Ian & Stuart's Australian Mac: Not for Sale/Another.not.for.sale (Australia).iso/fade into you/being there/Internet Accounting/Public Subsidy

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Subsidy    1    Schickele



THE ECONOMIC CASE FOR PUBLIC SUBSIDY OF THE INTERNET

                     Sandra Schickele

I  THE THEORY OF PRICE AND PRIVATIZATION OF THE INTERNET

It has been argued that little or no case for public subsidy
of the Internet1 exists and that the free market can produce
an adequate supply of network services at a price to be
determined by market forces. This argument depends on a
misunderstanding of the way  in which markets allocate
resources. It is the purpose of this paper to clear up that
misunderstanding and present  the model underlying the
argument in historical context so that it can be explicity
referred to in discussion of the economics of the Internet.

The ongoing debate about privatization of the Internet
involves implicit allusion to the neo-classical model of
price determination in free markets. This same model is
called by economists the "theory of price", or "price
theory". Its conclusions are referred to in literature, the
press, election campaigns, and private conversation without
any reference to the model's origins, assumptions, or
limitations. Any person or group wishing to influence the
direction of economic policy of the United States Government
must marshall arguments based on the price theory model, or
at least be able to counter arguments advanced by
individuals claiming to possess complete command of its
meaning.

This paper presents the neo-classical model of price
determination in a context which stresses its historical
development as a model. The model's assumptions and
limitations and their impact on  economic analysis of
Internet funding or pricing are spelled out. The neo-
classical model of price determination asserts that private
ownership of industry coupled with the sale of goods and
services at prices determined by unregulated market pricing
mechanisms will, under certain circumstances and subject to
certain limitations, result in an economically efficient and
socially optimal allocation of scarce economic resources.

A model is only as useful in practice as its assumptions
permit. Meaningful prediction or interpretation of real
world outcomes depends on correct understanding of premises,
on knowledge of any inherent limitations, and on formation
of a judgment as to whether or not the model's stated
preconditions are met in a particular circumstance.

The conclusion of this paper is that the assumptions which
must hold if the free market is to be efficient are
fundamentally violated by the nature of the Internet and any
likely successor to it, and that market prices cannot by
themselves efficiently allocate resources for the production
and use of the Internet.

The paper is divided into five sections. The first describes
parts of the theory of price and outlines the rest of the
paper.

The second section lists and defines several of the
assumptions that must hold in order for the efficient
allocation of resources hypothesized by price theory to
occur. In this section of the paper the price theory model
is taken as a given and the questions addressed are: on what
assumptions is the model based; when do these assumptions
hold; do they hold for the Internet?

The third section of the paper considers fundamental
limitations of the price theory or free market model itself.
Basic problems associated with relying on the model as a
guide to public decision making in an environment of rapid
change are described. Problems inherent in the nature of the
price or market system are shown to affect analysis of
potential Internet funding mechanisms.

 The fourth section turns to an analysis of some special
characteristics of the Internet which cause it to violate
several of the assumptions necessary to the efficient
functioning of free markets as described earlier in part
two. This finding leads to the conclusion that in the
absence of a subsidy the private market is not an adequate
producer of public network services. The fundamental
limitations of the entire price theory model discussed in
section three also affect analysis of Internet funding
opening the possibility that prices determined by the
private market may lead to a socially undesirable outcome.

In section five the outcome of the analysis overall -- that
it is not possible for the private market alone to create an
efficient or socially optimal production and distribution of
network services of the type represented by the Internet --
is presented. It is the case that whatever allocation
mechanism eventually is used to distribute network services,
primary reliance on market prices will not generate an
economically desirable outcome.

II CONDITIONS NECESSARY FOR EFFICIENT MARKET PRICES

Briefly stated, the theory of price holds in part that:

The privately owned firms which make up an industry will,
under competition, sell their goods at whatever price the
market will bear. In a competitive market that price will
ultimately in equilibrium just be equal to the marginal cost
the producer incurred in the process of production and
distribution.2 Firms will not have any control over the
price they receive. It is assumed that the firm's only real
decision will be whether to sell or not to sell at the price
established by impersonal market forces. A firm can stay in
business or shut down. The market does not care or notice.
If individual firms leave, their leaving will not have any
effect on the price at which the good is sold, because there
are many producers and no one of them has enough power to
control market price. It is assumed that prices and wages
are perfectly flexible. Market prices will be simultaneously
established in all industries; and the factors of production
(labor, capital, and raw materials) will flow into those
industries whose goods are in greatest demand where the
labor, capital, and raw materials can earn the highest
wages, interest, and rent. An economically efficient and
socially desirable allocation of resources will result.

