1. The New Economy: How do we measure it? Page 2
2. Software Could Help Fight the War on Inflation Page 7
3. Software: Durable or Non-durable? Page 10
4. Software Business & Distribution Cycles Changed Forever Page 12
5. Software Exporters Finally Given Equal Tax Treatment Page 14
6. Encryption will be the Key to Software Exports Page 15
7. International Foreign Markets - Exports & Imports Page 17
8. International Trading Agreements - GATT & NAFTA Page 22
9. Illegal Software: Modern Day International Piracy Page 24
10. Consulted Sources: Page 27

The New Economy brings great challenges to economists and economic policy makers. With the explosion of growth of software companies, and the advent of electronic commerce and the information superhighway, do we need to change the way we measure such things as productivity, production capacity, labor rates, and other factor inputs? Does this near record period of positive economic growth and record low employment signal impending inflation, or could this new economy react differently to those traditional models of measurement. Should we move to raise interest rates now to hold back inflation, or should we allow the economy to continue to grow and test the boundaries of this new economy? These are the tough questions that economists, economic policy makers, and the marketplace in general are asking themselves everyday to help determine their best course of action. Key economic decision-makers must take notice of this new economy. Failure to recognize these sweeping economic changes could result in seriously flawed decision making, which could harm both the economy and the consumer.

Inflation is perhaps the number one enemy to the everyday American consumer. If left unchecked, it has the potential to drastically reduce the consumers’ real spending power. With inflation, everything costs more to produce, and thus costs more to purchase. If the average income doesn’t keep up with inflation, the consumer will actually have less to spend in the end. The definition of inflation, or inflation rate is the percentage of annual increase in a general price level. Simply stated how much do prices increase for products or services from year to year. Inflation can be caused by many factors. In order to evaluate what affect the new

economy might have on inflation, we must look at what we currently know to cause inflation.

Total economic output, or GDP, and its related inputs are the primary tools used to forecast possible inflation. If the aggregate demand for products and services gets too high, the economy is forced to produce more than is efficiently possible. A company producing at or near capacity, will need to invest more capital in order to increase its production output. This means that the marginal cost for producing one more unit will increase; this will inevitably cause prices to increase as well. Producing at capacity also contributes to a rise in prices in the factor.

In a strong economy, all of the factor inputs such as land, labor and capital are in more demand. The higher the demand, the higher the prices are for those inputs. The higher the production output, the more people are employed. When output is near its capacity, the unemployment rate drops. This makes labor inputs more expensive, which increases the available spending power to the households of the economy. This drastic cycle spins out of control when the households spend their increased income, which in turn further increases the aggregate demand of the economy.

Now bring in the "New Economy." Real economic growth for the United States as a whole is roaring along at about a four percent annual rate, and unemployment has fallen below the critical five percent threshold for the first time in a quarter of a

century, and all this with inflation barely noticeable. Life is certainly good for this economy, but U.S. Policy makers and economists are puzzled. This contradicts two

of the most basic convictions of economics. Decades-old theories about how the economy performs and how to track its performance are being questioned by congressmen, labor leaders, businesses, as well as some economists. Growth over about 2.5 percent and unemployment below five percent should cause inflation. This suggests that the fundamental way that the economy behaves might be changing. Furthermore, the tools the government uses to understand the economy should be continuously examined to see if they have become outdated and faulty.

For example, as discussed above traditional economic theory says that if capacity utilization is too high at or around 85 percent, then inflation is sure to result. However, this factor only represents only about 25 percent of GDP. As the economy shifts from a manufacturing to a service based economy, less attention should be paid to that indicator. Furthermore, even in the manufacturing sector the productivity game is changing. Computer integrated software that links the entire supply chain is dramatically increasing efficiency. For years, economists and business leaders alike have battled with the so called "productivity paradox," or why billions of dollars have been spent on technology without having much impact on the bottom line. Many now say that basic management practices are catching up with the installed technology base. Managers are learning how to utilize this technology to increase productivity, and thus increase capacity.

