998 revenues. The third subsector is called the Intermediary/Market Maker Layer. It includes service-providing intermediaries such as travel and auction companies, which generated almost one-fifth of the I-ECON's 1998 revenues. The fourth and final subsector comprises mainly the companies directly engaged in Internet commerce in consumer and producer goods. It accounts for the remainder of the I-ECON's revenues. To date, most of the media attention focused on the I-ECON has been tracking the activities of major firms serving as makermarkets (e.g., ebay.com and e-trade.com) and consumer product distributors (e.g., amazon.com).

Distribution Channels and the Internet Economy

Two areas have been identified here: the distribution of goods and the distribution of information (provision of services). Viewed from a microeconomic standpoint, a key I-ECON issue that deserves serious attention is the determination of the pattern and pace of migration from traditional to Internet distribution of specific products and services.

Distribution of Goods

Figure 1 illustrates the basic differences between two traditional production and distribution channels (columns IA & IB), vis-a-vis two Internet alternatives shown in columns II and III. In both of the traditional channels shown in column I, end users get the goods they want from retailers. Some retailers order their goods directly from producers, while others operate at the end of a distribution chain, which includes one or more layers of wholesalers and/or regional distribution centers. Also, some industries have sales-driven distribution patterns (e.g., clothing, soft lines); others, such as the auto industry, are basically production driven, with sales forces with incentives to move products to consumers, via retail outlets, to clear out whatever their factories produce.

By way of contrast, the nascent Internet commerce sector appears to be employing two major alternative production/distribution models. The first, shown in column II, is characterized as Amazonic Distribution (named after amazon.com). In this model, the end user orders products (e.g., books) directly from a distributor that maintains a warehouse inventory of products. Those products are ordered and reordered from producers, in response to sales, usually via wholesale-level Internet or private Intranet transactions. The end user gets the product directly from the distributor. This channel bypasses retailers and thereby undermines the retailers' business.

Column III of Figure 1. characterized as Dellphic Distribution (named after dell.com), involves direct contact between end users and producers in which there is no inventory of finished products anywhere in the distribution channel. In this model, end users respond directly to producers' promotional efforts by ordering custom-made products (telephonically or via the Web), which are then produced and shipped directly to the buyer.

Services and the Internet

Many of the most publicly visible inroads of Internet commerce are in the service area, and most of them are Dellphic in nature. Airlines provide a good example. The industry has mounted intense efforts to migrate customers from traditional purchase methods (via travel agents or telephonic contacts) to direct electronic purchases. Incentives so far have been limited mainly to offering frequent flyer bonus miles and spot discounts on approaching flights with unbooked space. But it may not be long before airlines introduce yet another layer of price segmentation into their fare structure by offering across-the-board discounts to Internet buyers. As a result, except for travelers who seek a complicated set of travel services, direct Internet purchases will undoubtedly continue to siphon market share away from traditional travel agents in the airline ticketing business. The same goes for booking cruises, hotels, tours etc.