The chief benefit and major achievement of the price or free
market system  in  an environment of competitive unregulated
markets is said to be allocative efficiency. In other words
the market allocates the scarce resources available in such
a way that an equilibrium is reached in which no one can be
made better off without some one else being made worse off
(the condition called Pareto optimality is attained).3

A particular good, such as the Internet, can only be
efficiently produced through the free market, according to
the theory of price, if the good's  production and
consumption meet the first nine conditions listed below. If
the production or consumption of the good does not meet
these conditions the good cannot be efficiently produced
through a free unregulated market.

Some of the preconditions which must exist in order for
allocative efficiency to be said to occur in a single
industry and in the economy overall are the following:

1. Perfect competition exists in all product and factor4
markets.  No seller or buyer is large enough to have an
effect on market price, even if he leaves the industry.5
2. Perfect information (complete, accurate, and freely
available) on relevant prices and characteristics of
products and factors is obtainable by all buyers and sellers
of goods and factors.6
3. Perfect mobility of resources exists. Labor, capital, and
raw  materials flow unimpeded to their highest paid use.7
4. No externalities (positive or negative) are present in
the production and consumption of goods. The production and
consumption of a good has no effect on any individual or
group except the actual producer and consumer. No effects
fall on third parties.8
5. No public goods can exist.9 National defense and clean
air are examples of pure public goods. That is, if they
exist, they are available to everyone in the society. In
order for the free market to function properly the product
being produced and sold must have the "exclusion property",
meaning that everyone but the buyer of the good must be able
to be excluded from its benefits. Some goods have the
characteristics partly of private goods (no effects or
spillovers fall on third parties in the case of a pure
private good) and partly of public goods. They have
sometimes been called quasi-public goods. It is possible for
the free market to produce quasi-public goods to a limited
extent, but not at an appropriately high output level.
Education is an example of a quasi-public good, and it is
the contention of this paper that the Internet is the same
type of good.
6. No direct interdependence exists in the consumption or
production of any good. Consumer A's decision to consume a
good is not directly interdependent on Consumer B's decision
to consume the same type of good or any other good. Producer
C's decision to produce a certain amount of a good is not
interdependent with producer D's decision  to produce a
certain amount of the same or any other good.10
7. No significant economies of scale can exist. Costs faced
by large  producers are not significantly lower per unit of
output than costs faced by small producers. Stated somewhat
differently, this assumption implies there are increasing
costs in all industries at a relevant level of production.
If decreasing costs existed, the first producer  would find
that his costs fell continually as output increased, and a
condition of natural monopoly would exist, precluding
meaningful competition.11
8. Indivisibilities in production must be small. All factors
(such as capital investment) must be able to be varied by
small amounts. There must be no factor which has to be used
in large indivisible doses.12
9. Transaction costs must not be so great as to cause market
failure. Transaction costs are the costs incurred in
enforcing property rights, finding customers and suppliers,
and actually carrying out a transaction. They are the costs
associated with exchanging rather than producing goods and
services. If potential transaction costs, notably the costs
of enforcing property rights, are high, it may not pay
private producers to create a market in the good in
question. Private markets can be established only for goods
for which property rights can be guaranteed and easily
exchanged. If there are goods which the society desires to
have but which have large transactions costs, these goods
will of necessity have to be produced outside the free
market framework.13
10. The prevailing distribution of income must be accepted
as a given in the analysis.14 Efficiency criteria in
economics are dependent on the assumption that the pre-
existing distribution of income will not change. Changes in
the distribution of income will affect the efficiency of a
given set of prices and a given allocation of resources. In
other words, a particular set of market determined prices
can only be said to be efficient for one unique distribution
of  income. The same prices may become economically
inefficient if or when the distribution of income changes.

Few economists would assert that these conditions are
completely met in the modern industrial market system. It is
considered critically important, however, for the force of
competition to be great, for the availability of information
to be excellent, for the size of the capital investment
required to start a competing company not to be very great,
and so on.

If any of the first nine conditions listed above are not
substantially met a condition called market failure
exists.15 Market failure is said to occur when the choices
made by buyers or sellers in a market result in an
inefficient outcome. Neo-classical economic theory
postulates that the appropriate time and place for
government intervention16 in the market is when the market
fails.

In section four below it is argued that the Internet as a
good violates conditions 1,4,5 (in part), 6 and 7, and may
violate conditions 8 and 9 as well.

