INTANGIBLES

Foundations of the Knowledge economy: SHIFT TO The Intangible

Charles Goldfinger

New economic landscape: conceptual and measurement gaps

The trouble with conventional wisdom is not that it is wrong, as a matter of fact most often it is not, but that it creates an illusion of knowledge and consensus. Take the case of economic evolution. What is more banal than to assert its rapid pace, its breathtaking scope, its ubiquity ? Third Wave, Digital Economy, New Economy, Knowledge Economy…concepts became buzzwords, highly publicised and apparently well accepted. Yet, do we really understand today’s economy? Do we agree on its rationale and development path ? The answer to those questions is clearly no. Economists and statisticians are perplexed and bewildered. They openly admit that the standard measurements, such as national income accounts or corporate financial statements, no longer capture the underlying reality. According to Zvi Griliches, whose authority on measurement is unquestioned, the share of economy measured with a degree of accuracy by official statistics has fallen from 50% to 30% between 1947 and 1990.[1] Call it Griliches’ paradox: Weaknesses are most pronounced in the areas which are most dynamic and trend setting such as services or information technology. In this age of “information revolution” and “knowledge economy”, measurement systems shed little light on activities where information and knowledge are generated.[2]

This lack of clarity entails persistent disagreements about key issues such as the impact of Information Technology (IT). The economic impact of IT remains highly contentious. The controversy revolves around what Robert Solow called in 1987 a “computer paradox”: While technological progress has dramatically reduced the cost of processing, and storing information, computers are visible everywhere except in the final output.

The computer paradox prompted a large number of studies. Yet, opinions remain highly polarised. One group of analysts affirms that the computer paradox is simply a by-product of inadequate data and that detailed studies show a significant technology pay-off. Thus, Dale Jorgenson, from Harvard, believes the IT investment was a major factor in the excellent performance of the US economy in the late 1990s and that IT has permanently raised the long-term growth rate of the US economy.[3] On the other hand, sceptics persevere. For instance, Robert Gordon, from Northwestern University, forcefully argues that the impact of IT has been limited and temporary.[4]

Defining trend: the shift to the intangible

The gap between key trends which shape the economy and their conceptual representation is huge and growing, contributing to confusion and inadequate policy responses. The need for a new conceptual framework for the modern economy remains paramount. The classical economic theory, which underpins the measurement systems, remains based on an axiomatic assumption that the production of material goods is the source of growth and wealth. We would like to propose an alternative framework, based on an all-encompassing trend: the shift from tangible to intangible. The economic landscape of the present and future is no longer shaped by physical flows of material goods and products but by ethereal streams of data, images and symbols. On the demand side, we consume more and more content-based artefacts of information and entertainment. On the supply side, intangible assets such as brand, human capital, intellectual property and knowledge have become major determinants of companies’ performance and value. The creation and manipulation of intangible content is now the spring of value and fortune. Welcome to the Intangible Economy.

The shift to the intangible is general and long-lasting. It affects all sectors and all aspects of economic life. According to Diane Coyle, we live in an “weightless world”, where an ever increasing shares of GDP resides in “economic commodities that have little or no physical manifestations”. [5]

Evolving price-weight relationship

Product	Price in USD	Weight in lbs	Unit price USD per lbs
Pentium III	851	0,001984	42 893,00
Viagra	8	0,00068	11 766,00
Gold	301	0,06254	827,00
Mercedes Benz E-class	78 445	4134,00	19,00
Hot rolled steel	370	2000,00	0,20

Source: G.Colvin, Fortune

Three dimensions of the Intangible economy

Non-linear and non-deterministic, Intangible Economy presents the “bicycle dilemma”: it is easier to practice than to explain.[G1] By definition, intangible phenomena are elusive and defy common sense: they can be simultaneously durable and ephemeral, unique and ubiquitous, scarce and abundant. To provide a better understanding of Intangible Economy, we propose to approach it from three different perspectives:

- Demand perspective: Intangible artefacts: final output for end-user consumption.

- Supply perspective: Intangible assets, used by firms to establish and maintain their competitive position. They include brand, intellectual property, human capital, technological know-how, customer base and corporate culture.

