98-2

Planning 

Report

The Economics of a

Technology-Based

Service Sector

Prepared by:

TASC, Inc.

for

National Institute of

Standards & Technology

Program Office

Strategic Planning and

Economic Analysis Group

January 1998

U.S Department of Commerce

Technology Administration

THE ECONOMICS OF A

TECHNOLOGY-BASED

SERVICE SECTOR

January 1998

A Planning Report for:

NATIONAL INSTITUTE OF STANDARDS AND TECHNOLGY

Program Office

Strategic Planning and Economic Analysis Group

Prepared by:

David P. Leech

Albert N. Link

John T. Scott

Leon S. Reed

Approved by:

John F. Starns

James J. Lindenfelser

TASC, Inc.

1101 Wilson Boulevard

Suite 1500

Arlington, Virginia 22209
ii

Acknowledgments

The study effort reported here benefited greatly from the participation of Daniel Berg (Rensselaer

Polytechnic Institute), Eric Brynjolfsson (Massachusetts Institute of Technology), Lorin Hitt

(University of Pennsylvania), Lori Perine (National Institute of Standards and Technology), John

Perko (CHI Research, Inc.), and Gregory Tassey (National Institute of Standards and

Technology).
iii

TABLE OF CONTENTS

Page

EXECUTIVE SUMMARY............................................................................................. ES-1

ES.1 Introduction ............................................................................................... ES-1

ES.2 Technology in the Service Sector ............................................................... ES-2

ES.3 The Technology Landscape........................................................................ ES-4

ES.3.1 Retail Banking ............................................................................... ES-5

ES.3.2 Home Entertainment...................................................................... ES-6

ES.3.3 Health Care ................................................................................... ES-7

ES.4 The Technology Infrastructure ................................................................... ES-8

ES.5 Barriers to Technology Development and Use............................................ ES-10

ES.6 Key Service Sector Technologies............................................................... ES-12

ES.7 The Private Sector Response to Technology Barriers ................................. ES-16

ES.8 The Public Policy Response: Over-Arching Issues...................................... ES-16

ES.9 The Public Policy Response: Engaging the Service Sector.......................... ES-18

ES.10 Improving Policy Analysis: Lesson Learned................................................ ES-20

1. INTRODUCTION............................................................................................... 1

1.1 Purpose...................................................................................................... 1

1.2 The Service Sector is the Largest, Fastest Growing Sector of the

U.S. Economy............................................................................................ 2

1.3 The Role of Technology in the Service Sector............................................ 4

1.4 The Technology Infrastructure ................................................................... 6

1.5 The Technology Infrastructure of the Service Sector.................................. 10

1.6 The Outline of the Report........................................................................... 13

2. SOURCES AND USES OF TECHNOLOGY IN THE SERVICE SECTOR ... 15

2.1 Alternative Sources of Technology............................................................. 15

2.2 Focusing On Information Technology (IT) ................................................. 15

2.2.1 Existing Literature .......................................................................... 15

2.2.2 Other Systematic and Quantitative Data.......................................... 17

2.3 Technology Flows into Service Industries................................................... 19

2.3.1 An Estimate of “Imported” Information Technology....................... 19

2.3.2 Making Information Technology Work........................................... 21

2.4 The Strategic Intent of IT Purchases .......................................................... 22

2.4.1 The Strategic Importance of IT to Service Sector Firms.................. 22

2.4.2 New Information Technology Performance..................................... 23

2.5 Conclusions................................................................................................ 24
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3. THE CONCEPT OF MARKET FAILURE AND ITS APPLICATION........... 27

3.1 Introduction and Overview......................................................................... 27

3.1.1 Overview of Market Failures .......................................................... 27

3.1.2 Sources of Market Failure: Discussion and Examples of Barriers to 

Technology..................................................................................... 29

3.2 Technical Performance: A User Perspective On Technology Barriers......... 36

3.3 Public Support of the Technology Infrastructure ........................................ 39

3.4 Conclusions................................................................................................ 41

4. STATISTICAL ANALYSIS OF ECONOMIC PERFORMANCE AND MARKET

FAILURE IN THE SERVICE SECTOR ........................................................... 42

4.1 Introduction ............................................................................................... 42

4.2 Investments in Information Technology: Analysis in Brief.......................... 44

4.2.1 Quantifying the Barriers to IT Investment ....................................... 44

4.2.2 Quantifying the Strategic Response to IT Barriers........................... 45

4.3 Investments in Information Technology...................................................... 47

4.3.1 The Empirical Model ...................................................................... 47

4.3.2 The Data and Empirical Results...................................................... 50

4.4 Collaborating in Research: An Indication of Market Failure ....................... 53

4.5 Appropriating Technical Know-How: An Indication of Market Failure ....... 57

4.6 Conclusions................................................................................................ 61

5. CASE STUDY: BARRIERS IN TECHNOLOGY DEVELOPMENT

AND IMPLEMENTATION IN THE RETAIL BANKING

INDUSTRY ....................................................................................................... 62

5.1 The Significance of the Retail Banking Sector ............................................ 62

5.2 The Nature of Retail Banking Today .......................................................... 63

5.3 Major Competitive Issues........................................................................... 65

5.4 The R&D Function in Banking ................................................................... 67

5.5 The Technology Landscape........................................................................ 69

5.6 Barriers in Technology Development and Implementation .......................... 74

6. CASE STUDY: BARRIERS IN TECHNOLOGY DEVELOPMENT AND

IMPLEMENTATION IN THE HOME ENTERTAINMENT INDUSTRY .... 78

6.1 The Significance of the Home Entertainment Sector................................... 78

6.2 The Nature of Home Entertainment Today................................................. 79

6.2.1 Terrestrial Broadcasting.................................................................. 82

6.2.2 Cable Television ............................................................................. 84

6.2.3 Satellite Communications................................................................ 86

6.2.4 Cellular/Personal Communications Services (PCS).......................... 86

6.2.5 Telephone Communications............................................................ 88

6.2.6 Motion Picture and Video Tape Production .................................... 88

6.2.7 Newspaper Publishing..................................................................... 90

6.3 Major Competitive Issues........................................................................... 91
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6.4 The R&D Function in the Home Entertainment Industry............................. 93

6.5 The Technology Landscape........................................................................ 95

6.6 Barriers in Technology Development and Implementation .......................... 103

7. CASE STUDY: BARRIERS IN TECHNOLOGY DEVELOPMENT

AND IMPLEMENTATION IN THE HEALTH CARE INDUSTRY ............... 108

7.1 Introduction ............................................................................................... 108

7.2 The Size and Significance of the Health Care Sector................................... 108

7.3 The Nature of the Health Care Industry Today ........................................... 110

7.4 Major Competitive Issues........................................................................... 112

7.5 The R&D Function in Health Care Services................................................ 114

7.6 The Technology Landscape........................................................................ 116

7.7 Barriers in Technology Development and Implementation .......................... 121

7.7.1 Types of Barriers and Their Impacts............................................... 121

7.7.2 Investment Impacts of Barrier Removal .......................................... 123

7.8 Summary.................................................................................................... 126

8. CASE STUDIES: OVERVIEW AND POLICY CONTEXT............................. 127

8.1 Introduction ............................................................................................... 127

8.2 Size and Significance of Case Study Industries ........................................... 127

8.3 The Competitive Impact of IT Today ......................................................... 128

8.4 The Technology Landscape........................................................................ 129

8.5 The R&D Function in Service Sector Firms................................................ 132

8.6 Barriers to Technology Development and Implementation Investments....... 133

8.7 Barriers to Technology: The Policy Context.............................................. 138

8.7.1 Matching Policy Instruments and Barriers to Technology................ 138

8.7.2 The Private Sector Response to Technology Barriers...................... 142

8.8 Case Study Methodology Insights .............................................................. 146

9. DIRECTIONS IN TECHNOLOGY POLICY FOR THE SERVICE

SECTOR.............................................................................................................. 148

9.1 What We Have Learned ............................................................................. 148

9.2 A Service Sector-Specific Technology Growth Model................................ 149

9.3 The Locus of Service Sector Technology Policy Engagement..................... 153

9.4 Potential NIST Responses: Cross-Cutting Technological Issues ................ 160

9.5 Policy Analysis Improvements: Lessons Learned ....................................... 163

REFERENCES................................................................................................................ 166
vi

LIST OF FIGURES

Figure

ES-1 Role of Technology Infrastructure in the Service Sector...................................... ES-9

1-1 Industry Percentages of the U.S. Economy by Value Added................................ 3

1-2 The Share of Nonmanufacturing Industries in Economy-wide R&D

Expenditures (1963 to 1993)............................................................................... 5

1-3 Input Required to Deliver $1000 of Goods and Services to Final Demand........... 7

1-4 A Technology-Based Economic Growth Model .................................................. 9

1-5 Service Sector Technology Infrastructure ........................................................... 13

2-1 Growth of IT Intensity: Selected Service Sector Firms vs. All Patent Holders .... 19

2-2 The Role of Embodied IT in Service Sector Growth ........................................... 26

3-1 Barriers, Market Failures, and Underinvestment.................................................. 28

4-1 Disaggregation of Capital Stock in Service Sector “Production” Model .............. 49

6-1 The Convergence Value Chain............................................................................ 81

9-1 The Two Faces of Service Sector Technology Infrastructure............................... 151

9.2 Intra-Sectoral Technology Infrastructure............................................................. 153

9-3 Role of Technology Infrastructure in the Service Sector...................................... 154

9-4 Emerging Role for User-Oriented Anticipatory Standards Activity ...................... 157
vii

LIST OF TABLES

Table

ES-1 Cross-Cutting Infrastructure Technologies and Appropriate Policy Instruments .. ES-13

ES-2 Ranking of IT Performance Attributes by Industry .............................................. ES-15

2-1 Total R&D Activity in Selected Industries........................................................... 18

2-2 Comparison of Value Added, Information Technology Investments, and

Company Performed R&D: 1991 ........................................................................ 20

2-3 InformationWeek Survey Questions.................................................................... 23

2-4 Service Sector Firms' Responses to Survey Question 1........................................ 24

2-5 Service Sector Firms' Responses to Survey Question 2........................................ 24

4-1 Brynjolfsson-Hitt Data Set: Descriptive Statistics............................................... 51

4-2 Description of the Brynjolfsson-Hitt Panel, by Year ............................................ 51