III FUNDAMENTAL LIMITATIONS OF THE FREE MARKET MODEL

There are important limitations on the entire neo-classical
theory of price which must be understood before attempts are
made to use it to analyze or justify any particular economic
analysis or policy. The limitations most important for our
purposes are:

1. Serious questions have been raised about the
effectiveness with which the market mechanism allocates
resources between the present and the future. In theory long
and short term interest rates are the prices which allocate
resources between present and future--between short and long
term investment. Yet the market may devote too many
resources to current consumption. The future gets short
shrift in the market economy. Individual investment projects
represent a much greater risk to the individual investor
than to the society collectively. Individual investors may
choose not to undertake risky but potentially very valuable
projects. If citizens want more resources devoted to long
term investment and the creation of future wealth for the
society than private markets and private individual behavior
would provide, they must correct the market's shortcomings
through the ballot box.17 Interest rates as allocation
mechanisms are also flawed because government policy
manipulates interest rates frequently without regard to the
effect on the allocation of resources.
2. Some economists contend that the market model has no
theory of  technological change, no way to account for it or
create it.18
3. The socially optimal allocation of scarce resources
called Pareto optimality depends on a static economic
equilibrium with an economic pie of fixed size. Price theory
has historically been based on static analysis, not allowing
for economic growth or change in the distribution of
income.19
4. Modern economists have worked long and hard to
incorporate the effect of uncertainty of outcomes into
economic analysis, but it is very difficult to do so.
Analysis of uncertainty in modern economic theory tends to
depend on the assumption that a producer or consumer can buy
insurance against any uncertainty.20 In other words,
uncertainty is essentially assumed away. The greater the
uncertainty associated with future outcomes the more
unjustified it is to base economic policy on the belief that
the price system will provide an efficient and socially
desirable result.
5. As mentioned above, price theory assumes that the initial
distribution of income is given. Price or free market theory
applies equally well in a society in which the top one
percent of income recipients have ninety nine percent of
total income, and a society in which  income is distributed
completely evenly. Resource allocation  through the market
is equally efficient with any given income distribution, yet
market prices congruent with the pre-existing  income
distribution may at times provide an unacceptable outcome in
a democracy. Each unique income distribution generates a
different price structure. A given set of prices is only
efficient for one given distribution of income. Price theory
has nothing to say about the desirability of any particular
income distribution. Decisions about redistribution of
income are considered by economists to be entirely political
in nature. This point should be remembered in any serious
analysis of the economic impact of the Internet, because any
pricing mechanism which restricts access of the general
public to a national network may only exacerbate the
widening polarization in the distribution of income. That
is, the distribution of goods through the market mechanism
of price simply excludes low income individuals from the
market.
6. The definition of efficiency in economics is different in
kind from the definition of efficiency in engineering.
Efficiency in economics means efficiency in the allocation
of resources based on the concept of Pareto optimality which
says an economic system is efficient when no one can be made
better off without making someone else worse off. Some might
describe this as a subjective definition of efficiency.
Scientists and many others have at times been misled by
assuming that some objectively verifiable definition of
efficiency is involved in economic analysis. That is not the
case.
7. The theory of price only describes one of several methods
of rationing goods and services. Price is a system of
resource allocation. Price is a rationing device. As a
rationing device it has turned out to be much more useful
most of the time than direct rationing with ration cards or
other methods. It is certainly an easier system to manage.
But it is not the only rationing device ever invented. Other
things being equal, it is the most efficient. Where
externalities, market power, incomplete information, lack of
mobility of resources, direct interdependence in consumption
or production, public goods, indivisibility in factor use,
large economies of scale, or  large transaction costs exist,
other things are not equal and market prices cannot
efficiently ration the good in question.

All the limitations and complications of the free market or
price theory model of production and distribution listed
above impact on the Internet (or the NREN) and any future
national network as well.

IV  THE INTERNET AND THE MARKET

In this section preconditions for the efficient functioning
of  the private market from section two and potential
limitations of the market model from section three above are
examined with regard to how they affect potential Internet
funding mechanisms.

In the case of the Internet the market fails. Market failure
is created by the existence of large positive externalities,
possible significant economies of scale, the fact that the
Internet is a quasi-public good, the presence of some degree
of market power among producers and consumers as well,
interdependence in production and consumption, possible
indivisibilities, and possible high transactions costs.

A. Marginal Cost Pricing and the Internet

Is the marginal cost pricing which is required for an
efficient market solution likely to prevail in a private
market for Internet access and services?

The reality of business pricing activities is quite
different from the model. In practice, whether a company is
recovering its marginal cost of production or not will
simply determine whether it is making enough to stay in
business. Many large-scale U.S. industries are characterized
by prices in excess of the marginal cost of production. The
very existence of the marketing and advertising industries,
of price discrimination (special "sale" prices, software
"upgrade" prices, etc.), and of  business schools which
teach thousands of potential businesspeople how to establish
appropriate "mark-ups" on their products indicates that U.S.
industry does not always sell its products at the marginal
cost of production.