Many people argue that the official figures used to calculate capacity utilization leave out these increases in capacity due to technology. This omission would lead to an understatement of our true capacity. This, in turn, would lead to an overstatement

of our true capacity utilization. Furthermore, Washington narrowly defines productivity figures from output. The data ignores productivity gains in many of the

"information worker" tasks that benefit substantially from technology. Such improvements are critical as the U.S. economy shifts from industry to information. The questions of how to calculate capacity utilization and productivity further illustrates the importance of rethinking the way we measure performance of our key economic indicators.

Economists believe that if unemployment rates fall below five percent, the strain on the employment market will result in higher wages. This typically leads to an increase in aggregate demand and household spending that can lead to inflation. What this theory does not take into consideration is the uneven impact the new economy has on different layers of the workforce. Although, unemployment is considered low, there is a high degree of structural unemployment. This is employment resulting from heavy downsizing and an out dated education system. This leaves workers without the necessary skills to fill the available jobs. At the top of the employment market, 20 percent to 30 percent of Americans work in the technology and service-oriented economy. These salaries are strong, and unemployment for these professionals is thought to be non-existent. However, due to the high level of structural unemployment the overall pressure on the aggregate

demand averages out to be normal. This will tend to hold prices down, which should keep inflation to a minimum. Also, increasing aggregate supply at full employment without causing inflation might be easier productivity increases in the labor market as investments in technology start to pay off.

The implications of this great debate are clear. If this truly is a "new economy" then it would prompt new thinking on public and private spending. It would continue to invigorate stock markets, raise tax revenues and lower the deficit. Most importantly, it could spur broad-based wealth for Americans well into the next century. One thing is certain, America is experiencing sweeping economic changes that are challenging the ability of policy makers to comprehend. The stakes are high; if the old indicators are not enough to understand these complexities of what is unfolding in the American Economy, then actions taken solely on those indicators is not advisable. Although, the traditional economic measurements are sound and extremely valuable, economists and U.S. policy makers must keep an open mind to the dynamics of this new economy. Failure to do so will jeopardize our long-term growth potential, and our standard of living as a society as a whole.

There is no doubt that electronic commerce can increase output in the US economy. How much and to what affect it will have on inflation remains uncertain.

Business Week estimates in its June 22, 1998 issue that doing business on the Internet could pump up the national gross domestic product by $10 billion to $20 billion dollars annually by 2002. Business Week arrives at this estimate in the following logical analysis. Forester Research Inc.’s projects that electronic commerce will reach about $350 billion by 2002, from an estimated $22 billion this year. This figure includes direct sales to consumers and transactions between businesses. It is conservatively estimated that doing business electronically saves about 5 percent to 10 percent of total costs. Now assume that roughly half of those savings are transferred to the consumer in the form of lower prices, and that consumers increase their consumption by about the same percentage as prices fall. The math calculation would then predict that the GDP could increase between 10 and 20 billion dollars. If

this scenario holds true, and companies share these savings with consumers, the economy will grow and inflationary pressures will remain low.

As more companies realize the enormous potential for savings via electronic commerce, E-commerce will be injected into all of their primary internal business processes. Some companies utilizing this wired approach suggest that it is quite possible to reduce the production cost of a good or service by 5 percent to 10 percent, when it is created and sold with the help of the Internet. Cisco Systems has reportedly saved $535 million from online commerce since 1996, with over 27 percent of its orders being placed online.

Ernst & Young estimates that inventories can be slashed by as much as $350 billion dollars if businesses use electronic commerce to share such pivotal data as point-of-sales information, current inventory levels, sales forecasts, etc. If these capital assets were reinvested at an estimated rate of return of 10 percent, this could give the economy an additional $35 billion dollar boost.

E-commerce and the Internet has already produced a highly competitive online environment. Customers can literally shop in any store in the world for the best possible value for their dollar. The low cost of doing business online combined with this intense competition will dramatically hold down prices. This "win-win" situation will propel businesses to increase output of direct consumer sales, as well as

business-to-business sales over the Internet. This will progressively grow the economy, and hold down prices for years to come. Although the previous opinions could well be considered idealistic, this writer believes we are on the verge of a new economic frontier. The new "electronic" economy might just be the magic bullet to further increase economic growth with little inflationary side affects.