4-3 Least-Squares Regression Results for Equations (6)............................................ 52

4-4 RJVs Formed by Year......................................................................................... 55

4-5 Least-Squares Regression Results from Equation (7) .......................................... 56

4-6 Least-Squares Regression Results for Equations (6), (8), (9) and (10)................. 60

5-1 Banking Technology Focus Areas....................................................................... 71

5-2 Banking Industry IT Priorities by Technology Area and Type.............................. 73

5-3 Banking Industry Ranking of IT Performance Attributes..................................... 74

6-1 Entertainment-oriented vs. Information-oriented Technologies............................ 97

6-2 Key Entertainment Technologies......................................................................... 100

6-3 Entertainment Industry IT Priorities by Technology Area and Type..................... 102

6-4 Entertainment Industry Ranking of IT Performance Attributes ............................ 103

7-1 Key Health Care Technologies............................................................................ 117

7-2 Health Care Industry IT Priorities by Technology Area and Type........................ 119

7-3 Health Care Industry Ranking of IT Performance Attributes................................ 121

8-1 Ranking of IT Performance Attributes by Industry .............................................. 132

8-2 Evidence of Barriers by Market Failure Type and Service Industry...................... 136

8-3 Cross-Cutting Infrastructure Technologies and Appropriate Policy Instruments .. 141

ES-1

EXECUTIVE SUMMARY

ES.1 INTRODUCTION

Technological change is an important stimulus to economic growth. Therefore, economic policy

that promotes growth should address the conditions that facilitate the development and implementation of

new technology. This report analyzes the sources and uses of advanced technology in the service sector,

identifies barriers to more widespread use, and identifies policy options to ameliorate these barriers. In

addition to the overview information, it contains case studies on the following key service sector industries:

retail banking, home entertainment, and health care.

Effective technology policy recognizes the complementary roles played by the private sector,

government organizations, and universities in creating a robust technological infrastructure that supports

the development, diffusion, and implementation of technology. These organizations have widely varied

objectives and incentives; still they must interact and collaborate to support the optimum level and pace of

technology development and implementation.

Because technology development entails high levels of risk compared to other types of investment,

economic policy generally supports some type of incentive structure. The most commonly proposed form is

a broadly applicable policy, such as a tax incentive. More specific technology barriers often exist as well.

These too are amenable to policy action. To formulate such actions requires a deeper understanding of the

specific market environments in which the technologies are developed and applied.

The service sector is the largest and most rapidly growing segment of the U.S. economy. It

accounts for roughly three-fourths of value added in GDP, and it has been growing at about 10 times the

rate of the non-service sector. From 1984 to 1994, the U.S. economy grew 33.12 percent in constant 1987

dollars; service industries as a whole grew by 46.21 percent, while the non-service industries grew by just

4.63 percent. The service sector purchases large quantities of information technology and according to

recent data is increasingly responsible for developing its own technology. In addition, the service content of

“purely manufacturing” industries is increasing. More than 75 percent of a typical manufacturing firm’s

employees are engaged in essentially service activities. So, increasingly, services are “pulling” technology

development.
ES-2

Despite the economic importance of the service sector, technology policy has not explicitly focused

on this sector (though it is beginning to attract more attention). In part this lack of attention reflects the

complexity of the sector, encompassing both very high-tech sectors (such as communication services and

contract research services) as well as truly low-tech services (such as domestic services). In part, too, it

reflects the conventional wisdom that the service sector, as a whole, is technologically unsophisticated.

That belief has begun to change. This report supports the development of a technology policy for the

service sector by assessing the height of the technology barriers facing service sector firms; exploring the

sources of those barriers and the underinvestments they cause; and understanding how NIST can begin to

address the most important of these barriers.

ES.2 TECHNOLOGY IN THE SERVICE SECTOR

By and large, the service sector is a consumer of technology rather than a developer of technology.

While national statistics describe the steady growth of technology internal to the service sector —

increasing from less than 5 percent of total R&D performed in the U.S. 15 years ago to 26.5 percent in

1993 — it appears that the bulk of this technology development is performed by the communications and

computer services industries and that the typical service sector industry is far less active in R&D.

Far and away the dominant technology is information technology (IT). IT accounts for more than

80 percent of the technology purchased by service sector firms and is the predominant focus of service

sector RDT&E (research, development, test, and evaluation) staffs. While some level of technology

development is occurring throughout the service sector, it appears to be technologically diffuse and

quantitatively modest.

In the service sector, as a whole, it appears more appropriate to speak of the RDT&E function of

service firms than to speak of simply their R&D function. RDT&E staffs are small but growing. Corporate

technology managers sense that such staff growth is a response to secular changes in the nature of their

industries, such as the integration requirements that are the result of industry convergence and the

movement toward integrating IT into service content and delivery. For large firms, an RDT&E group of

15-25 people is typical. Often, this staff coordinates the efforts of additional engineering and RDT&E

staffs at the divisional level. The technical focus of 80-100% of the typical RDT&E staff is on information

technology.
ES-3

 Besides traditional “R&D” activities, these staffs are also occupied with information gathering,

research on potential vendors, pre-acquisition test and evaluation efforts, designing and monitoring of pilot

projects, assessing and monitoring software service agreements, and evaluating the applicability of IT

protocols developed by standards organizations.

What genuine R&D is performed in service sector firms often involves co-development efforts with

hardware and software suppliers. IT is increasingly being applied to service delivery and content, in

addition to traditional “back office” and “front office” operations. This appears to be stimulating more codevelopment efforts by service sector firms than in the recent past and the RDT&E staffs are becoming

increasingly important. Our case studies suggest that service sector firms are especially concerned with

research related to all aspects of the service provider - customer interface, from the hardware/software

aspects (e.g., bank research efforts geared to biometrics to ensure greater security) to the “content

development” aspects (e.g., entertainment company research on “how to appeal to the consumer’s sense of

exploration”). The literature also suggests that, increasingly, service sector firms must be concerned with

R&D in the areas of human factors, psychology, and applications design that address the service providercustomer interface. As these technologies become an integral part of the basic service that firms deliver,

internal control is perceived as more important.

In trying to explain the various ways in which technology is created and diffused, R&D policy

researchers have developed models depicting the various relationships among technology developers and

technology users. The model that most aptly captures the dynamics of the technology-based service sector

is the “supplier-dominated” model.

Despite the fact that firms in supplier-dominated industries perform some internal R&D, their

investments in new machinery and equipment, acquisition of hardware and computers, and manpower

training are often more meaningful indicators of technological innovation than R&D spending alone. A

concentration on process development rather than product development has been thought to be the root of

similarities among supplier dominated industries (manufacturers or service providers).

Our analysis of technology development and implementation suggests that this model is flawed, or

outdated, with respect to the service sector. There is a “phase shift” occurring in the application of IT in the

service sector. The application of IT, once confined to “back office” functions, is migrating forward to

service content development and delivery. This suggests a more dynamic model of technology development
ES-4

and use in which technology evolves from a process-orientation to a product-orientation. According to

conventional wisdom, process innovations follow product innovations. In the service sector the opposite

appears more typical. In the service sector, implementation of IT innovations has led to new, IT intensive,

“product” offerings.

Service sector firms are relying more and more on developing collective approaches to addressing

various technological issues. These take the form of formal collaborative R&D efforts involving suppliers

of technology (typically in the manufacturing sector) and service sector users that are increasingly

sophisticated in their understanding of the technology. More traditional institutions, such as trade

associations, also provide an important venue for IT-related collective activity.

ES.3 THE TECHNOLOGY LANDSCAPE

In the three service industries examined in depth for this study, the pace of technological change is

rapid and IT is effecting fundamental changes in industry structure and strategy. Yet the kinds of

technology “roadmaps” that appear to serve an ordering and risk-reducing function in fast-paced

manufacturing industries, such as microelectronics, are not being developed in service industries to our

knowledge. There appears to be little industry-wide (not to mention sector-wide), systematic discussion of

the technological division of labor (for example, between tiers of the industry, or among large and small

firms within a horizontal industry segment), of the nature of the underlying technologies, or of the timing

and level of technology investment by various key players.

Without a shared technological framework, at a minimum, it is extremely difficult to effectively

conduct policy planning or communicate its results. For expository purposes, we characterize the following

broad technology frameworks for the banking, home entertainment, health care industries:

• In retail banking three broad categories of technology development and application can be

discerned:

— Channel access technologies (by which banks gain access to their customer base)

— Customer targeting technologies (by which banks analyze data for the purposes of

defining financial services and targeting customer segments)

— “Back-office” technologies (aimed at improving the efficiency of banking

operations)
ES-5

• In entertainment, three broad technology scenarios can be discerned:

— Technologies that emphasize entertainment (TV screens, remote control, excellent

image and sound processing technologies, proprietary and specialized

communications)

— Technologies that emphasize information (computer screens, keyboard interaction,

communication via text strings, access through telephone modems)

— The merging of computer and TV technologies (teleputers, Internet communication)

• In health care, four broad categories of IT applications are recognizable:

— “Back-office” applications (maintenance and communication of medical services

performed and billing)

— “Front-office” applications (maintenance and communication of patient health and

treatment records)

— Health service content (the applications of IT to diagnosis and therapy)

— Health service delivery (especially on-line health services).

Within these technology landscapes, key infrastructure technologies have been identified. Each

industry, indeed each firm, has a somewhat unique set of technologies, or technology implementation

concerns, that are paramount. But some concerns appear to be common to all industries, even industries

that are otherwise very different.

ES.3.1 Retail Banking

Of the three broad technology categories that are important to the banking industry (channel access

technologies, customer targeting technologies, and “back-office” technologies) managers emphasize

technologies that operate at the interface of the bank and the customer. Within the broad category of

channel-access technology, bank security and network monitoring and control are stressed. Technology

managers perceive these technologies as essential to building customer confidence about utilizing electronic

channels.

Equally important in terms of customer confidence, though decidedly “behind the scenes,” are the

extensive testing and piloting techniques and procedures banks employ in preparation of IT implementation.
ES-6

Because of the volume of transactions that could be affected, missteps or errors in implementation are

carefully avoided.

The bank can be described as a physical network, with nodes and branches. Increasingly, the

banking network has transformed itself into a physical network of interoperating electronic information

systems. The future of banking appears to be a movement farther in this direction with an increasing need

for interorganizational connectivity, first within the banking and financial services industries and,

increasingly, with other segments of the economy as well.