To the extent that competition has in fact prevailed in the
electronics industry, the individual firms in that industry
experience great insecurity. This very uncertainty and the
price flexibility associated with it are indicators that
segments of the electronic industry currently exist in a
classic competitive situation. There may however be
economies of scale in production of Internet related goods
or services. If that is the case, then there is likely to be
a resulting "shakeout," among the firms in the industry,
with the survivors able to price products well above
marginal cost. These same survivors will then dominate the
market until another new round of technological development
threatens their hold or sweeps them away. Many years ago the
economic historian Joseph Schumpeter characterized the
periodic bouts of fierce development in capitalism as the
process of "creative destruction."21
It is also the case that there is a wide disparity in market
power among the different producers and consumers in the
industry for Internet related services and goods.
Ultimately, the disparity in market power among the
different sub-groups involved is likely to affect the level
of market prices.

The potential exists for the development of a classic
oligopoly 22 in unregulated long distance carrier service.
Although the price setting behavior of firms in an industry
dominated by a few large producers may vary, oligopoly
prices are often determined by the behavior of a "price
leader." It is well established in price theory that
conscious collusion is not necessary to maximize price in an
oligopoly industry.23 One company, usually the largest,
announces its prices, and the others follow suit.  When the
members of an oligopoly group disagree among themselves a
price war results. This phenomenon can be seen in the
behavior of the deregulated airline industry.  A more
successful oligopoly price strategy, however, is the price
leadership method of price determination. Market prices in
an oligopoly environment are not usually determined by
marginal cost, or even by average cost of production. A
typical oligopoly industry is characterized by prices well
above marginal cost.

There is a potential mitigating factor which can influence
oligopoly behavior. The theory of contestable markets24
hypothesizes that if entry into and exit from the industry
are low in cost and unimpeded, it may be possible for small
firms to enter the market and pull away some of the market
share of the large firms if prices set by the oligopoly are
far above average cost. The theory is that the possible
entrance of smaller firms will act to discipline oligopoly
behavior.

There are industry sub-groups involved in production for the
Internet to whom the theory of contestable markets probably
applies. It seems doubtful that long distance carrier
service falls into that category, however.

There are many other companies and sub-groups of producers
involved in the Internet "industry" who do not possess
market power. Their situation is sufficiently different from
the largest companies involved that the two groups should
always be distinguished from each other for analytical
purposes.

There is also a wide disparity of market power among
Internet "consumers." The federal government and the various
state governments, among others, have market power. They can
negotiate for prices.

The reality is that an attempt to produce Internet network
services through the free market will result in negotiated
prices based on relative market power for the largest and
most powerful participants in the market. Other producers
and consumers in the market will for the most part merely
experience the end result of the negotiated outcomes.
This paper will argue that if access to a future Internet is
determined by the ability to pay market prices, most users
will almost certainly not be paying a price equal to the
marginal cost of their use. They will be paying what the
market will bear in a situation not characterized by
competitive equilibrium. They will pay an amount which may
be well above marginal cost. A market price substantially
above marginal cost of production is one indicator that
market failure has occurred.

B. Social Benefit, Externalities, and the Internet

To give one simple concrete example of  positive
externalities associated with access to the Internet: if
teachers at all levels of education have network access,
they have the ability to train students in network use. When
the students graduate they become workers. If it is
desirable to future employers that these workers possess
familiarity with network use, then the employers benefit
from the students' education in network skills. The
employers are third parties who receive positive
externalities (or spillovers) from the students' education.

The benefits of basic research are not appropriable to a
single producer and basic research itself is not susceptible
to production through the market mechanism. Any social
institutions which contribute to basic research activities
are generating positive externalities by doing so. Any
system, such as the Internet, which helps institutions
pursue basic research development, is generating positive
externalities in the process.

It seems likely that the development of "virtual
communities"  in the form of highly specialized sub-groups
which regularly "meet" and "talk" through the Internet
contributes to the creativity of the groups in question.
Such groups are capable of a division of labor and a
specialization of skills beyond any which have ever existed.
There is no reason to believe that useful specialization has
lost its capacity to increase economic output since it was
described by Adam Smith in his report on the contribution of
the increased division of labor to the productivity of a pin
factory in "An Inquiry into the Nature and Causes of the
Wealth of Nations".25

Alan McAdams of Cornell University believes that all who use
the Internet, and those who may use it or its successor in
the future, benefit from (receive positive externalities
from) the contributions made to its usefulness by other
persons on the Internet. In other words, a substantial group
of the (usually heavily subsidized) current users are
creating positive externalities through their creative
contributions to the net.