Since its launch last month Windows 98 has been well received. The commercial success of this new updated operating system has surprised many industry experts. Many believed that Windows 98 would be a great disappointment to consumers, as well as the Washington-based software manufacturer, Microsoft. These experts believed that because software could be considered a durable good, most consumers would tend not to rush out and purchase the updated version. At the time they made their predictions, the reasoning they employed seemed sound. People who had Windows 95 were content with the product, so the chances that they would spend another $100 for a mild upgrade seemed remote. However, despite this sound reasoning, Windows 98 has been strongly embraced by the public. This further clouds the issue as to whether software is a durable or non-durable product, or both.

There are many reasons that explain the early success of Windows 98. First of all, with unemployment rates down and interest rates in check, people are using their disposal income to purchase computers and nearly all of these machines come with Windows 98 pre-installed. This includes first time buyers and buyers who have decided to replace their outdated equipment. Another reason has to do with the increasingly popular Internet. As more consumers become aware of all the things the Internet has to offer, they are swarming their local computer stores in search of computers. This seemingly insatiable drive for the latest and greatest in software applications could move this industry closer to the non-durable definition. Those products are in essence repurchased in under 3 years.

However, whether or not a product is durable or non-durable might depend on the income level of a particular market. For example, senior citizens on a fixed income my tend to keep the software they have until absolutely necessary. On the other hand, strong pensions and government retirement benefits that continue to exceed inflation could increase discretionary income that could move buyers to update their software more frequently than three years. That would mean it could be considered a non-durable good.

Government and big business purchases is yet another trend to examine whether or not software is a durable or non-durable good. Government and big business are the two largest buyers of software from Microsoft, as well as many other suppliers. Together they invest billions of dollars a year on software in an effort to make them more efficient. Large entities also need to keep up with modern data interfacing demands that only the latest software programs can handle. Businesses feel the need to keep up with the latest technology, as they believe that it is a wise capital investment that aids them in maximizing profits. Due to this need they annually spend billions to get or maintain the software competitive advantage.

This ever-increasing demand for new and innovative software solutions makes it difficult to classify all software as to whether it is durable or non-durable. Analysis could probably be more useful on an item by item basis. However, for each software application there are many factors such as market combined income, consumer disposable income, tastes as well as other intrinsic deciding factors that might prompt consumers to buy software with varying degrees of frequency.

In a typical booming industry, production dictates just how much a company can sell, and what price it can charge for those sales. Traditionally, supply was dictated by how much could physically be produced with the current available resources. In the software industry, theoretical sales capacities are reaching an unlimited proportion. One company, Egghead Software recently closed all 250 of its retail stores and slashed all but 20 percent of its workforce. It now plans to sell all of its software over the Internet and through the mail. In an effort to compete with the large retail chains, Egghead knew they had to dramatically reduce costs to survive.

Web commerce cuts overhead costs to the vanishing point. No longer do you need a building with bricks and mortar, or even a person to take orders. The necessity to spend increasing percentages on point-of-purchase packaging is also eliminated. The Internet allows companies to reach markets too small for a physical store presence, anywhere in the world, 24 hours a day, with limitless shelf space. In such a cost scenario, marginal costs, or the cost incurred to sell one more unit of a

product is almost non-existent. Therefore, software companies can lower prices, increase sales and still make money. International Data Corp. predicts that sales for

software distributed over the Internet will increase from $550 million today to $4.6 billion by the year 2000.

Using the Internet as a distribution vehicle not only maximizes distribution efficiencies, but it also speeds product development cycle times. For example, teams around the globe can create software programs and then distribute them almost instantaneously to each other and then ultimately to the end customer. In the course of a year this means more products to market, and thus more corresponding sales. Having limited overhead costs can allow a software company to sell more product items on a continual basis. Egghead software plans on increasing their available products from 40,000 items to 100,000 items by the end of the year.

The software industry is vigorously embracing the very technology that they are creating. E-commerce offers businesses the opportunity to increase market reach, and at the same time drastically reduce product costs. The Internet also allows companies to expand customer service, reduce product development times and bring more products to market. Eventually, all industries will catch wind of the E-commerce advantage, and the rest will be history.