The larger the network, the greater the benefit to the consumer of joining the network. So

anticipating the consumer rush to the emergent standard service network, banks are precariously perched

between advancing their proprietary positions (while solving the difficult integration problems that the

continuous upgrading of legacy IT systems requires) and building a more open, interoperable, secure, and

reliable electronic banking infrastructure that will promote consumer confidence and greater usage.

Standard drawbacks to such an environment are underinvestment in experimentation and the rush by

consumers to the standard solution rather than to the best solution.

ES.3.2 Home Entertainment

In the home entertainment industry, the development of new information and entertainment services

is predicted to take place along two broad fronts associated with two families of user interface equipment:

the television and associated technologies (set-top boxes and multimedia CD players) on the one hand; and

information access via a general purpose personal computer on the other hand.

It is widely believed in the entertainment industry that for the foreseeable future computers and

entertainment-oriented devices will continue to develop as related but separate digital system families,

rather than converging into a single family. While the merging of the two into “information appliances” or

“teleputers” is believed likely, most industry representatives considered it to be a decade away for the

average household.

Underlying these technology scenarios are important technological trends in digital data

transmission systems, digital data compression techniques, and multimedia hardware allowing steady

decompression. These three technological areas, in turn, support a burgeoning market for home
ES-7

entertainment services: digital TV (HDTV, 500 channels, DBS, interactive TV); video games and

multimedia CD players; on-line entertainment services; and digital audio.

Digital compression technology — specifically, “going beyond MPEG-2” with practical, widely

adoptable standards — was perhaps the most consistently discussed area requiring technological advance.

Compression technology appears to be important throughout the home entertainment value chain, from the

expansion of programming channels through more effective use of limited (though rapidly expanding)

bandwidth, to the conversion of large stocks of vintage analog film and the production of next-generation

CD-ROMs (DVD technology).

Cable service operators were particularly concerned about network management, transaction-basis

billing, and more effective video servers. The shift to new digital technology, and especially the preparation

for video-on-demand, appears to be taxing conventional cable and broadcast operations.

Digital copyright protection is a pervasive and fundamental concern to the entertainment industry.

Simply put, “[w]hen copies multiply, value collapses.” Industry observers are concerned about a nearfuture environment in which the memory and bandwidth exist to share any artistic creation as an e-mail

attachment. As industry looks forward to video-on-demand, similar concerns are expressed. Further

development and implementation of encryption technologies are of critical importance to the industry.

ES.3.3 Health Care

In the health care industry, IT is embodied directly in medical techniques and applications as well

as in “back-office” and “front-office” information management functions. In many direct applications to

medical problems, IT has been enormously successful. Such applications include the use of computer

controlled beams of radiation to treat cancer, the use of high-speed computing to do computerized scanning

and magnetic resonance imaging, and the use of IT to monitor the vital signs of patients.

The technologies currently important to health care organizations, and those technologies expected

to be critical in the next five to ten years, show a strong emphasis on efforts to contain costs. There are

immense data acquisition, communication, and storage problems to be addressed with IT. Clinical

information systems are still very much paper based. One hospital might move 4000 patient [paper] charts

a day and that is growing by the week. Long-term archival policies compound the problem.
ES-8

The key problems within the health care organization are interoperating across large numbers of

organizations — both within a parent organization and across independent organizations (such as the

providers and the insurers) — and containing costs by figuring out a way to reduce all of the paperwork —

that includes patients charts that are passed around in hospitals and it includes writing prescriptions and

signing them. Exotic imaging tools and the like are in the works, but inter- and intra-organization

interoperation and paperwork reduction are the critical near-term objectives for the productivity of IT in

health care.

ES.4 THE TECHNOLOGY INFRASTRUCTURE

Diverse institutions play crucial, complementary roles in the development and implementation of

complex technologies. Universities, private firms, government agencies, and collaborative organizations

involving combinations of members from the various estates, develop technologies and interact on the basis

of different types of incentives. As a result, technologies have both proprietary attributes, attributes that are

public (i.e., non-proprietary), and attributes that are partly private and partly public (i.e., quasi-public or

mixed). The technological elements provided by public and quasi-public organizations comprise a

technological infrastructure which is both essential to technological progress and likely to receive too little

investment if left to the private sector incentives alone.

The elements of the technology infrastructure can also be distinguished by the role they play in the

process of technology development and market implementation. Two aspects of the technology

infrastructure are of particular concern from NIST’s perspective: “generic technologies” and

“infratechnologies.” Generic technologies are the laboratory-proven concepts that provide the immediate

basis for research and development activities aimed at market-specific products (so-called, “applied”

R&D). Functionally, generic technologies reduce uncertainty and technical risk enough to allow the

magnitude of investment often necessary to bring technologically complex products and services to market.

Infratechnologies, on the other hand, are shared “technical tools” such as measurement and test methods,

reference materials, artifacts or data, that are used to verify the accuracy or quality of a process or output.

Functionally, infratechnologies reduce market risks by verifying compliance with agreed upon standards

and, increasingly, the physical or functional interface between components of a system. Infratechnologies

provide the technical basis for industry standards.
ES-9

The service sector’s requirements for technology infrastructure are complex and comprehensive.

Figure ES-1 depicts the three essential layers of the infrastructure that support technology development and

implementation in the service sector. Technology infrastructure is required to support the interface between

manufacturers and service providers; within the service sector to support the interface between service

content providers and delivery modality providers (cable, telephone/Internet, broadcast, and wireless); and

within individual service industries in support of the physical networks that characterize much of the

service sector. The role of the technology infrastructure in the service sector is extensive, supporting the

interaction of markets at many levels and at many stages of the value chain that runs from manufacturing

to the final consumer. Within this framework, the provision of NIST’s technology infrastructure occurs at

both interfaces, for example, supporting increased interoperability through support for vertically organized

generic co-development efforts, or the development of techniques and tools for assessing complex systemsubsystem-component compatibility. At the service provider-customer interface, organizational processes

(like the National ISDN Users), or infratechnologies to advance or characterize the security, reliability, and

usability of service delivery technologies, are likely to be appropriate and desirable. The identification and

support of infrastructure elements can mitigate the barriers that lead to market failure in several aspects of

the service sector’s development and use of technology.

Figure ES-1. Role of Technology Infrastructure in the Service Sector

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ES-10

ES.5 BARRIERS TO TECHNOLOGY DEVELOPMENT AND USE

The existence of barriers and market failures in the development and implementation of technology

is the primary rationale for government involvement. Due to barriers that raise the risk and diminish the

appropriability of investments in technology, the private sector sometimes fails to invest at a level and pace

that is optimal from a societal perspective.

Three aspects of the IT revolution have been especially responsible for creating barriers to the

development and implementation of IT: the convergence of different industries and technologies; the

increased requirement for multi-faceted expertise and technical knowledge; and the rapidly evolving pace of

technological change. These three themes are repeated over and over again in every phase of our

investigations. In light of the systems nature of the innovation process and the frailties of the private

market’s incentive system related to innovative activity, these forces create a broad array of barriers that

can, and do, lead to underinvestment in IT development and implementation.

Our statistical analysis of firm-level data clearly demonstrates that IT acquisitions are having a

significant impact on firm performance. The results of this study indicate that a $1 investment in IT capital

contributes substantially more to value added than a $1 investment in non-IT capital. Specifically, a $1

investment in IT capital yields $1.96 annually. These results imply that the rate of return on IT capital is

196 percent. On the other hand, a $1 investment in non-IT capital yields $0.11 each period, or a rate of

return of 11 percent. This finding is interpreted to suggest that firms in service industries are, on average,

realizing sizable returns on their investments in IT and that some non-financial barrier is preventing firms

from making additional, highly productive investments in IT systems.

Service sector firms that systematically attempt to protect their investments in technology

development, and those that participate in collaborative R&D activities, are investing more in IT capital

than service sector firms that do not engage in such activities. While the statistical analysis is suggestive of

further areas for research, even the best available firm-level data is insufficient to provide the detailed level

of insight into technology barriers and their causes required for NIST strategic planning purposes.

Case studies of high-tech service sector industries — retail banking, home entertainment, and

health care — allow the identification of specific technology issues that are important to industry growth

and development and barriers that stymie their implementation. For selected technology areas, estimates of
ES-11

the underinvestments (hence market failures) that these barriers entail were developed. Estimates of the

degree of underinvestment range from 20 percent to 300 percent of the current investment levels.

Bank executives describe planning horizons of no longer than 18 months, and health care

technology managers describe the need for longer-term planning horizons to solve serious legacy system

problems. They describe the gap between what is technically and physically required to provide IT-based

operations, services, and service delivery, on the one hand, and what financial constraints impose, on the

other. Estimates from health care technology managers suggest IT underinvestments of greater than 20

percent. These problems are compounded, in some cases, by overinvestments that were the result of “wildly

inaccurate” projections of past waves of innovation.

These perceptions of high technological and business risk are the result of several phenomena that

result in uncertainty about banking’s technological future: the convergent nature of IT; the related fact that

the locus of technological change is driven by forces outside the banking industry; organizational inertia in

the banking industry itself; the inability to accurately predict customer response to “the networked bank;”

and the host of technological issues that continue to confuse IT development and implementation planning:

technology specific challenges, technology insertion, interoperability, security, and usability. The

uncertainties caused by convergence are compounded by the systems nature of technology implementation

in banking.

In health care and banking, pervasive legacy system integration problems are reported. Health care

executives estimate that these problems cause IT underinvestments of 50% or more. The legacy systems

problem is only one manifestation of a much larger system coordination problem that affects service firms

and their customers as well. Technology managers across all industries express acute uneasiness in the face

of rapid technological change and rapidly-evolving IT system choices. Bank executives, for example,

express grave concerns about being “stranded” by investments in the wrong network technology.

The development and adoption of effective standards is regarded as critical in all our case study

industries. Health care experts, for example, argue that in the absence of effective standards maintaining

multiple formats for health care information, dealing with exceptions, and developing new interface

software as new proprietary data management approaches come in and out of fashion all drive up costs and

offset the potential savings from electronic processing of records and transactions. Electronic data

interchange, for example, is not achieving rapid adoption because its benefits are understood to be
ES-12

contingent on a systemic change in health care practices and the development of integrated health service

delivery systems. These are only beginning to emerge.

