Moore's Law and Diminishing Economic Returns

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I
learned a great deal over the weekend about how to get a great deal
on a new computer. I’m going to pass this information along to you.
It has to do with Moore’s law.

Gordon
Moore is a co-founder of Intel, the microcomputer chip manufacturing
company. Intel has dominated chip production for a generation. It
invented the first silicon chip with embedded transistors. In 1965,
Moore observed that every 18 months, chip capacity doubles. Nothing
else in nature or society doubles this rapidly.

Raymond
Kurzweil invented speech recognition software. He has looked at
the evidence and has concluded that this process has been going
on since 1910. Calculating power per dollar doubled every three
years from 1910 to 1950. It doubled every two years from 1950 to
1965. It doubled every 18 months from 1966 to 2000. It is now doubling
every year. In other words, the rate of change is accelerating.

If
this rate of increase continues — and Moore himself is highly
skeptical about this — then by 2023, the computer chip’s capacity
per $1,000 will equal the human brain. By 2036, one penny will buy
this much capacity. In 2049, we will be able to buy a chip with
the capacity of the entire human race’s brains for $1,000. In 2059,
this will cost one penny.

http://www.kurzweilai.net/articles/art0134.html?printable=1

The
growth of computer capacity is rising so fast today that computer
manufacturers are now finding it difficult to deliver new machines
at a profit. The machine becomes technically obsolete too fast.
The buyer knows that the latest and greatest machine will be unsalable
within months. On the used computer market, it will sell for a fraction
of its price today. It pays the consumer to wait to buy.

Yet,
worldwide, the computer market continues to grow. Price competition
is bringing the price of computer power into the budget range of
millions of Asians. Americans may be jaded, but Asians aren’t. For
them, the computer revolution is barely beginning. The Internet
beckons.

Asian
governments, especially China’s, see what is coming: unofficial
information and opportunities that they would rather not share with
the public. The days of the information gatekeepers are numbered.
This has never happened before in human history. "Every man
a publisher" is becoming a possibility.

THE
FEAR OF DEFLATION

One
of Keynesianism’s arguments against price deflation is that it is
bad for business. Consumers know that lower prices are coming. It
pays them to wait to purchase anything. It makes them smarter shoppers.
So, the Keynesian says, consumer demand falls despite falling prices.
The recession gets worse. So, as soon as it looks as though monetary
policy is moving toward stability — a rare event — mainstream
economists and central bankers start worrying.

What
we have seen with computational power since 1910 is a standing testimony
against any argument against deflation. Price competition broadens
the market, attracting new buyers. Example: it looked in 1960 as
though American phone companies would soon saturate the market:
one phone line per home. Now look at the phone market: an Internet
line, a regular phone line, a kids’ phone line, and maybe a small
business line. Then there is the cell phone. This doesn’t count
cable TV. As for businesses, they buy lots of phone lines.

Falling
prices don’t scare off buyers; they attract buyers. When one group
of buyers delays buying, content with their existing units, another
group rushes in to get what its members could not afford before.
They don’t want to wait. They have waited forever. They want in
on the deal. From Model T Fords to the latest desktop computer,
falling prices increase demand.

That’s
why all the hand-wringing over the threat of deflation — for
which there is very little statistical evidence — is so much
wasted worry. We should be so fortunate!

To
understand the benefits of falling prices, let me tell you about
my experience in buying a new Dell computer.

HOW
TO BUY A NEW COMPUTER

I
have problems with my old computer. This will sound crazy. It won’t
recognize a modem. Anyway, it won’t recognize it after I bring the
machine home from the repair shop. In town, it hooks up to the Internet
with no problem. Then I bring it home. I turn it on. It works. But
if I turn it off and then turn it on again, it loses all trace of
any modem. I have to take it to town again. This has been going
on for two weeks. Nobody can fix it.

Because
of the falling price of computers, a computer is now a throw-away
item. My unit is a 1998, obsolete, 500 megahertz machine. The cheapest
new desktop machine is more than twice as fast. Most are four times
as fast.

The
computer companies are facing intense competition today. Small companies
can go on Ebay and sell new machines without monitors for about
$500. The units come with warranties. The growth of on-line purchasing
is unstoppable. The information cost of finding a new machine keeps
falling.

Falling
information costs are now a major factor in pressuring retail computer
sellers to sell lower. What I found last weekend about how Dell
sells was a revelation to me.

