Date created:4 May 1999

Last modified: 4 May 1999

Maintained by: John Quiggin

John Quiggin

Don't overrate E-commerce

Australian Financial Review

22 April 1999

The Internet is the great paradox of the 1990s. It was built on a co-operative non-profit basis, and most attempts to make a profit out of it have failed. Yet huge fortunes turn on the belief that the Internet will soon generate huge profits for those ready to exploit its potential.

Restricted until a few years ago to academics and students, the Internet has experienced seemingly limitless growth. As its newsgroups and mailing lists were supplemented, then largely displaced, by the World Wide Web, the number of users doubled and redoubled. Then, in the early 1990s the restriction non-commercial use was abandoned. Commercial networks like Compuserve and America Online were swallowed whole and the Internet hit the front pages.

Although the profit motive was a latecomer to the Internet, it has made up for lost time. In the stockmarket boom of the 1990s, Internet startups have been the hot items. Companies like Yahoo, offering search engines and 'portals' for entry to the Web, are valued at 400 times earnings. But these are the conservative choices. Many firms with market valuations in the billions have yet to turn a profit. In the 'new economy' based on 'wired workers' it is claimed, those investors who wait until profits actually appear will be too late to enjoy the benefits

To assess the prospects for this 'new economy' it is useful to employ some old-fashioned economics. In his pathbreaking analysis of the economics of agriculture, 19th Century economist David Ricardo distinguished between the extensive margin (bringing new land under cultivation) and the intensive margin (increasing productivity on existing land). A similar approach is useful in thinking about the Internet.

The spectacular growth of the Internet has taken place mainly on the extensive margin. A few years ago, the Net was mainly the domain of academics and students. Now it is estimated that one third of the population has access to the Net. Since at least one third of the population will never go online, there is scope for at most one more doubling on the extensive margin.

Any hope for big profits from the Internet must therefore rely on the intensive margin.This implies a bleak outlook for the owners of portals and search engines. Portal services are of most benefit to 'newbies' (new users). They rely on the fact that because of inertia, people are slow to change their start page. Eventually, though most people stop surfing the Web and go directly to the sites that interest them. The whole idea of a portal as a 'one-stop shop' is the antithesis of the limitless variety that makes the Internet so appealing.

A more promising way of making money on the Net is by selling goods and services. Superficially, the scope for growth here looks limitless. So far, however, sales on the Internet have been strong only where a lot of business was previously done by phone or mail-order. Examples include computer hardware and software, books and CDs (particularly hard-to-get items), florists and travel services. Once the bugs are ironed out, the Net will offer a better service than a call-centre or paper catalog. So, business on the Internet should grow to a level comparable to that of the present mail-order and phone-order sectors.

There are two big problems for investors, however. First, Internet commerce is a 'process improvement' which will allow existing firms to provide better services without necessarily creating a huge potential for new entrants. More importantly, the market valuation of Internet stocks far exceeds anything that could be justified even if the entire mail-order sector was taken over by Internet startups. To justify such valuations, Internet sales would have to displace shopping malls. There is no sign that this is happening.

If scepticism is appropriate in assessing the Internet stock boom, it is even more necessary in relation to the other computer fad of the 1990s, the panic over the 'Year 2000' bug. The whole thing now looks very much like an April Fools' Day joke. The first of April, the beginning of the US fiscal year 2000, was supposed to herald widespread Y2K-related failures in financial systems. Instead, the computer news of the day was the unrelated and unanticipated Melissa virus. The massive expenditure on eliminating the Y2K bug, estimated at as much as 1 per cent of GDP, looks more and more like a waste of money.

Professor John Quiggin is a Senior Research Fellow of the Australian Research Council, based at James Cook University.

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