In banking too, a large number of formal and informal initiatives are underway to promote an

effective infrastructure for Internet banking. Technology managers within the industry express concern that

the formal standards process is not meeting their needs in this respect. Some 40 independent initiatives are

currently underway to facilitate the evolution of a seamless electronic financial services delivery and

payments environment.

In the home entertainment industry, cable service operators were particularly concerned about

network management, transaction-basis billing, and more effective video servers. The realization of

improvements in video server technology could double or triple investment. And the mitigation of barriers

to the implementation of video-on-demand technologies could lead to additional billions of dollars of annual

investment by cable network operators. Similarly, entertainment industry executives estimate that more

rapid progress on next generation digital compression standards could unlock investments to support

billions of dollars in the home video market revenues. Advances in data compression standards are expected

to lead to investment by television broadcasters as well, as these technologies will enable additional

programming while utilizing existing satellite transponder capacity. Entertainment industry technology

managers project that improvements in Internet protocols would result in a 30 percent increase in related IT

investments. Finally, digital copyright protection is a pervasive and fundamental entertainment industry

concern. Industry representatives argue simply that as copies multiply, values collapse. Perceived

inadequacies in digital copyright protection appear to be a source of technology investment barriers.

ES.6 KEY SERVICE SECTOR TECHNOLOGIES

Effective technology policy recognizes the complementary roles played by the private sector,

government organizations, and universities in creating a robust technological infrastructure that supports

the development, diffusion, and implementation of technology. Only through the interaction and

collaboration of these diverse organizations, with their varied objectives and incentives, is the foundation

created to support the optimum level and pace of technology development and implementation.

Table ES-1 shows some key technology areas which should be among NIST’s first priorities in

developing a strategy to support the service sector’s technology infrastructure. The nature of the policy

response (support for generic or infratechnology development) is also indicated. Given the complexity of
ES-13

the service sector and of the IT that supports it, some form of triage is essential to focus initial specific

policy efforts. In-depth evaluation of the nature of infrastructure technology support should begin with

technologies that are described as cross-cutting, in the middle column, and proceed to those described as

inter-industry in the right column. Within each industry, there also appear to be technologies that are

deemed uniquely important to a specific industry. While these too can entail important “public” elements,

technologies that are more broadly applicable should receive priority attention.

Table ES-1. Cross-Cutting Infrastructure Technologies and Appropriate Policy Instruments

Appropriate

Policy

Instrument

Cross-Cutting Technologies Inter-Industry Technologies Intra-Industry

Technologies

Support for

Generic

Research

• Electronic Commerce

Applications

• Monitoring & Control for Large

Networks

• Set-top Boxes

• Distributed Data Bases

• Design for Speech Recognition

Hardware/Software

• Data Management

• Systems Management

• Systems Integration

• Operating Systems & Utilities

(Banking)

• Video Servers (Entertainment)

• Hierarchical Mass Storage

Systems (Entertainment)

• Virtual Reality (Entertainment)

• Techniques for Manipulating

Unstructured Text (Health

Care)

• Visualization Methods for

Complex Visual Information

(Health Care)

• Image Recognition & Processing

(Health Care)

• Scaleable Parallel Systems

(Health Care)

• Software Testing & Analysis

Tools (Health Care)

• Open Distributed Processing

(Health Care)

Support for

Infra-technology

Development

• Cryptographic Standards

• Firewalls and Internet-based

Tools

• Network Scaling

• Data Compression

• Wireless Communication

• WWW & IPv6 Security

• Conformance Testing for

Cryptographic Standards

• Authentication Technology

• Next-generation Internet

Protocols

• Multi-media Quality of Service

Tools

• Compression Algorithms

• User Interfaces & Information

Access (Entertainment)

• Multimedia Protocols

(Entertainment)

• Internet Security Policy

Development (Health Care)

• Vulnerability Analysis &

Testing (Health Care)

• Multimedia Collaborative

Computing (Health Care)

• Common Windowing Protocols

(Health Care)
ES-14

Consider the technology areas common to all three case study industries (column 1): electronic

commerce applications, cryptographic standards, firewalls & Internet-based tools network scaling, data

compression, and wireless communication. Of these, the private sector appears to have a dominant role in

developing and implementing electronic commerce applications, but the fact that all three industries ranked

this technology area as critical to their future suggests, at a minimum, some public policy concern to

identify and address cross-cutting barriers (such as interoperability and security issues). Perhaps there are

underlying generic technologies involved in electronic commerce applications that would be appropriate

targets of collaborative research of the type supported by NIST’s Advanced Technology Program. As part

of a generic research effort in support of the service sector, such a program would aim at proposals that

included vertically related partners, including representatives of service sector industries. In the other five

technology areas, NIST information technology experts identify important issues appropriate to public

sector involvement. In fact, NIST is currently engaged in the development and implementation of

infratechnologies that support these technology areas, though, to our knowledge, these have not been

focused or organized to support any special needs of the service sector per se.

While the high-priority technology areas common to retail banking and home entertainment —

monitoring and control for large networks, set-top boxes, and distributed data bases — are the focus of

much private investment, their priority ranking by representatives of two very different industries suggests

that generic technologies and infratechnologies may underlie the effective service delivery strategies that

these technologies support (column 2). Further evidence of the potential for a public sector role in

providing infrastructural support for at least one of these technology areas (set-top box technologies) is

suggested by intensive standards-related activities that have surrounded the regulation of interactive TV

services. These activities pertain to the existence of complex systems of interfaces that can retard

interoperability and timely adoption of technologies. Interactive TV technologies, such as set top boxes, are

critically important to the service delivery strategies of services sector industries and firms.

The critical technology areas common to other service industry pairs (health care and banking,

health care and home entertainment) more clearly involve technology areas in which NIST does provide

infrastructural support (conformance testing for cryptographic standards, authentication technology, next

generation Internet protocols, multimedia quality of service tools, and compression algorithms). Even where

the proprietary role in technology development would appear to dominate (e.g., design for speech

recognition hardware and software), the cross-industry nature of the priority accorded this and other
ES-15

technology areas (data management, systems management, systems integration) increases the probability

that elements of generic technology are important to their fullest development and implementation.

Listed in column 3 of Table ES-1 are technology areas considered critical to members of single

industries. These would be the lowest priority for technology policy initiative unless additional information

allowed the selection of individual service sector industries as recipients of technology policy support.

It is very clear that across the service industries examined, the broadly defined technology areas of

computer security (cryptographic standards, firewalls and Internet-based tools, conformance tests for

cryptographic standards, advanced authentication technology) and networking (network scaling, data

compression, wireless communication) are the dominant concerns of the service sectors. In both of these

areas, NIST is already involved in providing technology infrastructure support.

Based on apparent overlaps in areas of technological interest, it appears that some community of

technological interests exists between the entertainment, banking, and health care industries, with respect to

technologies important to NIST.

In an attempt to understand service sector IT needs from a functional standpoint, industry

technology managers were asked to rank five IT performance attributes. Table ES-2 shows their rankings

of these IT performance attributes. The importance of usability and reliability across the sectors reflects

some of the technical barriers service providers are facing as they attempt to implement new IT-based

modes of operation and service delivery.

Table ES-2. Ranking of IT Performance Attributes by Industry

Retail Banking Home Entertainment Health Care

Usability Interoperability Usability

Security Usability Reliability

Reliability Reliability Scalability

Interoperability Scalability Interoperability

Scalability Security Security
ES-16

ES.7 THE PRIVATE SECTOR RESPONSE TO TECHNOLOGY BARRIERS

Based on our case studies of service sector industries, firms are responding to barriers in at least

four ways. First, they are investing considerable funds into coping with IT development and implementation

barriers. The cost of IT implementation can be four to five the times the investment in hardware and

software. Second, firms are increasingly investing in technology development, typically in the form of codevelopment projects with suppliers in the manufacturing sector. Third, they are engaging in collective

R&D efforts with other members of their industry (though these, too, often involve manufacturing sector

participants). These collective efforts are typically formed to gain access to complementary research or

technical skills that are unavailable to individual service sector firms; they are less oriented to basic

research than non-service sector collaborations; and often have standards- and protocol-related objectives

(i.e., are more infratechnology focused), more so in fact than collaborative R&D projects undertaken in

non-service industries. Finally, service sector firms are engaging in standards-related activities as a means

of overcoming barriers to IT development and implementation.

All these forms of collective industry activity are attempts to address both technology-specific

types of market failures (e.g., high risks due to technical complexity, requiring technical expertise not

available to the firm) and market-related types of market failure (e.g. high transactions costs associated

with systemic nature of IT that standards-related activities attempt to address). It appears that NIST’s

mission and expertise are highly complementary to the objectives of these efforts.

ES.8 THE PUBLIC POLICY RESPONSE: OVERARCHING ISSUES

A targeted technology policy that aims to support the development and implementation of IT in the

service sector must address three overarching technology issues:

• Industry and technology convergence

• Service sector-customer interface

• System interoperability and security.

The industrial and technological convergence that is taking place in the service sector as a result of

the IT revolution creates uncertainty among service providers and users. Corporate technology managers

typically describe the technology landscape that they face as extremely chaotic. The uncertainty facing
ES-17

consumers is undoubtedly more intense than that facing professional technology managers and compounds

technology investment barriers. Technology investment decisions by service providers are often “on-hold”

in the face of both high risks and profound uncertainties arising from consumer ignorance about

preferences in the face of rapid technological change.

The development of technology “roadmaps” (and the process that produces them) is an essential

public policy tool and should go some distance in mitigating the intense technological uncertainty that

pervades the service sector. The externalities associated with such an undertaking suggest a “public” role.

A second overarching issue concerns the design, development, implementation, and interoperation

of technical customer interfaces. As IT is increasingly used by the service sector to develop and deliver

service content, the importance of making these interfaces far more “user friendly” (appealing to all types

of users), reliable, standard, and secure is apparent. And while the design and development of such

interfaces may be largely a private sector responsibility, evaluation methods and techniques for assessing

the quality of customer interfaces has important “public” aspects and could yield benefits across the service

sector in terms of hastening customer acceptance.

NIST’s multi-faceted role in developing evaluation methods and techniques for assessing the

quality of customer interfaces is likely to be an especially important aspect of NIST’s support of the

service sector. This aspect of service sector IT implementation will have important benefits across the

service sector in terms of hastening customer acceptance.