On
Saturday, I read through a Dell Small Business catalogue dated September
2002. On page 5, there is an ad for a nice little desktop computer:
the Dimension 4500S. It has a small vertical case no taller than
the monitor, and half as wide as a conventional case. It’s a 2 Ghz
machine that uses a Pentium 4 processor, a 20 GB hard drive, a 15"
monitor (13.8" viewable). Price: $599. Not bad. Even better:
there is a $100 rebate.

For
an extra $70, you can buy a CD/RW (read/write) drive. For $50, you
can upgrade to 256 MB of SDRAM. That’s a total of $619. If you order
on-line before Sept. 25, shipping is free.

Now
comes the fun part.

I
called. I was told that this machine is no longer being manufactured.
But I could order a Dimension 2300.

I
had been on the Dell site earlier last week. The 2300 is a more
expensive machine.

I
asked what it would cost with the features I wanted, but without
a monitor. The salesman refused to give me a price until I supplied
my name and address. He said this was because of varying shipping
costs. He had to know where I live. So, he planned to charge me
for shipping. But the catalogue announces: "FREE Ground Shipping."
His sales pitch assumed that the caller wasn’t responding to the
catalogue, even though the phone number I used is provided at the
bottom of each page in the catalogue. After I gave him this information,
I was told that I could buy the entire package for $798. This included
a $100 rebate.

If
I figure that my $120 in upgrades would have been offset by the
absence of a monitor, as well as cheaper shipping, Dell was trying
to get me to shell out an extra $299 over the $499 rebate catalogue
price. That’s a 60% price increase. I passed.

Then
I went to Dell’s Web page listed in the catalogue:

http://www.dell.com/d4500s-september

I
found that I could still order the model I wanted. It’s not out
of production after all. In fact, if I ordered it on-line, I could
skip the $99 shipping fee. I bought the machine with the monitor
and the upgraded SDRAM and the read/write CD drive for $650, delivered.
I really don’t need the monitor, but I can use it.

This
model doesn’t have a modem, but I prefer an external modem anyway.
With an external modem, I can see when it’s connected to the Internet.
It has lights.

Dell
is hurting. To pay for its telephone sales force, Dell appears to
have adopted a familiar sales technique. It used to be called "bait
and switch." I was told that the model I wanted was no longer
available, despite the fact that I was ordering from a September
catalogue. "The catalogue was printed three months ago,"
the salesman told me.

As
I learned ten minutes later, the model was still available on-line
at a special price: a $100 rebate and no shipping.

The
salesman was obviously using a different sales pitch for old-fashioned
buyers who still prefer to buy over the phone. Those who buy on-line
are more price sensitive. They must be offered a better deal. They
know that Ebay or other sources are out there.

Dell
is taking advantage of information differences among different classes
of buyers. The company is selling higher-priced machines to people
who have poorer information skills. The buyer over the phone is
more easily upsold by a salesman with a story: "I’m sorry,
that model is out of production."

When
I decided to pass on the higher priced model, I made a mental decision
not to buy from Dell again. I decided not to trust Dell’s catalogues.
That meant that I would no longer trust their phone salesmen. But
then I thought, "I wonder if I can beat the system. Can I use
on-line ordering to get what I want at a price the salesman says
is unavailable?" I found that I could.

Dell
got my money. I ordered the machine that I wanted. But I learned
a lesson: price competition is cutting profit margins at Dell to
such an extent that different classes of customers are treated differently
in terms of information.

Now
you know. Don’t order from Dell by phone. Order on-line. But before
you do, check here
to see the “steal of the day.”

The
same thing is happening to the airlines. On-line ticket ordering
is making highly price competitive deals available. The deals offered
on the phone are not as good.

The
large carriers have always made their profits off their business
travellers. Their profit margins depend on three or four high-priced
business travellers per flight. Now the discount carriers with low
overhead are making low fares available to business flyers. The
major airlines must match the offers to remain competitive. The
majors are getting killed. One by one, the airline transport unions
are biting the dust. They are having to back off. Price competition
is fierce. The Web is the great equalizer. Yet it’s the Sabre reservation
system that the Web sellers use. American Airlines developed the
Sabre system. American Airlines has laid off 20,000 workers.

This
is good for consumers. But the majors are howling. "If we go
out of business, consumers will face higher prices!" There
are still congressmen who are calling for the re-regulation of the
airline industry for the sake of "maintaining competition,"
and the majors are in agreement. The producers’ hatred of price
competition is always with us.

Price
competition works for the consumer. If the old-line, high-overhead
sellers get hurt, too bad. The free market is structured in terms
of consumers’ sovereignty, not producers’ sovereignty, a fact that
outrages older producers with established markets. Price competition
erodes established markets. This is why they hate price competition.
It lets newcomers beat the Establishment to death. This is why price
competition gets a bad press — but not on-line. The bad press
is the paper-based press that survives on advertising paid for by
established firms.