- Market perspective: Logic of dematerialisation: a set of trends and forces that affects all economic activities, changing the nature of economic relationships.[6]

Intangible artefacts include various forms of information, knowledge, entertainment and culture, without forgetting finance, the ultimate intangible. All artefacts are joint products. They combine intangible content with physical support: song with a magnetic tape for an audiocassette; history and a building site for a classical monument. Traditionally, content and support were tightly linked, making artefact reproduction arduous and costly. The development of storage and replication technologies has loosened the link: the same content can now be easily replicated and associated with various physical supports. Like a witch in the enchanted forest, identical content appears in various disguises: a news items can be printed, shown on television, spoken over a radio or distributed via a data network. A financial payment can be made in cash, by a check or a card. Content - support uncoupling led to proliferation of intangible artefacts in two ways. First, it eliminated capacity constraints. Previously, a theatrical show or a sports game could be only watched by those who could physically attend them. Today, television multiplies the number of spectators ad infinitum. One could argue that live attendance and TV watching are two different artefacts. That is precisely the second dimension of proliferation: the same content provides a base for a family of artefacts: a book in a hardcover, in a paperback, on a CD-ROM or on-line. The ability to generate such families is what makes companies such as Disney or AOL Time Warner successful: each film concept generates not only movies but also videos, park attractions, books, toys and other sources of revenue, thus leveraging the content by a factor of two to four.

The consumption of intangible artefacts displays specific and interrelated properties:

- It is joint (always consumed with other products, tangibles or intangibles).

- It is non-destructive: the same artefact can be consumed repetitively either by a same consumer or by a different one.

- It is non-subtractive (or non-rival): one’s consumption does not reduce anyone else’s consumption. In other terms, the opportunity cost of sharing is zero.

Intangibles such as information are often presented as a “public good,” comparable to fresh air or to national defence, whose consumption cannot be limited to a single consumer and therefore is inherently collective. We prefer to use the term “shared good,” to the extent that sharing is a notable property of intangible artefacts. Sharing can be sequential or simultaneous and applies to space as well as to time. Intangible artefacts create their own space-time which lifts the constraints of geographical proximity and time continuity.

Sharing affects critical aspects of intangible artefacts transactions such as the allocation of property rights. While a seller of a physical good loses his property rights to it, an intangible artefact seller continues to hold them.

Intangible assets

The shift to the ethereal is not limited to the demand. The ascent of intangible artefacts is accompanied by the rise of intangible assets on the supply side.

Statisticians and accountants have long recognised that capital accumulation and asset deployment means more than the acquisition of physical plant and equipment.

The share of intangible investment is expanding relative to physical investment. Intangible investment represented 30% of total investment in 1992 in France and was growing at a quicker rate than the traditional fixed assets. Partial evidence suggests that in other countries, such as the UK, the percentage is even higher.

For consumer goods companies, Coca-Cola, Philip Morris or Nestle, brand management is the top priority. Brand is also essential for IT companies such as Intel and Compaq, which spend substantial sums to build it. Attempts are being made to quantify this “brand equity.” The valuation of leading brands such as Coca-Cola, Microsoft or Intel, largely exceeds their total balance sheet.[7]

The recognition of the weight of intangible assets is not limited to brands. Intellectual property - patents, trademarks, technological know-how - is considered a critical competitive weapon, particularly in software, electronics and biotechnology. Its control is often a matter of life and death for companies. It is through intellectual property litigation that AMD managed to preserve its foothold in microprocessors, despite Intel’s domination. In merger and acquisition transactions, apparently extravagant amounts paid for media assets, such as Hollywood studios or newspapers, is justified by the value attributed to brands, content and publishing rights.

While managers live and die by intangible assets, many accountants still refuse to include them in published financial statements. Microsoft considers software development, its core competence, as an expense and writes it off in the year incurred. English football clubs do not include the value of their players in their accounts. Reuters, the leading electronic information provider, acknowledges that its balance sheet does not include the global databases of financial information or its software and other intellectual property.

Accountants’ reluctance is understandable: intangible assets are not like tangible assets. To begin with, they are highly heterogeneous: one hour of software programming does not equal another hour. Revenue-generating capacity of an intangible asset is uncertain. When a company buys a new machine, it can quantify a potential output contribution. When it hires another programmer, it cannot.

Intangible assets do not follow standard depreciation rules. Some depreciate very rapidly, others, like a good wine, appreciate with age, stills others follow non-linear and unpredictable lifecycles. Also, intangible assets are difficult to separate, thus violating a cardinal rule of asset valuation. Distinction between assets and expenses is often arbitrary: an advertising campaign or training course can be classified as a current expenditure and/or an investment outlay.