The third overarching issue that needs to be incorporated into an effective program to support

service sector technology concerns the interoperability of forthcoming, current, and vintage IT software,

components, and systems. Often referred to as “the legacy problem,” it is so widespread and costly, that

any attempt to bolster the technology infrastructure of the service sector must address the issue. Clearly

there are common problems in this regard within the same industries and, more than likely, there are

common problems across industries. But to the extent that these common problems are being addressed

individually by firms, or by industries where inter-industry solutions are possible, extra transaction costs

are being incurred and less technology is therefore being acquired and implemented.
ES-18

ES.9 THE PUBLIC POLICY RESPONSE: ENGAGING THE SERVICE SECTOR

NIST can play a potentially important and complementary role in the development of technology

infrastructure supporting the service sector. Barriers to the more effective development and use of IT can

be readily identified and NIST’s policy tools — the development of generic technologies and

infratechnologies — can contribute to their mitigation. Nevertheless we are still left with the question of

how NIST is to engage the service sector in an effective manner.

Taking each of these issues in turn, NIST’s Advanced Technology Program (ATP) has funded

many generic technologies that are important to the service sector. It is a small step to identifying emerging

technologies that are widely applicable to the service sector and encouraging their development. ATP

already supports “focused programs” to advance the development and implementation of generic health

care technologies. Other technological areas were identified that cut across a number of the industries

covered in the case studies reported here, for example electronic commerce technology, speech recognition

technology, and set-top box technology. ATP’s approach to identifying generic technologies could be easily

applied to cross-cutting technologies that could support the service sector more broadly.

Similarly, NIST has traditionally supported the manufacturing sector of the economy by

participating in voluntary standards organizations through the development of the “tools,” databases, and

reference materials/artifacts that support performance assessment and conformance testing. In a

technology-based economy, standards, and to a greater extent the infratechnologies that support them, are

taking on increased importance due to the complexity of new products, the speed at which new models

come into being, and the fact that these products are frequently embedded in systems whose effectiveness

is, in turn, dependent on the interfaces between the components. Undoubtedly these infratechnologies are

just as important — perhaps more so — to the development and implementation if IT for the service sector.

Planning a program of infratechnology support for the service sector poses an unparalleled degree

of complexity. NIST’s traditional approach of working through voluntary standards bodies is unlikely to

prove effective in supporting the service sector for two reasons: one having to do with the evolution of IT

and IT standards; one having to do with the nature of service sector as user rather than a developer of IT.

The pace of IT development and the ubiquity of IT applications has put the standardization system

under pressures. Standards have become more urgent but consensus among interest groups is increasingly
ES-19

more difficult to achieve because of uncertainties associated with the pace of technological change. This

dynamic has given rise to functional standards (e.g., Open System Interconnection - OSI) which define

performance to be achieved at different layers of technological systems but retain some freedom in deciding

how the standard will be met; and anticipatory standards, which are developed before the expression of the

formal standard and before the onset of competition and its impacts on technology investment and adoption.

The relevance of anticipatory standards will depend on the ability of their developers to assess the

potential outcome of ongoing research in the areas under consideration. Yet due to their anticipatory nature

— anticipating demand and often the very existence of potential users — a distance has grown between IT

producers and IT users. If the traditional standards process is a “post-marketing” function, involving

marketing and engineering elements, increasingly the IT standards process is part of an R&D function that

is by nature farther removed from the locus of relationships between sellers and buyers. That is, the locus

of standards development activity for much IT has drifted upstream from the IT manufacturer-service

provider nexus. This interpretation is consistent with case study observations that traditional standards

organizations lack the focus and the flexibility to meet the needs of service sector firms, and with the

emergence of collective industry organizations in response to various IT barriers.

The change in the pace and complexity of IT and its myriad applications, along with greater

recognition of the importance of the quasi-public goods nature of certain technology elements, has caused

several new types of ad hoc standards-related organizations to emerge. For example, Cooperative Research

and Development Agreements (CRADAs) between government technology organizations and industry often

have the early development of infratechnologies as their objective.

Other types of ad hoc organizations, such as research joint ventures (RJVs) and private consortia,

have emerged as well, some expressly formed to bypass the formal international standardization process by

delivering sponsored de facto standards ratification by the market. The integration of NIST core

capabilities into these emerging IT-focused, collective organizations may provide critical infrastructural

support to the service sector.

Across the service sector firms and industries we have studied, collaborative R&D mechanisms are

being utilized to acquire the expertise needed to conduct IT-related research, develop specialized IT

capabilities, and advance IT standards. In the banking industry, traditional industry associations are

organizing special technology-focused efforts to rationalize diverse, overlapping, and potentially redundant
ES-20

technical development and standards-related activities. In many cases industry has expressed interest in

exploring the participation of NIST.

These collective service sector activities are an important link in the overall development of the

technology infrastructure that is increasingly important to the service sector. NIST can engage with these

service sector organizations in ways that promote communications between IT users and the traditional IT

standards organizations, while at the same time providing much-needed expertise in the analysis and

anticipation of IT trends, in the evaluation of competing standards proposals, and in supporting the solution

of other important cross-cutting technological issues that are stifling IT development and implementation in

the services sector.

Such an orientation is consistent with the recently articulated strategic plan of NIST’s new

Information Technology Laboratory (ITL). ITL’s strategy focuses on the development of measurement

tools for impartially measuring IT products so that developers and users can evaluate how products

perform and assess their quality. The strategy emphasizes involvement in early phases of standards

development and specification development in advance of the formal standards process; support of informal

standards groups (including industry consortia and professional societies) in defining and managing

standards in a more precise and robust manner; and selected involvement with formal standards

organizations where NIST’s contribution can be significant.

ES.10 IMPROVING POLICY ANALYSIS: LESSONS LEARNED

Based on the investigations undertaken for this report and our experience with economic tools and

data bases, we recommend important areas for additional research in support of NIST’s service sectorfocused strategic planning. First and foremost, additional case studies are in order. In-depth case studies

are the only route to gaining the level of detailed understanding needed by NIST to support investment

choices. Additional case studies would undoubtedly lead to an improved conceptualization and

documentation of the role of the technology infrastructure in the service sector. For educational and public

communications purposes, an improved conceptual model of NIST’s role in supporting the service sector

could be very important.

Another important area of research in support of NIST’s service sector-focused planning should be

directed to the theory and application of the concept of market failure. In our judgment, market failure is
ES-21

rarely discussed from the perspective of the buyer. Development of market failure concepts from a buyer’s

perspective would help clarify important issues and lead to better applied analytical tools.

Such tools are another important concern. For case studies of the quality (in terms of focus and

depth) required by NIST, it would be very useful to develop “rule of thumb” metrics (not unlike the

Hirshmann-Herfindahl Index used as an applied microeconomic analysis device in support of antitrust

policy) that provide useful, though imperfect, insights under circumstances of relatively sparse detailed

industry information. Relatedly, the development of a standard, easy-to-use methodology for generating

estimates of IT underinvestment based on readily available accounting information would be very useful

and could support priority ranking of industries for infratechnology support. In the conduct of case study

surveys, it was often difficult to establish a baseline of information from which to derive underinvestment

estimates.

To the extent that improved statistical estimates of the degree of underinvestment in the service

sector are warranted, four areas of further research would add depth to the quantitative analysis contained

in this report. First and foremost, public agencies need to collect much better data on the scale and nature

of innovation in the service sector. Second, broader and deeper analysis of the role of RJVs in standardsrelated activities across the service sector would provide additional insight to the work reported here which

focused on just one of the service sectors — communications services. Third, it would be useful to improve

statistical models of service sector productivity by the addition of components that address the competitive

impact of standards-related activities. Finally, the above models, and hence public policy, would benefit

greatly from better characterization and measurement of the private and public elements that make up

service sector technologies, as well as the interactions among these elements. It is these respective economic

roles and their complex interactions that create the need for a public policy response.

1

1. INTRODUCTION

1.1 PURPOSE

This report is the first attempt to examine and understand the “technology infrastructure” of the

service sector. This study has two explicit purposes. First, it aims to identify barriers to the development

and implementation of technologies important to service sector firms; to understand why these barriers

exist; and to assess the extent of the underinvestment these barriers cause. The second purpose is to suggest

specific technology areas that are amenable to the policy tools at NIST’s disposal, and to suggest the

outlines of an initial course of action that will lead to the successful engagement of NIST and the service

sector.

This study has an implicit purpose as well: to create a factual foundation for actions taken by

NIST to support the economic vitality of the U.S. service sector. That foundation rests on: i.) an analysis of

the Nation’s innovation system and how the institutional components of that system respond to the various

policy instruments available; and ii.) the application of the analytical concept of market failure. The former

allows us to identify the core capabilities that NIST can bring to bear in addressing problems that retard the

development and use of technology by the service sector. The latter allows us to identify those areas that

would suffer from underinvestment by the private sector in the absence of efforts by NIST. Together they

allow us to prescribe the most effective types of policy response for addressing the specific barriers to

technology development and use encountered by service sector firms.

The investigation reported here was guided by the following three questions:

• Does the service sector’s development and use of technology differ from other sectors? If

so, in what ways?

• Are there barriers that are causing service sector firms to underinvest in technology and

can we understand these barriers at a level of specificity that is appropriate to policy

planning?

• Is there an appropriate role for NIST in supporting technology development and use in the

service sector?

In brief, the answer to each of these question is affirmative. The diffusion of technology within the

service sector differs from the pattern typical of the manufacturing sector in two major ways: for the most

part the service sector depends on “imported” technology; and the nature of that technology appears to be
2

primarily information technology (Chapter 2). The barriers to greater employment of technology are

quantifiable (at a general level) and identifiable at the specific level (Chapters 4-8). Many of the important

barriers to development and use of technology can be mitigated by the policy tools available to NIST

(Chapters 8-9).

1.2 THE SERVICE SECTOR IS THE LARGEST, FASTEST GROWING SECTOR

OF THE U.S. ECONOMY

The service sector is the largest and most rapidly growing segment of the U.S. economy. It

accounts for roughly three-fourths of value added (GDP), and it has been growing at about 10 times the

rate of the non-service sector. From 1984 to 1994, the U.S. economy grew 33.1 percent in constant 1987

dollars; service industries as a whole grew by 46.2 percent, while the nonservice industries grew by just 4.6

percent. The dominance of service sector can also be seen in employment data. Between 1984 and 1993

employment increased 23.6 percent in the service sector and decreased 4.4 percent in non-services. (U.S.