Software companies can now enjoy the same export tax incentives given to the music and recording industries. In the early 1980s when the software industry was being created, companies received tax incentive for exporting products through the Foreign Sales Corp., an agency charged with monitoring U.S. exports. However, the Internal Revenue Service (IRS) took back the tax incentive, claiming that the industry did not qualify for that tax break. The IRS maintained that software duplicated overseas did not originate in the United States, and therefore should not be considered an export.

The software industry argued for years that it deserved the same tax advantages enjoyed by the music and recording industries. After aggressive lobbying by software companies, including Microsoft Corp., the U.S. Congress finally passed revised legislation in 1997. Under provisions in the Taxpayer Relief Act of 1997, firms now can take advantage of tax credits for software licensed for reproduction abroad. The provisions will save software companies 15 percent on their foreign-license revenues, and millions of dollars over time. Microsoft alone stands to save up to $1.7 billion over the next decade.

Encryption technology and government regulations will determine the strength of future export software sales, and could also determine how fast E-commerce reshapes the world. Encryption technology is simply secure programming code designed into software that acts as a security lock to keep out unintended viewers. The higher the encryption, the harder it is for someone to break your code, and thus the harder it is to break into your business via computers. Encryption will soon become a mandatory component of every program that is used across open networks such as the Internet, Intranets or an Extranets. Furthermore, E-commerce itself will not reach its full potential unless increasingly secure monetary transactions are made possible. Without that security designed into software exports, American software makers will eventually find it hard to compete in the global software marketplace.

Under current law, the U.S. government treats encryption technology very similar to that of munitions. That is that it is illegal to export hardware or software encryption encoding tools designed to increase security levels of software. The legal limit of encryption export policy is a 40-bit electronic key. An electronic key is a digital string used to "unlock" encrypted communication transactions. This key is sort of like a password or a combination used to open the lock of vault. A bit is a single digit in a binary number system. Binary system means twin or double number system specifically "0" and "1." There are a two achievable one bit keys (0 and 1). For a two bit encryption system there are only the following "4" possible

combinations: (1,0),(0,1),(1,0),(1,1). A 40-bit encryption key has 1,099,511,627,776 distinct possibilities. The more combinations possible the harder and longer it takes

a computer to find the key to crack your software program. Experts believe some companies have the computing power to break a 40-bit key in less than seven seconds.

The message on encryption is clear. In order for US Software companies to continue their global dominance in the software arena, allowable export encryption levels must be raised. High-tech firms estimate the encryption technology could be worth a $60 billion and 215,000 jobs by the turn of the century. Currently there are several bills that move to raise the legal limits. If not increased soon, US software companies run the risk of losing out to foreign companies who develop competing software that contains higher security capability. In the end, the US software industry could also lose valuable leverage in the exploding E-commerce market. Probably only then will the government move to allow increased encryption. In the end, who is to say that is all bad. However, that is the other side of the great encryption debate.

Over the last few years Microsoft has concentrated their efforts in expanding foreign markets. Microsoft has had a relatively easy entry into foreign markets due to its monopolistic dominance in the prepackaged software industry. The numbers speak for themselves. Computer users around the world have shown an enormous acceptance for Microsoft’s products, particularly for the Windows operating systems and their Office software. While there may be exceptions, like Japan for example, a country in which people have a clear preference for customized software more than prepackaged software, there is still a large target market overseas that Microsoft wants to continue to grow.

It can be said that Microsoft is quite interested in foreign markets not only for increased sales revenues, but also for increased investments in those countries. During the 1997 fiscal year, which closed in June, Microsoft sold a total of $13.4 billion in prepackaged software. From this amount, Microsoft exported $4.5 billion to foreign markets, which comprised almost 34% of its total sales. Microsoft has $4.1 billion invested in total assets abroad. This represents over 25 percent of the software giant’s total assets. The largest portion of Microsoft’s foreign assets are deployed in North and South America and Europe. More specifically these countries include the following: Germany, Great Britain, France, Japan, Australia, Canada, Mexico, and South America.