Fortunately,
the home computer industry was never regulated by the Federal government.
It came out of nowhere before Congress ever got its hooks into it.

Dell
faces competition from no-name producers on Ebay. Now that computers
are throw-away items, buyers can risk buying on Ebay. This is great
for buyers and tough for producers with high overhead. That’s the
way it should be. Michael Dell became a billionaire by offering
a price-competitive product line to IBM’s PC’s, beginning in 1983.
Now it’s his turn to scramble.

When
sellers scramble, buyers win.

FAST
DEPRECIATION

My
need to buy a new computer is not high. Had it not been for that
"no-modem" glitch, I would have stayed with my 1998 Dell
model. For accessing the Internet, I don’t need anything faster
than a 1998 computer. I won’t in two or three years, either.

Most
people use five or six pieces of software: a word processor, an
e-mail/browser program, and a utility program or two. Most of these
programs are cheap: under $50. Some are free. The most important
utility programs that I use are Norton AntiVirus and a $25 program
called TextPad, which strips out HTML code and creates clean ASCII
files out of Web pages. I also use ZoneAlarm, a firewall program.
(If you use a cable modem, download it.) I use Cookie Cutter. I
don’t add programs often. I’m still looking for a good free-form
data base for Web pages, e-mails, and notes. With these programs,
I don’t need any more computer speed. I don’t use CAD/CAM programs
or digital movie editors. I don’t use a spread sheet.

Yet
the chips keep getting faster. The chip producers are not being
driven by consumer demand to make these improvements. They are being
driven by the fear of falling behind their competitors. Consumers
are not pressuring computer companies to produce ever-faster machines.
This is why advertising revenues have collapsed. Computer magazines
are thin today. Ziff Davis Publishing is no longer a cash cow. Computer
buffs are not reading every page to find out what the latest and
greatest is. The increase in computer speed is not matched by an
increase in productivity. The return on investment for buyers is
low. The law of diminishing returns has set in.

The
result is a reduction of the rate of economic obsolescence for old
machines. Rapid technical obsolescence does not produce rapid economic
obsolescence. Old machines can do the grunt work of new machines
with no noticeable reduction in efficiency. Updated software doesn’t
run that much worse on a 1998 machine. In 2005, that will still
be true for most machines and most operations. Your old machine
can’t be sold for much money, but it need not be replaced. Since
you can’t get much for it, you might as well keep it.

When
a computer breaks, it should be replaced. Fixing it is a waste of
time and money. If it can’t be tweaked and put back into production
in a couple of hours, replace it. But computers rarely break down.
I’m typing this report on a 166-Mhz Dell that has to be seven years
old. I keep it separate from my Internet machine, for virus reasons.
I use a 1983 PC AT keyboard. My keyboard is worth five times to
me what my machine is. It’s not digital. It holds its value. For
WordPerfect for DOS users, it actually goes up in value. Newer keyboard
models are less productive because of the function key placement.

ECONOMIC
GROWTH

Some
of you are aware that the government uses what is called a "hedonic
index" to measure increases in output. Quality changes that
are said to be the result of increasing computer speed are used
to judge the productivity of the economy. But as computer speeds
accelerate, and as output that results from increased computer speed
ceases to increase, the hedonic index becomes increasingly a statistical
game that makes the economy look better. What we want is cheaper
food, cheaper car repairs, and cheaper housing. What we get are
faster computers, which we no longer need. Yes, Asians benefit,
but the economic index is for Americans.

Moore’s
law is still operational. Computer chip density doubles every 12
months. If this were matched by an increase in general productivity,
we would all be as rich as kings in two decades. But the law of
diminishing economic returns has set in. Output is no longer rising
rapidly as a result of faster chips.

The
government’s statisticians are busy making the economy look as though
it’s growing faster than it really is. Imperceptible increases in
output are being counted as significant because of the measurable
increase in chip speed. Meanwhile, consumer debt rises and corporate
debt rises even faster. What is accelerating is the debt/output
ratio. It takes more and more debt to achieve one percent economic
growth.

The
U.S. economy is climbing a wall of debt. The law of diminishing
returns is making itself felt in the debt/output ratio. It takes
ever-larger infusions of credit to keep the system running.