Department of Commerce, July 1995b; U.S. Department of Commerce 1988, 1994).

Growth in the service industries is shown in Figure 1-1 by observing each industry's proportion of

nation-wide value added at both the beginning and the end of the period 1984-94. In 1984, the nonservice

sector was 31.5 percent of the U.S. economy, while services constituted 68.5 percent. By 1994, the

nonservice sector created 24.7 percent of the economy's value added, while services provided 75.2 percent.

All nonservice industries have seen their share of the economy fall from 1984 to 1994, with the largest

nonservice sector, manufacturing, falling from somewhat more than 22 percent to less than 18 percent of

the economy. Among the service industries, the finance, insurance, and real estate industries and the

collection of "other private services" have grown dramatically as a proportion of the economy, with the

remaining service industries becoming somewhat smaller as a proportion of the entire U.S. economy. (U.S.

Department of Commerce July 1995a; U.S. Department of Commerce 1988)

In 1984, the nonservice sector was 31.5 percent of the U.S. economy, while services constituted

68.5 percent. By 1994, the nonservice sector created 24.7 percent of the economy's value added, while

services provided 75.2 percent. All nonservice industries have seen their share of the economy fall from

1984 to 1994, with the largest nonservice sector, manufacturing, falling from somewhat more than 22

percent to less than 18 percent of the economy. Among the service industries, the finance, insurance, and

real estate industries and the collection of "other private services" have grown dramatically as a proportion
3

of the economy, with the remaining service industries becoming somewhat smaller as a proportion of the

entire U.S. economy. (U.S. Department of Commerce July 1995a; U.S. Department of Commerce 1988)

Figure 1-1. Industry Percentages of the U.S. Economy by Value Added

Government services

GOVERNMENT

Other private services*

Finance, insurance and real estate

Retail Trade

Wholesale trade

Electric, gas and sanitary services

Communications

Transportation

PRIVATE

SERVICES

Manufacturing

Construction

Mining

Agriculture, forestry and fisheries

NONSERVICES

0 5 10 15 20 25

1994 1984

______________

Sources: U.S. Department of Commerce, Survey of Current Business, July 1995, Vol. 75, No. 7 (Washington,

D.C.: U.S. Government Printing Office, 1995). The data for 1994 value added are from Table 6.1C, "National

Income Without Capital Consumption Adjustment by Industry, Domestic Industries," p. 18. U.S. Department of

Commerce, Survey of Current Business, July 1988, Vol. 68, No. 7 (Washington, D.C.: U.S. Government Printing

Office, 1988). The data for 1984 value added are from Table 6.3B, "National Income Without Capital

Consumption Adjustment by Industry, Domestic Industries," p. 79.

A more detailed breakdown of the service sector would show that the growth within "other private

services" has come in several areas. Health services is the largest industry in this category and it showed

substantial growth, but several other categories have grown substantially as well, among them hotels and

other lodging places, business services, auto services, motion pictures, amusement and recreation services,

legal services, educational services, social services, membership organizations, and engineering and

management services. (U.S. Department of Commerce 1994; U.S. Department of Commerce 1988)

The service sector is extremely complex; including some of the most technologically advanced

industries in the economy as well as some of the least advanced. Despite its importance to economic growth

and development, the service sector is not well understood. While some useful generalizations about the

role of technology in the service sector can be gleaned from available statistics, little information specific

enough for the formulation of effective technology policy is readily available. For example, the fastest
4

growing industrial grouping, “other private services,” arguably contains some of the most dynamic

industries in the service sector. But these dynamic industries are embedded (for statistical purposes) in this

broadly defined statistical grouping, making it impossible to use standard data to identify industry-specific

status, trends, and solutions. For this and other reasons, experts believe that the service sector has been

largely ignored in the national policy discussions concerning U.S. international competitiveness. (Quinn,

1992)

1.3 THE ROLE OF TECHNOLOGY IN THE SERVICE SECTOR

The service sector itself is not well understood, and has long been virtually ignored in general

economic policy discussions. It is therefore not surprising that policy discussions concerning the role of

technology in the service sector have received little attention. In part this has been due to a widespread

misconception that the service sector is unworthy of serious policy attention. According to leading service

sector experts:

Contrary to the widespread misconception of services as predominantly simple, laborintensive activities, the service industries include many large, technology-intensive and

technically sophisticated firms in transportation, financial services, banking, insurance,

retail and wholesale trade, telecommunications, health care, and professional and personal

services. (Quinn et al., 1994)

This perception is beginning to change. A recent high-level review of U.S. technology policy

describes the technological dynamism of the U.S. service sector and observes that the growth of the service

sector has not been reflected in U.S. technology policy. (Executive Office of the President, 1996) This

report is an important step in the direction of a well-grounded technology policy to support the service

sector.

Given the importance of the service sector to U.S. economic growth and the belief that technology

is the driver of economic growth, it is vitally important to understand the sources and roles of technology in

this sector. Technology is either developed within a firm or industry or it is acquired, often in the form of

“embodied technology” contained in purchased equipment. Both sources of technology are important to the

service sector. We conservatively estimate that 83 percent (by value) of all technology “imported” into the

service sector is information technology (IT). Implementation costs are estimated to be 5 times greater than

hardware costs alone.
5

Internal technology development is increasingly important to the service sector.1 National Science

Foundation (NSF) data provide an overview of the size of R&D activity in service industries as compared

with the rest of the economy. As shown in Figure 1-2, manufacturing is still the leading performer of R&D

in the U.S. economy. U.S. Department of Commerce (July 1995b) and U.S. NSF (1996) show that

manufacturing originates just 17.8 percent of the economy's value added yet performs 73.5 percent of total

R&D. Services originate 75.3 percent of value added, and perform most of the 26.5 percent of total U.S.

R&D performed by nonmanufacturing.

Figure 1-2. The Share of Nonmanufacturing Industries in Economy-wide R&D Expenditures

(1963 to 1993)

0

5

10

15

20

25

30

1963

2

1973

3

1983

5

1988

11

1993

26

Percentage of R&D

In addition to the growing importance of the non-manufacturing sector in U.S technology development

activities, it also appears that the nature of the technology being developed across the economy is

increasingly less specific to manufacturing and manufactured products. This finding is based on an analysis

of all U.S. patents between 1981-85 and 1991-96. Between these two periods, patents classified as non-

 

1 As shown in Chapter 2, the technology development within the service sector appears to be concentrated in the

communication services and the computer services industries.
6

manufacturing specific increased 23 percent, from 22 percent of all U.S. patents in the first period to 27

percent in the current period.2 In part, this reflects the fact that even while the manufacturing sector

dominates technology development activities, the service content of manufacturing activities is itself

increasing. According to a leading management consultant:

The average manufacturing company today ain’t [sic]. Seventy-five percent to 95

percent of a “manufacturing firm’s employees are in non-manufacturing activities

- engineering, design, sales, marketing, information systems, purchasing, service,

distribution. That is, they are in the professional-service development and delivery

“business.” (Quinn, 1992)3

Both the increasing prominence of the service sector and the interdependence of manufacturing and

services are reflected in the flows of products and services between the two sectors. As shown in Figure 1-

3, services are increasingly important inputs to the production of goods as well as services: 4 the amount of

service inputs needed to deliver $1,000 worth of final goods or services increased by $79 between 1977 and

1987. Moreover, the requirements for non-service inputs declined by $150 during the same period. And

while the average increase in demand for service inputs as a whole increased 8.3 percent between 1977 and

1987, requirements for service sector inputs by specific industries rose dramatically. The “computer and

office equipment” industry, for example, registered a six-fold increase in its demands for services between

1977 and 1987. (U.S. Department of Commerce, 1996)

1.4 THE TECHNOLOGY INFRASTRUCTURE

Technology is the most important ingredient in the formula for economic growth, accounting for

more than one-half of the long-term rate of increase in an industrialized economy's output of goods and

 

2 The manufacturing/non-manufacturing patent segmentation was performed by CHI Research, Inc. To segment the

population of all U.S. patents granted from 1981 to 1990 into two categories (manufacturing specific and nonmanufacturing specific), CHI Research, Inc. utilized the International Patent Classification (IPC) code. IPCs were

categorized as manufacturing-specific, non-manufacturing specific, and hybrid. A list of the IPCs contained in each category

is available upon request.

3 This quotation is from management consultant, Tom Peters. It is taken from the foreword to Quinn (1992).

4

For those unfamiliar with reading input-output tables, the following question might be posed of Figure 1-3: “How can it

take in 1987 $1,035 in services and $821 in non-services to deliver $1,000 worth of goods and services?” The answer is as

follows. In an input-output context, output of an industry is used either as an input by other industries or is sold directly to

the final consumer. So for every $1,000 of final demand, the economy (in 1987) produced $1,856 in gross output ($1,035 of

which was produced by service industries and $821 by non-service industries). The additional $856 in output was used by

other industries as intermediate inputs. So the double-counting of the value of intermediate inputs explains why it appears

to take more than $1,000 of services and non-services to provide $1,000 worth of goods and services.
7

services. (Tassey, 1995) The Economic Report of the President (1997) recently referred to research and

development as a "pillar of growth" leading to "greater economic efficiency". So economic policy that aims

at fostering growth (and the rising incomes and employment opportunities that come with economic growth)

must, at the same time, aim at fostering the development, diffusion, and implementation of new technology.

Figure 1-3. Input Required to Deliver $1000 of Goods and Services to Final Demand*

1987

0

300

600

900

1200

1977

971 956

1035

821

services

nonservices

Input Requirements in Dollars

Total Economy

______________

*Weighted average based on Bureau of Economic Analysis 1977 and 1987 Input-0utput tables (1987 final

demand weights).

Source: U.S. Department of Commerce (1996).