Microsoft’s operating income from these countries are even more dramatic. As the following graph illustrates, Microsoft’s foreign market operating income is 40% of its domestic operating income. Financially speaking, it can be inferred that

Microsoft’s exporting costs are relatively lower than its domestic costs. The end result is that Microsoft is more profitable in the foreign markets. To illustrate this a simple calculation can be used. Divide assets deployed by the corresponding operating income. The resulting ratios are as follows:

Export assets /export operating income = 2.76 $ in assets/ op. Income $.

Domestic Assets /domestic operating income = 3.11 $ in assets/ op. Income $.

This proves that there is more than a 12 percent higher rate of return on assets deployed in foreign markets.

Operating in foreign countries has always been a risky proposition for American firms. This is owed to, among other things, the volatility of many foreign currencies. The current Asian crisis highlights just how devastating a major downturn can be to foreign investors. However, it is still possible to calculate if the benefits of such a proposition outweigh the risks. There are many other economies, like for example Europe, where risks can be estimated with a higher degree of certainty. Due to the high growth potential in sales and earnings abroad, it is more risky to avoid foreign markets than it is to invest in them. In order to maximize profits in the global economy of today, all markets must be considered and attacked. Microsoft is increasing its international marketing efforts.

In the following graph, using data supplied by Standard & Poor's Corporation, we can observe that Microsoft has been principally targeting the largest and most affluent countries in Europe, Asia, and South America.

• South America includes Brazil (5%), and the rest of the Continent (4.7%).
• Others are formed by Mexico (3.8%) & Canada (1.6%) – NAFTA, and Australia (4.8%).

From the data observed in the graph above, as was expected, the countries that are demanding more of Microsoft’s products are the ones with the most prosperous economies and largest populations, among them Germany, Great Britain, Japan, China, and Brazil.

Although exports offer a good profit potential, there are inherent risks such as what is happening with the Asian crisis. When an economy is in a crisis, its currency typically loses value compared to the dollar. This is what is commonly called "devaluation". The country in crisis often suffers because international debts and

loans are tied to the dollar. This means that the country in crisis has to spend more of its own currency to buy dollars in order to pay back the loans to international banks.

Devaluation of a country’s currency also has an impact on other trading partners as well. For example, countries with a strong currency may have trouble exporting goods to a country with a weak currency. Products will become instantly more expensive due to export market having less buying power with its currency. Also, countries with a weak currency will have greater export power. Their products will be cheaper to the other countries, which could have a negative impact on the stronger economies. For example, domestic companies could suffer when competitive import goods are much cheaper than the domestic equivalents.

Returning to the Asian crisis, this phenomenon has considerably decreased demand for American imports in the orient. Among these imports the importation of prepackaged software is included. In the scope of this essay, it is difficult to measure the amount of software that the Asians have stopped consuming. Nearly 19% of Microsoft‘s total foreign sales are concentrated in Asian countries. However, Microsoft is strong enough to cope with this economic phenomenon.

The whole purpose of a treaty is for all countries to benefit. In the United States, prior to the signing of the GATT and NAFTA trade agreements, there was a great degree of skepticism as to whether these trade agreements would benefit the United States as much as they favored the other foreign nations. Contrary to the opinions of the skeptics, the American economy has been well served by the GATT and NAFTA trade agreements. Presently, American industries can trade with more than twenty-five countries without being penalized with punishing tariffs.

The goal of the General Agreement on Tariffs and Trade (GATT) is to lower trade barriers. The latest negotiations began in Uruguay in November 1986, and so are commonly referred to as the "Uruguay Round". Each round to date has entailed protracted negotiations about how to lower trade barriers. The Uruguay Round extended trade agreements to farm products and intellectual property such as computer software. Congress approved the GATT agreement in November 1994.

After GATT, the United States, Canada, and Mexico began to seek similar benefits from the North American Free Trade Agreement (NAFTA). NAFTA was signed by these three nations in December 1992. The ultimate goal of NAFTA, like GATT, is to eliminate all trade barriers between these three countries.