An initial very rough approximation of the size of the
social benefit (and some indication of the positive
externalities) being generated by the Internet today may be
calculated by setting a dollar value on the time which
individuals are devoting to the network. Thousands of
individuals who are not paid to maintain the network
nonetheless devote tens of thousands of hours to using it.
If we assume they are rational consumers, we must assume
they set a high value on its usefulness. Since most of the
non-student adults using the net probably earn  the average
wage for professionals, technicians, and managers, their
time is worth $20-$50 per hour (or more). Thousands of
students and graduate students also spend time voluntarily
on the net. If we value their time at only $4-$6 per hour, a
dollar estimate of the value they set on the use of the net
will still be considerable.

Even those who are using the net for recreational or purely
social purposes are indicating by their use of their time
that social benefit  is being generated by the availability
of the net. The dollar value of the social benefits
attributable to the development and maintenance of public
parks, for example, consists in part of estimating the
recreation value of the park to the public. That value is
considered to be in excess of any price set on the use of
the parks.

In other words, even the recreational use of the net
generates social benefit in the economic sense. In that case
the benefits accrue to the immediate users and are not in
the form of externalities falling on third parties, but
since they cannot at the moment be measured in dollars of
payment through the market, they must be added to our
estimate of social benefit for purposes of cost/benefit
analysis. Attempts to charge for purely recreational use of
the net, as opposed to non-recreational use, are going to
present very difficult problems.

It seems probable that some distinction in types of Internet
use will eventually have to be made. Those uses generating
primarily private benefits are better able to be produced
and sold through a private market than those uses likely to
generate positive externalities. It is not by chance that
the anticipated successor to the Internet is called the
NREN, or National Research and Education Network. Questions
of just how much of high-tech industry should be included on
such a network at minimal private cost are complex. The
author's personal view is that the positive externalities
associated with widespread low cost access to the Internet
extend far beyond the traditional research and education
community but that it will prove impossible in the present
national economic circumstance to provide as large a subsidy
as a national network really merits.

C. The Internet as a Quasi-Public Good

That the Internet is inherently a quasi-public good is
demonstrated by the fact that production of Internet
services and consumption of the Internet as a product have
been and currently are being financed jointly by the public
and the private sector. The Internet is like the education
system, the health care system, the transportation system.
The Internet has some of the characteristics of both a
public and a private good. As a quasi-public good it will
never be produced in sufficient quantity or be as generally
available as true allocative efficiency would require unless
it receives a generous enough subsidy to reach an optimum
level of output and use.
Today we have a national network infrastructure being
jointly developed by private companies (who presumably are
selling their goods at a profit), non-profit institutions
including private universities, and federal and state
government entities.  The State of California pays for the
portion of the Internet that the author uses -- CSUNET. The
United States Government pays for part of the NSFNET
backbone CSUNET is connected to, while numerous private
companies provide access for other public and private sector
participants. Both public and private sector users can
readily communicate with other public and private sector
users and companies through the network.

The Internet is clearly an example of a mixed-use, mixed-
funding good: a good used and funded by the public and
private sector jointly. If the current level of funding and
subsidy to the U.S portion of the Internet from all parts of
the public and non-profit sectors were to be totaled, it is
quite possible that such spending makes up the largest share
of spending on the net. Although it is the case that private
companies now make up the largest number of attached network
hosts on the NSFNET 26, the data about different hosts'
expenditures and uses of the net are not complete enough to
permit much analysis. The lack of availability of economic
data about expenditures on the network by U.S governmental
units at all levels, and by U.S. non-profit entities and
businesses as well, makes generalizations difficult.

The fact that the Internet is by its very nature global in
scope, and that its international characteristics are the
source of much of its value, adds complexity to the attempt
to formulate appropriate public policy in the U.S.
concerning the Internet. Nonetheless, it is the
responsibility of U.S. policymakers to consider first and
foremost the economic and political impact on U.S. citizens
of decisions about future funding and regulation of the
network. For purposes of federal government decision making
in the U.S., the Internet must be viewed as a U.S. based
quasi-public good.

D. Other Sources of Possible Market Failure

Indivisibilities in investment can be seen in the fact that
it took the U.S. Government to build the initial network
backbone. Is it really the case that no further large scale
investment is required? Can future investment  proceed in
small divisible steps? Doesn't eventual conversion to a
completely fiber optic system require massive investment? If
so, then this infrastructure cannot be built in small
increments. It experiences indivisibilities in production.
Are potential large transactions costs associated with any
national electronic network?  What will be the costs of
attempting to enforce property rights in a system built on
electronic documents? If property rights are going to be a
nightmare to enforce on the Internet, then there are high
transactions costs associated with the net as a good.