Thus traditional asset valuation methods cannot be applied. The historical cost of acquiring or creating an intangible asset is largely irrelevant. Asset heterogeneity makes it difficult to calculate the opportunity costs. A market or transaction-based approach also has serious pitfalls. For most intangible assets, markets are narrow and imperfect and transaction-based values are subject to wide fluctuations. The range of methods used to value intangible assets is getting larger, making the consensus on measurement of their value ever more elusive.[8]

Dematerialisation logic

Intangible economy does not eliminate agriculture or industry. However, its underlying logic of dematerialisation affects all activities, reshaping economic relationships and transforming nature of firms and markets. Dematerialisation logic is unsettling and runs squarely against basic tenets of conventional economics.

The conventional logic is concerned with scarcity, the dematerialisation logic with abundance. The former stresses equilibrium; the latter, disequilibrium. Obsolescence, redundancy and volatility, which have been perceived in the past as pernicious epiphenomena now constitute essential and necessary vectors which shape consumption patterns and supply-side resource deployment. Instability and volatility become pervasive: market positions and hierarchies change rapidly and dramatically.

Intangible Economy is structurally abundant. Physical goods decay and their consumption marks the beginning of the end of their economic life. Intangible artefacts, on the other hand, are not eliminated or depreciated through consumption. Many intangible artefacts are eternal: we will forever read Shakespeare, listen to Mozart or watch Fellini.

The intangible economy superimposes on the abundance of production the abundance of accumulation. Financial systems generate too many transactions; Hollywood, too much entertainment; the Internet, too much information. The on-going deregulation of markets for intangibles along with technological evolution continue to extend the magnitude of the gap between supply and demand of intangible artefacts. For instance, the number of television channels in the European Union increased from 40 in 1980 to 150 in 1994 and over 200 in 2000. Moreover, the gap is self-perpetuating: to navigate through the information overload we need catalogues, indexes, documentation, whose very proliferation calls for more cross-references, hypertext links and so on. Information about information is a growing business.

A crucial implication of supply abundance is the ubiquity of failure. Flops are the rule, success, an exception. In Hollywood, hundred projects under development result in one movie, and only one of every six movies released makes money. In the pharmaceutical industry, only one in 4000 synthesised compounds ever makes it to market and only 30% of those recover their development costs. In consumer goods, over 80% of new products launched fail within two years. Yet, despite this dismal outlook, the pace of product introduction does not slacken. Ours is a wager economy: higher and higher stakes against lower and lower odds. Wager analogy explains why companies stay in the products race. As long as they continue to bet, they have a non-zero probability to recoup their past losses. Only if they walk away, losses become final.

Another reason for a continuous new product generation is what can be called the “bookstore” effect. The best bookstore is the one that offers the widest choice. It is however not enough to have a wide assortment, it is also important to keep it current, hence the need for continuing influx of new products. The bookstore effect explains for example why Reuters maintains 20 000 pages of data in its on-line financial information services, while the overwhelming majority of its clients use only four or five. The value of its databases is derived not only from particular pieces of information but also from the total inventory of data.

Structural abundance also has a major impact on the notion of capacity and the use of productive assets. While in the industrial economy excess capacity is synonymous with costly inefficiency, in the intangible economy it is widespread, functional and inexpensive. It is functional, as it enables users and producers to cope with demand volatility. Excess capacity is inexpensive because the key flows are those of information rather of physical goods. The economics of adding additional capacity for information flows are very different from that for physical goods handling. The latter is clearly subject to diminishing returns and thus its marginal costs are high. In the Information Technology realm, there might be diminishing returns at some point but they are unlikely to be reached in the foreseeable future. The long-term trend is for an exponential progression mode and for a dramatic fall in unit processing and transmission costs.

The changing nature of the firm

Intangible economy undermines traditional frontiers and distinctions. Previously separate sectors of telecommunications, informatics and audio-visual entertainment are now overlapping. Time honoured separation between work and leisure, home and work-place, intermediate good and final output, consumer and producer, become blurred. This is not an one-off effect of transition to a new environment but a core trend. Intangible economy does not follow the rules of binary logic of exclusivity but that of fuzzy logic of overlapping.

Overlapping and blurred boundaries deeply alters the nature of the firm. Internal links, between the firm and its employees, become weaker; external links, between the firm and its suppliers and clients, stronger. While employees are told to work at home, suppliers are invited to work on premises. Many of functions traditionally considered as a core business of a firm are now subcontracted or outsourced. Nike, leader in sport shoes, does not manufacture any shoes. Nor does Dell, a leading supplier of personal computers, own any industrial plant.