NAFTA requires that all tariffs between these countries be eliminated within a period of fifteen years. The NAFTA agreement was specifically important to the software industry as it incorporated and protected literary works such as computer software programs.

In the next graph, we may observe that in the case of Microsoft the advantages given by GATT and NAFTA are obvious. Being a worldwide monopoly enables Microsoft to spread the territory of its dominance. These results can be seen in the increment of its exports since the U.S. decided to take part in these agreements. Microsoft’s leading products, Windows and Office, are used in every country that belongs to these treaties. If Microsoft ‘s domestic anti-trust problems increase, they will no doubt increase their international focus.

As the Department of Justice continues to make Microsoft walk the plank, software manufacturers continue to have their decks swabbed by modern day international pirates. Certainly the Microsoft monopoly case will affect the software industry, however software piracy is perhaps a bigger threat to the industry’s long term growth and prosperity. Mutual collaboration among the software industry is underway to petition governments, both domestic and foreign, to use their muscle to sink illegal copiers and distributors of computer software. Although software piracy is common in the United States, it is especially pervasive in foreign markets. It is estimated in many countries that illegally copied software represents 80 to 90 percent of total software units. This translates into enormous losses of income and jobs tot he U.S. software industry.

As the losses continue to compound daily, how can the industry stop their software from being illegally copied and distributed? The United States government, at the urging of the industry, has made numerous attempts to pressure foreign governments to comply with international copyright laws. However, as we will later explain, these governments have had little effect on those who pirate computer software. Seeing the ineffectiveness of the governments’ efforts, the industry has contemplated many methods to slow piracy, and as a result hope to reclaim their intellectual treasure. One of these ideas that has received attention is to make CD-ROM distributed software that can only be used one time. The rationale is simple. The consumer buys the software and inserts it into his/her computer. After loading

the product the CD becomes worthless. While this may appear to be a simple solution to a multi-billion dollar dilemma, there are some problems. For example,

what happens to customers who have more than one computer. These customers expect to be able to use the software they purchase in their home and office computers in the same way as they play a compact disc in their home and car or even when they go to the beach on the weekends. Would they tolerate being forced to buy two or even more copies of the same software program? The answer is probably not. The industry will have to make a choice between alienating customers and stopping pirating.

Apart from the millions of programs that are illegally copied from CD-ROMs, the industry-wide trend of selling their products over the Internet will further exacerbate the problem. Online distribution makes software easier to illegally copy, but by selling software products online, they can effectively bypass all middlemen which will increase profit margins while reducing delivery costs. Once again the industry finds itself in a Catch 22. If they continue to distribute their product electronically, they run the risk of increasing their vulnerability to software pirates.

So far it appears that the industry has left the matter in the hands of the United States government. The industry seems to feel that the only way to reduce pirating is to depend on stricter enforcement of the copyright laws. The software industry recognizes that they themselves do not possess the means or the authority to tighten the nooses around the necks of the pirates.

The government has listened to the software companies, but even with all their influence and power, software piracy is still on the rise. According to a recent economic study released by the Business Software Alliance (BSA), software piracy cost the U.S. economy 130,000 jobs in 1996. A recent study conducted by International Planning and Research, estimates illegal software piracy losses in the U.S totaled $2.3 billion, with global losses exceeding $11.3 billion in 1996.

One of the main reasons for the failure of the attempt to stop piracy has to do with a great lack a cooperation from foreign governments. Why are foreign governments so uncooperative when it comes to protecting copyrights of software programs? As less fortunate nations attempt to increase productivity having an inexpensive illegal supply of software proves to be the end that justifies the means. Foreign governments must choose to either help the US software industry, or help their economies increase productivity. For most, it is a quick and easy decision.

Warnings about illegal reproducing software do play a role in reducing piracy, but until the software industry adds some bite to those threats, piracy will probably remain business as usual. However, recent bills are before congress that might just give them that muscle. Enforcing copyrights in other countries is much more difficult. In the end, international piracy might just become a dreaded cost of business that for the mean time is just impossible to stop.

PC Plus

NAFTA treaty, chapter 17 "Intellectual Property".