Interdependence in production of Internet goods and services
is revealed in the announcement sent to various network
mailing lists on January 5, 1993, concerning NSF network
information services awards made by the National Science
Foundation to AT&T, Network Solutions, and General Atomics.
This announcement states that a consortium of private for-
profit companies and non-profit organizations overseen by
government entities will split the job of creating necessary
products to increase the usefulness of the network by
cooperating in the Network Information Services Managers
Project called INTERNIC. Decisions to produce seem often to
be interrelated on the net. Decisions to use the network
(consume its services) are interrelated as well. The value
of the Internet to most users (including the author) and a
user's decision to "consume" it as a good are often directly
dependent on who else uses the net and in what way.

Interdependence in production always exists by definition
when an industry is an oligopoly.27 To the extent that
portions of the Internet "industry" will consist of
oligopoly groups, there is no doubt that there will be
interdependence in the decision to produce. A case of
market failure will arise.

The general problems with reliance on the market or price
system listed in section  three affect the Internet. The
bias against long term investment displayed by markets is
liable to make the market seriously deficient in allocating
resources between the present and the future. Markets tend
to allocate too much to the present, not enough to the
future. A study of the history of infrastructure development
reveals that governments have had to give large grants and
subsidies to secure major economic infrastructure, or just
build infrastructure directly. Heavy market discounting of
risky long term future cash flows mitigates against long
term private sector investment and has historically had to
be compensated for by goverment investment. Privately owned
firms are subject to fierce short term constraints. They
need to show current profits to retain their market value.
Important legal and tax factors also discourage private
investment in expensive new plant and equipment. For
example, the accelerated cost recovery schedule for
depreciation built into current tax code does not in
actuality do much to encourage long term investment. The
term "accelerated" is viewed by some in the finance field as
bordering on the humorous when applied to the current code
which requires that plant and equipment be depreciated over
a period of up to 10 years. At the time of this writing even
equipment to be used in research and computer equipment must
be depreciated over 3 years.

Markets experience great difficulty in dealing with rapid
technological change. U.S. competitors in the EC28 and Japan
cooperate with their governments to follow industrial
policies developed outside the framework of free markets
which may  smooth economic and technological change for
them.

Considerations pertaining to the distribution of income are
very important with regard to pricing Internet services.
Provision of network access solely on a private market basis
will ultimately exacerbate the social tensions created by
U.S. income inequality. Distribution of network services on
a market basis may even contribute to an increase in
inequalilty in the distribution of income, because market
provided services will effectively screen out a huge portion
of the population.

While all of the necessary conditions for efficient
functioning of the private market are relevant to analysis
of appropriate funding for the Internet, the requirement
that there be "perfect information" access may perhaps be
specially pertinent. The possibility exists that free or
very low cost access to the Internet might increase
efficiency in all sectors of the economy by ultimately
creating the first society actually to approach a  condition
approximating perfect information availability. Note that
without "perfect" or at least very high quality  information
the allocation of resources will by definition be
inefficient and the market (any market without excellent
access to relevant information) will fail to function
properly. It is certainly the case that fast access to high
quality information would increase the efficiency of the
public sector as well as the private sector.

A relatively new field in economics studies the importance
of information availability for the efficiency of economic
performance: information economics.  Although the economic
analysis of information necessary to achieve efficiency is
oriented at this time toward the private sector, and treats
information merely as an input to be purchased in the
process of production of other goods, some of the findings
of information economics shed light on the unique character
of the Internet.

Information economists have struggled with some of the
special characteristics of information in their efforts to
incorporate it into economic analysis. They have found that
information is not easy to define. The quantity of
information obtainable from a particular action is not
clearly defined. Information which is obtained is not
homogeneous among its users. Forms of economically useful
information are too varied to permit the kinds of price-
quantity characteristics that economists use for evaluating
markets for most goods. The technical properties of
information as a good create further difficulties. Most
information is durable and retains value after it has been
used. Sometimes information itself has the characteristics
of a pure public good. Information may be nonrival in that
others may use it at zero cost and it may be nonexclusive in
that no individual can prevent others from using it. The
technical qualities of information imply that market
mechanisms often operate imperfectly in allocating resources
to information provision and acquisition.29

These findings of information economics are relevant to
analysis of funding mechanisms for the Internet because the
Internet is a system for distributing information. Yet
information as a good has unique characteristics which cause
it not to be amenable to simple market based production,
distribution, or sale.

V CONCLUSION

The Internet is a system of many products, uses, and
suppliers. Yet it is a whole. There may be, and probably
will be, products sold through it. It is itself the
connection mechanism through which information and,
potentially, goods (such as on-line books) will flow.

The Internet has something basic in common with the electric
power industry, the highway system, the education system,
and the health care system. None of these systems has been
created without subsidy or managed without government
regulation. They are all quasi-public goods.The Internet has
some of the characteristics of both a public and a private
good. As a quasi-public good it will never be produced in
sufficient quantity or be as generally available as true
allocative efficiency would require unless it receives a
generous enough subsidy to reach an optimum level of output
and use.