Dematerialisation logic modifies the market power balance and the value chain structure. Traditionally, final product assembly guaranteed a control of the value chain, leaving subcontractors in subordinate position. Despite the fact that Michelin, by facilitating road travel with maps, signs and guides, contributed more to the development of the automobile than Renault or Citroen, the latter captured market power: few people buy their car in function of the brand of its tires. Today, a subcontractor, who controls key intangible assets such as operating system (Microsoft) can gain upper hand over companies such as IBM or Compaq, who control final assembly.

The weight of the value chain has moved closer to the consumer, from production to distribution, leading to the emergence of “power retailers” such as Wal Mart or Ikea. They dictate product design, set prices, and establish a brand umbrella.

But the transfer of market power does not stop at the check-out counter. Dematerialisation logic dramatically reduces the information asymmetry between producers and consumers. Today in many businesses, the customer knows as much about products and markets as the supplier. This entails not only substantial end-user price declines, due to the loss of the supplier’s market power, but also an unbundling of the production and assembly processes. The unbundling is particularly apparent in the IT domain. Software applications and corporate networks are often designed and built by customers, using inputs from different suppliers. Of course, they can also be created by suppliers with inputs from customers. “Make-or-buy” decisions are becoming more convoluted. The nature of competition changes: for computer services firms, such as IBM or EDS, their biggest competitors are not the other suppliers but their clients.

These developments suggest that the traditional rationale for the existence of the firm, articulated by Ronald Coase as the minimisation of transaction costs, is no longer universally valid An alternative and broader rationale for the firm needs to be developed, which would stress the brand umbrella, the intellectual property repository and the control of distribution channels as key cohesion factors and functions of the firm.[9]

Changing nature of value discovery mechanisms : intangible markets

Conventional pricing and transaction mechanisms do not adequately capture the economic value of intangibles. The two standard approaches are difficult to apply. Production costs/marginal costs cannot be used as guide for pricing when marginal costs are falling or nil. Moreover, there is no proportionality between inputs and outputs. Mass consumption does not imply mass production. Economies of scale for intangible artefacts are often determined by consumption rather than by production.

The willingness to pay approach also has serious pitfalls, given the ease of replication and sharing and associated externalities. For intangible artefacts, purchase does not equal consumption (how many people read all the books they buy?) and consumption does not necessarily imply purchase: in newspapers or in broadcast television, the number of “free riders” far exceeds that of paying consumers. Another problem, which particularly affects informational artefacts, is what Stiglitz called the “infinite regress”: it is impossible to determine the value of a given piece of information without having this information.[10]

Thus, a very large share of intangible artefacts is consumed free of charge. When a price exists, most often it is based on the support rather than on the content: a price of a book is function of its thickness and print quality. Technological progress has modified this situation: it is now possible to introduce price discrimination based on content use and/or value. However, as pricing of intangibles zeroes on content, it highlights its inherent volatility. The value of content is time-sensitive, user-specific and varies widely: financial data can be worth millions in the morning and nothing in the afternoon. As metering technologies allowing to measure the consumption of intangibles become more widespread, the range of pricing schemes is getting broader and more complex. Internet provides a testing ground for various schemes: bundling, unbundling, access-based, usage-based, service-based, sponsoring or bartering. These schemes should be seen as complementary rather than mutually exclusive.

Changes in economic relationships necessarily implies a change in the nature of markets. Their main purpose is no longer to support trading of physical goods but to facilitate exchange of intangibles.

Markets for intangibles differ from markets for physical goods.[11] In the latter, it is easy to identify discrete transactions, as buyers and sellers are usually distinct. In intangible markets, transactions form a continuous process. Academics exchanging data over Internet or financial institutions on a trading network are simultaneously producers and consumers. Moreover, markets for intangibles are structurally unstable. In intangible markets the notion of an intrinsic value is largely meaningless. Value is transaction-dependent and is determined not only by the willingness to pay but also by the market characteristics and pricing mechanisms used. Industrial economy has introduced price uniformity and stability. Intangible Economy favours price differentiation and variability.

The dematerialisation logic does not point to a single optimal trajectory. It actually widens the range of alternatives. As a result, schizophrenia appears as a guiding principle of business strategies. On the one hand, competition has never been keener; the fight for market share, more brutal; rivalry between firms, more intense. At the same time, alliances proliferate and management theorists extol the virtues of co-operation and sharing. The resulting business strategies must he more complex and open-ended. There are many more ways to he successful in software or in biogenomics than in car manufacturing or steel making.

At the core of Intangible Economy, contradictory forces are at work: economies of scale and increasing returns, on the one hand, value shift to the consumer and market renewal, on the other hand. These forces will continue to coexist and to interact. Schizophrenia becomes the foundation of business strategies.