To understand the policy implications of the increasing technological sophistication of the service

sector requires that we first understand how technology influences economic growth and identify the

various institutional actors in our Nation’s system of technology development and implementation. With

such a framework before us, we can begin to ask the really important policy questions posed by a

technology-based service sector. These policy questions, in turn, drive the analytical objectives of the study.
8

Researchers and policy makers are becoming aware of the various institutional components of the

nation’s innovation system and the respective, complementary roles that government, business, and

universities play in the “production” of technology and in the implementation of technological change in the

interest of competitive advantage.5 The resulting technology has proprietary attributes; attributes that are

public (i.e., non-proprietary) in nature; and attributes that are part private and part public (i.e., quasipublic or mixed). It is the public and mixed attributes that give certain elements of industrial technology an

infrastructural character and it is these attributes that make it likely that the private sector will underinvest,

from a societal point of view, in the public or quasi-public attributes of technology. These

underinvestments, in turn, are supplemented by technology and market-specific programs to bolster

technology development and market development activities.

According to Tassey (1997), technology infrastructure is defined as:

[A]n element of an industry's technology that is jointly used by competing firms. One category

of this advanced infrastructure is what has come to be called an industry's generic or

fundamental technology.6 A second category of technology infrastructure includes the various

techniques, methods, procedures, etc., that are necessary to implement product and process

strategies [all of which trace back] to a set of generic underlying principles.7 A third category

of technology infrastructure consists of a set of technical tools for making the entire economic

process more efficient, or, in some cases, possible in the first place.8 Collectively, these tools

are called infratechnologies.

A disaggregated model of the innovation system is depicted in Figure 1-4. In this model, innovation

is derived from a number of different technological inputs and from a variety of institutions. The collection

of technology inputs marked off in the box at the lower left corner of the figure — proprietary technologies,

generic technologies, infratechnologies, and science base — are of particular concern because non-market

actors and unconventional market forces have varying degrees of impact on these inputs. For example, the

development of generic technologies is a typical objective of research consortia, organizations formed with

 

5

For further discussion of the “systems” or “network” nature of the innovation process see: Link and Tassey (1987), Porter

(1990), Tassey (1992), and Lundvall (1992).

6 A generic technology embodies laboratory-proven concepts, but not the subsequent market-specific products and processes.

For example, demonstrating in the laboratory that the generic concept of a ceramic engine can operate at higher output per

unit weight with improved gas mileage and lower pollution than a metal alloy engine is a long way from mass production at

reasonable cost.

7 Total Quality Management (TQM), for example, falls into this category.

8

Standard reference materials (SRMs), standard reference data (SRD), and test methods, for example, fall into this category.
9

increasing frequency to supplement the incentives available to individual market actors. The growing

prominence of these organizations as vehicles for industrial R&D represents the market failure phenomenon

at work in the sense that in many cases whole research programs, involving scores of commercially

significant research projects, would probably not have been undertaken — in the absence of these collective

organizational mechanisms — on the basis of market incentives available to individual firms alone.9

The public sector has played an important role in many of these consortia as substantive technical

contributors and as sources of finance, both directly and through government support to universities which

are often involved in consortia as well.10

Figure 1-4. A Technology-Based Economic Growth Model

LABOR CAPITAL

STRATEGIC

PLANNING

INNOVATION

NEW PRODUCT & PROCESS RISK REDUCTION

TECHNOLOGIES; NEW MARKET &

ORGANIZATIONAL STRATEGIES

PROPRIETARY

TECHNOLOGIES

GENERIC

TECHNOLOGIES

MARKET

DEVELOPMENT

VALUE

ADDED

PRODUCTION

INFRATECHNOLOGIES

SCIENCE BASE

MARKET

EFFECTS

TRANSACTION

EFFECTS

 

Source: Tassey (1997, Chapter 4)

The role of basic science is also depicted in Figure 1-4. The development and dissemination of

basic scientific understanding, common to all technological development, has long been considered the role

of publicly funded colleges and universities. Recent evidence suggests that, in fact, the results of this

 

9

See Hagedoorn (1996), Link (1996a), and Baldwin (1996).

10 See Link and Tassey (1989).
10

publicly funded research tends to be more broadly applicable (basic) and less commercially appropriable

than corporate research. 11

So-called “infratechnologies” have special importance in this study because NIST has a special

role in identifying barriers to the development and implementation of technology that can be addressed

through the development and diffusion of infratechnologies. While infratechnologies are provided by public

as well as private organizations, they are believed to be underfunded by the private sector, requiring public

support. A less widely recognized component of the national innovation system, infratechnologies include

evaluated scientific and engineering data used in the conduct of R&D; definitive measurement and test

methods used in research, production, control, and acceptance testing for market transactions; various

technical procedures, process models and techniques; and interface standards.

Taken together, all these components of the national innovation system — basic research,

infratechnologies, generic technologies — serve as a technology infrastructure and support private sector

R&D investment in specific products and processes. Much as the national transportation system facilitates

the flow of goods and services in the economy at large, so too the technology infrastructure facilitates the

creation and flow of technology development and implementation activities. And just as public sector

investment in the transportation infrastructure is essential to the productivity of the economy, so too

investment in the technology infrastructure is an essential element of an effective innovation system.

1.5 THE TECHNOLOGY INFRASTRUCTURE OF THE SERVICE SECTOR

Information technology (IT) is at the heart of technological change in the service sector. It has even

been suggested that the technological and industrial dynamics that have resulted from the growing

prominence of IT have caused the emergence of a system of complementary public and private institutions,

described above as providing the Nation’s technology infrastructure, from the ashes of the “old innovation

system” dominated by large centralized corporate labs. 12

 

11 See Trajtenberg, et al., (1993).

12 See, Christopher Freeman, “Formal Scientific and Technical Institutions in the National System of Innovation,” pp. 169-

187, in Lundvall (1992).
11

Three aspects of the IT revolution have been particularly important in creating challenges for

service sector technology managers: the convergence of distinctly different industries and technologies; the

increased requirement for multi-faceted expertise and technical knowledge; and the rapidly evolving pace of

technological change.13 These three themes are repeated over and over again in every phase of our

investigations. They are among the defining characteristics of the IT paradigm which service sector firms

appear to be adopting. In light of the systems nature of the innovation process, and the frailties of the

private market’s incentive system as it pertains to innovative activity, these forces create a milieu of

barriers that can, and do, lead to under-investment in IT development and implementation.

This report represents the first attempt to examine the technology infrastructure of the service

sector. The model shown in Figure 1-4 helps in two different ways: it presents a guide to the investigation

of barriers to technology development and implementation, and provides a benchmark for understanding the

sources and uses of technology in the service sector. What is the level, scope, and nature of proprietary

research and development efforts in the service sector? What new organizational forms and programs are

being dedicated to the development and dissemination of generic technology? What kinds of

“infratechnologies” are fundamental to the development and growth of the service sector? Are these

infratechnologies readily available or, as expected, do we find them underdeveloped due to their quasipublic character? To what extent are the activities and outputs of the entire network of private, public, and

private-public technology activities being coordinated to positively influence the commercialization of

goods and services and the global struggle for market share?14

As a benchmark device, we ask, “How should this model be altered (if at all) to account for the

dynamics of technology development and implementation in the service sector, or particular industries

within the service sector?” Unlike the manufacturing sector from which our model of technology

infrastructure is derived, the service sector is largely (but certainly not exclusively) supplier dominated.

That is, despite the rise in “internal” R&D, the service sector still acquires the vast majority of its

technology “embodied” in purchased equipment and software.

 

13 See Perine, et al., (1996).

14 For answers to these and many related questions for the manufacturing sector see Tassey (1992) and Leyden and Link

(1992).
12

Nevertheless, service sector firms are deeply engaged in technology-related activities in the form of

test, evaluation, and implementation of technology developed outside the firm and in co-development efforts

as “lead users” of technology. Part of the evaluation efforts of service sector firms are devoted to the

development and assessment of standards and protocols being developed outside the immediate purview of

the service sector firms. Increasingly, we believe, service sector firms are directly developing technologies

and engaging in standards-related activities to meet their specific needs. As lead users, service sector firms

(other than communications services and computer services firms) are involved in technology development

activities as traditionally defined. These co-development efforts are undertaken to guide and leverage the

ongoing technology activities of traditional technology producers in the manufacturing industries. There is

a sense that this is an increasingly important function and that service sector firms are increasingly

participating in this kind of technology activity.

Another prominent feature of service sector technology is its systems nature. Information

technology is the predominant form of technology being used and developed in the service sector and this

technology is being used to increase process efficiency and to develop and deliver services. All of these

functions require complex and demanding system integration efforts that involve multiple units within the

same organizations; integration among service providers; and integration between service providers and a

large and diverse population of end users. On the “back-end,” service sector providers need to integrate

“incoming” technology from numerous vendors.

So while the technology-based growth model depicted in Figure 1-4 serves to identify the

component parts of the innovation system, and the various functions these components serve in reducing

barriers to technology development, implementation, and the creation of value in the market place, the

systems integration aspect of the technology that so dominates the role of technology in the service sector is

under-emphasized. Figure 1-5 attempts to capture the above essential features of technology

implementation in the service sector and to show the locus of technology infrastructure requirements.15 (The

specific infrastructure roles of generic and infratechnologies in the service sector are discussed in Chapters

5-9 of this report.)

 

15 The depiction of technology infrastructure shown in Figure 1-5 is consistent with the model of service sector technology

infrastructure developed by Tassey (1997).
13

1.6 THE OUTLINE OF THE REPORT

Chapter 2 provides a characterization of the technology developed in and used by the service

sector. It emphasizes the relative importance of information technology (IT) in this sector and provides

estimates of the scale of internally developed and “imported” technology. Information concerning the chief

performance characteristics demanded of purchased technology and its competitive significance is

presented.

Chapter 3 develops the concept of market failure and describes numerous economic phenomena

that can create barriers in the development and implementation of technology. Each barrier is described and

illustrated with an example drawn from the trade press concerning the

Figure 1-5. Service Sector Technology Infrastructure

T

E

C

H

N

O

L

O

G

Y

I

N

F

R

A

S

T

R

U

C

T

U

R

E

T

E

C

H

N

O

L

O

G

Y

I

N

F

R

A

S

T

R

U

C

T

U

R

E

Manufacturer 1

Manufacturer 2

Manufacturer 3

Hardware &

Software Manufacturers

Service 

Sector Firms

Customers

TECHNOLOGY

INFRASTRUCTURE

Bank

Bank

Bank Bank Technology

Infrastructure

Manufacturer 1

Manufacturer 2

Manufacturer 3

Digital

Wireless

Cable

TelephoneBroadcast

Technology

Infrastructure

Content Providers

Transportation/ Delivery

Modalities

utilization of technology in the service sector. This chapter also discusses the policy instruments that are

best suited to mitigate the various types of barriers. Finally, Chapter 3 also explores technical performance

barriers to the implementation of technology from a service provider’s perspective and characterizes the

prevalence of these performance barriers based on a systematic review of technical trade literature.
14

Chapter 4 presents the results of a statistical analysis of firm level data that estimates the scale of

service sector underinvestment (market failure) in IT and explores the effectiveness of selected strategic

responses to market failure.