Since it seems probable that user fees have already been
decided on as a financing mechanism for the Internet, one
can only reiterate that reducing or eliminating access for
large groups of users in either the public or private sector
may amount to killing the goose that lays the golden egg.
This is the case if McAdams is correct in his assertion that
the current rapid growth and generally conceded usefulness
of the Internet are direct results of positive externalities
created by the individuals who have used the Internet the
most heavily, usually on a subsidized basis.

Public sector providers of information on the net, including
universities, are considering charging for access to such
services as on-line catalogs. If this trend spreads, as
seems likely because the public sector is in terrible
financial straits, widespread use of the national network
will slow to a crawl in the absence of  complete federal or
state subsidy. This stagnation will occur not because the
information is not valuable, but because other public sector
users simply do not have the funding to permit use.

In order for public investment to be socially desirable it
must be the case that the discounted present value of the
benefits of the investment, to whomsoever they may occur,
should exceed the discounted present value of the costs, to
whomsoever they may occur.  Costs and benefits may and often
do fall heavily on separate groups and be subject to great
uncertainty. The opportunity cost of public funds is the
(properly calculated) return they could earn in their next
most productive use. Estimates of the benefit/cost ratio for
public investment may use too high a discount or interest
rate, and fail to value or weigh future benefits properly
against more easily measured present dollar costs. Such
flawed analyses have worked against public investment at
times, and need to be guarded against. There have also been
cost/benefit studies done by public agencies in the past
which have erred in the opposite direction.

A literature and a history of past practice exist which
permit a reasonable analysis of benefits and costs.
Estimation of a genuinely appropriate discount rate taking
into consideration some of the factors mentioned in this
paper, as well as inclusion of all relevant externalities,
are the keys to producing a useful analysis. In a highly
politicized atmosphere in which powerful vested interests
are competing for advantage, it is difficult to find support
for an objective examination of the alternatives.

Public subsidy of the Internet is being discussed in a
context and in a country which is historically suspicious of
publicly financed infrastructure if any profit is to be
made, and if the private sector is interested in owning the
infrastructure.

Several areas need more analysis. 1)If price is going to be
used as a rationing mechanism a more carefully thought out
pricing policy is needed. 2)Rationing mechanisms other than
price deserve careful examination, including the possibility
of setting priorities in message transmission if necessary.
3) Problems associated with provision of commercial products
on a publically subsidized network are still unresolved. 4)
A study of the size and nature of possible government
subsidy of network users, either public or private, by a
grant or voucher system, needs to be done. 4) A study of the
implications and costs of private versus public ownership of
a backbone network has never really been done.

At this point the economic data needed to make sensible
statements about what is being spent on the existing
structure, by whom, and from what source, do not exist. The
study of a systematically collected sample of material  on
expenditures and subsidies, direct and indirect, would
provide very useful information. Such a study should include
data gathered from local, state, regional, and national
public and private users and providers. An appropriate study
could be carried out by the General Accounting Office, a
special workgroup in the Office of Science and Technology
Policy, or some other agency. The design and collection of
appropriate economic data is an urgent need.

Those who know the Internet well are in the best position to
provide information which will make it possible to judge the
Internet's potential as a force in economic development and
estimate the size of the externalities it can create, the
economies of scale associated with it, the degree of
interdependence involved, the size of indivisibilities in
production and consumption, and the nature and size of
transactions costs. Economists can provide economic data
collection and analysis stills and analytic tools to help in
the decision making process.

The Internet and any likely successor to it constitute,
among other things, the public library system of the future.
The Internet will be the repository of all public
information: the public information gathered with by the use
of taxpayer money. It may not be too extreme to say that
there cannot be a democracy in the United States if the
public does not have almost unlimited access to the public
infomation that is on the Internet now and will be there in
the future. Other countries will eventually be in the same
situation.

Within the past few months increased pressure has been
brought in the U.S. Congress to require expanded public
electronic access to government databases currently sold to
private information providers, who then resell them to the
public at a fee.30 Public pressure and public scrutiny are
not going to go away. Decisions about funding and control of
quasi-public goods invariably cause profound controversy in
our economic system.