The
statisticians can play all the games they want. The fact is, the
stock market is heading down. So are corporate profits. So is corporate
investment. Businesses profitability is kept low by fast-depreciating
computer technology. It no longer pays to keep upgrading. By heralding
high tech investing as the wave of the future and the key to future
growth, the touts — Alan Greenspan is chief — persuaded
investors to buy shares, or at least not sell them. But the investment
in high tech has not produced comparable productivity. Businesses
have stopped making these huge commitments that depreciate rapidly
and do not lead to greater profit.

This
is why the NASDAQ really is dead. It isn’t coming back. The mania
of high tech investing is over. All that remains are the depreciation
schedules. The best you can say is that there is no compelling need
for businesses to upgrade. That spells years of low growth for technology
companies.

SERVICE
WITHOUT DIGITS

I
have been working since July, 2001 on a manual. It’s for an industry
that is highly profitable. It is essentially a mom & pop industry.
It is immune to would-be Wal-Marts. A friend of mine got into it
in 1991 with a $35,000 investment. He took in $1.4 million in fiscal
2002. The real estate side of the operation has increased his net
worth by $500,000. It will be $1 million in ten years. Yet he can
run his entire operation with $1,000 worth of used computers. All
he needs is one copy of QuickBooks Pro per location, a $200 program.
He could run this on a $100 used computer.

Eventually,
I will go public with the full story. My point here is that this
industry is pure service. It is low tech. Yet it is highly profitable.
I look at the inventory expenses of a business like auto parts or
toys or retail book sales, and I see huge outlays. Yet there are
lots of little service businesses that can do quite well without
inventory or computerized delivery systems.

I
know very few people whose livelihood is dependent on Moore’s law.
At the same time, I see industries that are high tech with razor-thin
profit margins. The airlines are the best example, but so are steel
and autos. Price competition is ruthless. It spares no producer’s
feelings. It respects no one’s monopoly. The Web is the most price-competitive
institution in history. You had better have a niche market if you
want to survive. I can do no better than to quote Norm Brodsky:
"Barriers to Entry," Inc. Magazine (Oct. 1, 2001).

Given
a choice, moreover, I’d always go for a hard-access business over
an easy-access one.

Why?
Because in an easy-access business, the product or service you’re
selling will eventually become a commodity, if it isn’t one already.
Not that there’s anything wrong with commodities. You’re just
severely restricted in what you can charge for them, so you’re
forced to operate with much thinner gross margins than those you’d
enjoy in a business that is more difficult for competitors to
enter.

http://www.inc.com/magazine/20011001/23475.html

That’s
why I pay through the nose to get an electrician, plumber, or common
skilled worker to make house calls. Skilled workers with low-tech
tools can name their price. We have sent our children to college.
The best and the brightest are earning sociology degrees at good
universities and getting entry-level $25,000 a year jobs. But journeymen
plumbers are living well. There is a lesson here. There is no prestige
in cleaning out septic tanks — just a lot of money.

THE
CUTTING EDGE

The
biggest firms are struggling. They have adopted high technology
to secure a cutting edge. But he who lives by the cutting edge dies
by the cutting edge. These huge firms have used high technology
to give them an advantage, but, year by year, Moore’s law is lowering
the barriers to entry. The high tech advantage must be paid for.
Front-runners must keep shelling out big money to maintain their
advantage. Intel is the model. As a new technology spreads, more
newcomers can get into an industry. The cost of maintaining a significant
lead is reaching the law of diminishing returns. This is great for
consumers and bad for "buy and hold" investors.

Digital
technology is a democratizing force. It keeps getting cheaper: Moore’s
law. As digits get cheaper, more of them are demanded. More users
of digital technologies become skilled. This is why the return on
invested capital keeps falling. American companies are seeing their
market share taken away by Asian firms. This will not change. Digital
technology spreads. It doesn’t respect borders.

It
goes to the highest bidder.

Trailing
edge technology is becoming so powerful technologically that its
ever-lower price overcomes the advantage that cutting edge technology
once provided. What is happening in desktop computers is happening
in every area of the economy. High technology no longer secures
a long-term stream of income for producers.

Half
of the Fortune 500 firms in 1980 were not on the list in 1990. If
you bought and held, you survived only because the stock market
rose in response to retirement money pouring into a narrow market.
Those days are over for our lifetime. Now, you must buy the right
stocks. Buy and hold won’t do it for you any longer.

Respect
Moore’s law. It takes away advantages that were once thought to
be secure. To the extent that any industry’s barrier to entry is
digital, that industry is now on the defensive. The days of digital
wine and roses are over. It’s hangover time.

September
27, 2002

Gary
North is the author of Mises
on Money
. Visit http://www.freebooks.com.
For a free subscription to Gary North’s twice-weekly economics newsletter,
click
here
.

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