Can the Internet as a system be produced and maintained by
the private sector? The application of price theory to the
Internet leads to one principle analytical conclusion:
market prices cannot by themselves efficiently allocate
resources for the production and use of the Internet. In
order for an appropriate level of production and use to
occur, direct public investment and/or user subsidies are
necessary.
1   The term "Internet" in this paper refers to the system of networks and gateways using
the TCP/IP protocol suite which function as a single, cooperative virtual network.
Although the Internet is by its nature international in scope, the U. S. network system
can by spoken of separately for purposes of analysis. The U..S. network system and
possible future variants of it are also referred to here as the net and the national network.
2   In the case of the Internet the marginal cost would be equal to the incremental or extra
cost of carrying one more message.
3   MICROECONOMIC THEORY: BASIC PRINCIPLES AND EXTENSIONS, 5th
edition. Walter Nicholson, author. Published by Dryden Press, 1992. See page 224.
4   The factor markets are the markets for labor, capital, and raw materials including land.
5   Economics: Principles and Policy, 3rd edition. William J. Baumol and Alan S.
Blinder, authors. Published by Harcourt Brace Jovanovich, 1985.See pages 468-469.
6   Ibid.., page 468. See also THE ECONOMICS OF THE PUBLIC SECTOR by
Robert Henry Haveman, published by John Wiley & Sons, Inc., 1970. Page 26.
7   Haveman, op. cit., page  26. There is no better introduction in plain English to the
market system than Haveman's book and no clearer explanation of some of the free
market's limitations than his second chapter titled: The Conditions For Efficient Market
Operation.
8   ECONOMICS, 2nd edition. David N. Hyman, author. Published by Richard D. Irwin,
Inc., 1992. See pages 394-403. See also Baumol and Blinder, op. cit., pages 539-543.
9   Hyman, op. cit., pages 403-407. Also Baumol and Blinder, op. cit., pages 543-544.
10 MULTIPLE PURPOSE RIVER DEVELOPMENT: STUDIES IN APPLIED
ECONOMIC ANALYSIS, John V.  Krutilla and Otto Eckstein, authors. Published by
Johns Hopkins Press, 1958. See pages 43-44 and p.60. This text for economic
practitioners has an  outstanding and clearly written second chapter on the concept of
economic efficiency and its practical meaning in evaluating public investment projects.
11  Haveman, op. cit., pages 24-25. See also Baumol and Blinder, op. cit., pages 506-
507.
12  Krutilla and Eckstein, op. cit., pages 44-46 and p.60.
13  Hyman, op. cit., pages 134-135..
14  Krutilla and Eckstein, op. cit., pages 50-51 and p. 125.
15  Hyman, op. cit., Ch. 15, Market Failure and the Role of Government in Allocating
Resources, pages 394-411.
16  Economic theory assumes government intervention will take the form either of direct
government regulation, or subsidy or tax. It is  assumed a subsidy will be provided in the
case of a socially desirable good, and that a tax would be appropriate to discourage use in
the case of a socially undesirable good. See footnote 15 for reference.
17  THE MARKET SYSTEM, 2nd edition. Robert Henry Haveman, author. Published
by John Wiley & Sons, Inc., 1970. See pages 258-259. See also Krutilla and Eckstein,
op. cit., pages 47-48, and 122-126.
18  AN INTRODUCTION TO MODERN ECONOMICS, McGraw Hill, 1973.Joan
Robinson and John Eatwell, authors. See bottom of page 215, top of page 216.
19  A HISTORY OF ECONOMIC THEORY AND METHOD by Robert B. Ekelund, Jr.
and Robert F. Hebert. McGraw Hill Publishers, 1975. Page 330 states:"Pareto
utilized...Edgeworth's consumer 'indifference curves'...to show that in the case of a
fixed supply of goods a welfare optimum in exchange would obtain when no
individual could benefit from trade without injuring someone else." (Emphasis added.) See
also Krutilla and Eckstein, op. cit., pages 50-51 and p.125; and Nicholson, op. cit., page
224.
20  Nicholson, op. cit., pages 252-262.
21  Capitalism, Socialism, and Democracy, Third Edition, by Joseph Schumpeter.
Published by Harper and Brothers Publishers, 1950. See page 83, and Chapter VII "The
Process of Creative Destruction."
22  An oligopoly is a market dominated by a few sellers, several of which are large
enough relative to the total market to be able to influence the market price.
23  Hyman, op. cit., pages 356-375. See also Baumol and Blinder, op. cit., p.523-535
24  Baumol and Blinder, op. cit., p 533.
25  An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith.
26  Internet System Handbook,Addison-Wesley Publishing Company, Inc.,1993. Daniel
C. Lynch and Marshall T. Rose, editors. See page 723, figure 18.5.
27  Baumol and Blinder, op. cit., pages 524-526. The interdependent nature of
oligopolistic decision making is the very factor which makes analysis of the resulting
allocation of resources under an oligopoly extremely difficult.
28  Consider the case of the European Airbus.
29  Nicholson, op. cit., pages 269-270.
30  See Internet mailing list "[e-mail]" April 26, 1993.