Having quantified the scale of service sector market failure with respect to IT and tested our ability

to assess policy responses based on statistical analysis tools, Chapters 5 through 8 present case studies of

three service sector industries (retail banking, home entertainment, and health care), identify weaknesses in

the technology infrastructure supporting these industries, and develop cross-cutting policy concerns.

Chapter 9 develops an analysis of the institutional framework that supports the technology infrastructure

for the service sector; extends the “Tassey model” of technology-based economic growth to the service

sector; and suggests the broad outline of a strategy through which NIST can engage the service sector.
15

2. SOURCES AND USES OF TECHNOLOGY IN THE SERVICE SECTOR

2.1 ALTERNATIVE SOURCES OF TECHNOLOGY

Broadly speaking, technology is the application of knowledge. With individuals, knowledge comes

from myriad sources. Formal education is one form of acquiring knowledge, but knowledge can also be

gained experientially. Further, each source of knowledge can augment the human capital of individuals

differently. So it is with an organization's technical knowledge. There are alternative sources for acquiring

technical information, and each source can augment the production or service delivery processes

differently.

One can broadly characterize sources of technical information as being either internal or external to

the firm.16 The most obvious internal source is in-house research, development, test, and evaluation

(RDT&E) activity. External sources of technical information are more varied. One important external

source is other firms; firms acquire technology that is embodied in purchased capital equipment.17 In the

case of IT hardware purchased by service industry firms, a significant of in-house RDT&E is devoted to

implementation. While the service sector has been increasingly responsible for internal technology

development, so far as technology is concerned, the sector is still best categorized as supplier-dominated.18

2.2 FOCUSING ON INFORMATION TECHNOLOGY (IT)

2.2.1 Existing Literature

Given that the term “service sector technology” is effectively limitless, to focus the research effort

we asked if areas of technology concentration could be discerned that are broad enough to be meaningful

for a discussion of technology policy in support of the vast service sector, but narrow enough to be

 

16 One review of the history of the "make versus buy" literature is in Bozeman and Link (1983).

17 There are other important external sources. The federal government is one important source (Tassey 1995.) Firms involved

in either contracted research or cooperative research and development agreement (CRADA) relationships can appropriate

technical information from their project involvement. A second source is universities. Firms appropriate technical

knowledge from universities by funding participation in university-based research, or by hiring graduates. A third source is

other firms, domestic or international. Firms can also acquire technical information directly through mergers, or indirectly

through their participation in collaborative research relationships. Another important external source of technical

information is informal inter-organization communication between technical personnel (vonHippel 1988). Finally, firms can

license technology from other firms.

18 The concept of a supplier-dominated variation of Tassey’s technology-based economic growth model (described in Section

1.4), and its appropriateness for the service sector, is discussed in Chapter 9.
16

somewhat exclusive. Previous research had focused on the role of “information technology” in the service

sector.19

To verify the validity of this focus, we conducted an initial review of trade literatures.20 This

review added weight to the hypothesis that IT — broadly defined — was indeed the focus of much industry

discussion and concern.21 An unbiased review of the general trade press indicated that service sector

concerns about technological change is overwhelmingly IT-oriented. Across the broad service sector

industries — transportation, communications, utilities, wholesale & retail trade, finance, insurance, and

real estate, educational services, hotels, health services, and business services — the preponderance of

articles discussed the development and implementation of communications technologies, networking,

integrated messaging, next generation Internet development and applications, on-line service provision,

voice and data network enhancements, electronic catalogs, desk-top conferencing, e-mail, open system

information solutions, talking menu boards, computerized registration systems, telemedicine, and

teleshopping to name but a few specific areas of interest. While non-IT technologies (e.g., multipurpose

vehicles, hardware devices, architectural design research, video server and computer hardware) were

discussed, the overwhelming focus in the trade literature concerned with “technological change in service

industries,” discussed information technology for improved operational efficiency and for the creation of

new services.

 

19 For in-depth treatments of these various aspects of the service sector’s role in the economy, and the role of information

technology in service sector industries, see Quinn (1992, 1994), and U.S. Department of Commerce (1996).

20 The methodology used to select the population of literature articles was in no way biased to report IT-related technologies.

We interpret the results to be indicative of the primary technological focus of service sector firms. An electronic search to

find recent articles related to technological change and services was conducted. ProQuest's ABI/INFORM Global CD for

January 1994 through November 1995, as well as CDs covering earlier literature during all of 1992 and 1993, was searched

for articles using a variety of keywords such as "technological change" and "service industries", "innovation" and "services

industries" and so forth.

21 Although there is not a formal, generally accepted definition of information technology, we use the term to refer to

traditional communications and computational technologies as well as technologies emerging due to the analog to digital

shift in information dissemination and representation. According to IT specialists, information technology is still evolving

as a distinct category of technology due to an ongoing convergence of two distinctly different industries, communications

and computing. Advances in digital technologies have eroded the demarcation between the historically analog

communications world and the digital computing world. And despite the fact that communications technologies were firmly

entrenched in incompatible analog systems, the digital basis upon which the computing world was built is expanding to

encompass the formerly analog technologies of telephone, broadcast, cable television, wireless communication, and satellite

transmissions. (Perine et al., 1996)
17

2.2.2 Other Systematic and Quantitative Data

Other systematic data support a focus on IT as well. Based on the National Science Foundation

data presented in Table 2-1, a majority of the R&D activity in service industries appears related to

information technology. Communication services (SIC 48) accounts for 17.5 percent of the total R&D and

15.5 percent of the R&D scientists and engineers in the non-manufacturing (mostly services) sector.22

Computer related services (SICs 373, 871) take 32.2 percent of total non-manufacturing R&D and 38.2

percent of R&D scientists and engineers.23 Computer-related services account for about 4.1 percent of

private service's value added and 2.8 percent of private service's full-time equivalent employees.24

Thus, a lower-bound estimate is that 49.7 percent (49.7% = 17.5% + 32.2%) of service sector

R&D is by communications services and by computer-related services firms. Because IT is becoming a

critical element of the activities of these two industry segments, we conclude that 49.7 is a reasonable

approximation of the percentage of service sector R&D directed to information technology. (Perine, et al,

1996) And, to the extent that R&D in other service industries is devoted to information technology as well,

49.7 percent may be a lower-bound approximation.

Patent data provides another window onto the technology activities of service sector firms. We

know from the NSF data presented in Chapter 1 that the service sector’s share of total R&D is rising.

Patent data is the only readily available, systematic source of detailed technical information that provides a

window onto the specific content of firms’ technology-related activities.25

 

22 These percentages were calculated as follows. Total non-manufacturing R&D from Table 2-1 is $31,321 million

($5,491+$339+$10,092+$132+$2,084+$13,183 million). Communication services ($5,491 million) is 17.5 percent of this

total. Similarly, the total number of scientists and engineers employed in non-manufacturing is 190.8 thousand

(29.5+1.6+72.9+0.9+13.6+72.3 thousand). Communication services (29.5 thousand) employs 15.5 percent of this total.

23 These percentages were calculated as follows. Total non-manufacturing R&D from Table 2-1 is $31,321 million

($5,491+$339+$10,092+$132+$2,084+$13,183 million). Computer related services ($10,092 million) is 32.2 percent of

this total. Similarly, the total number of scientists and engineers employed in non-manufacturing is 190.8 thousand

(29.5+1.6+72.9+0.9+13.6+72.3 thousand). Computer related services (72.9 thousand) employs 38.2 percent of this total.

24 The Census of Service Industries (U.S. Department of Commerce 1995a) shows that SIC 737 and 871 represent 10.9

percent of the receipts for the "other private services" listed in Table 2-1, while "other private services" make up 37.5

percent of the private services for the service sector as a whole. Employment figures from the Census show that SIC 737

and 871 represent 6.2 percent of the employment in "other private services" which itself takes 44.9 percent of the

employment in private services.

25 We believe that the technology development activities of most service sector firms are best categorized as belonging to the

T&E portion of the RDT&E spectrum. To the extent that patents reflect the whole cycle of development and

implementation of firms’ innovative activities, and not just the inventive activities reflected in R&D data, as suggested by
18

Table 2-1. Total R&D Activity in Selected Industries

Industry and SIC Code 1993 Total

R&D*

($millions)

1993 R&D Scientists

and Engineers

(thousands)

Total $118,334 764.3

Manufacturing (SICs 13,20-39) $87,013 573.5

Communication services (SIC 48) $5,491 29.5

Electric, gas, and sanitary services (SIC 49) $339 1.6

Computer programming, data processing, other

computer-related engineering, architectural, and

surveying services (SICs 737,871)

$10,092 72.9

Hospitals and medical and dental laboratories (SICs 806-

07)

$132 0.9

Research, development, and testing services (SIC 873) $2,084 13.6

Other non-manufacturing industries** $13,183 72.3

 

* These estimates are total R&D performed in each industry, including private, Federal, and other sources of

funding.

** Other non-manufacturing industries include agricultural services, forestry, fishing, and hunting (SICs 07-09);

mining (SICs 10, 12-14); construction (SICs 15-17); transportation, communications, electric, gas, and sanitary

services (SICs 40-42, 44-49); wholesale and retail trade (SICs 50-59); finance, insurance, and real estate (SICs 60-

65); holding and other investment offices (SIC 67); hotels and motels (SIC 701); business services (SIC 73, except

737); automotive repair, service, and parking and miscellaneous repair services (SICs 75-76); motion pictures and

amusement and recreation services (SIC 78-79); health and legal services (SICs 80-81, except 806-07); social

services (SIC 83); museum, art galleries, botanical and zoological gardens (SIC 84); engineering, accounting,

research, management, and related services (SIC 87, except 871 and 873); and miscellaneous services (SIC 89).

Source: National Science Foundation (1996).

Figure 2-1 indicates that the patenting activity of selected service sector firms is increasingly ITrelated.26 The percentage of IT technologies in the patent portfolios of service sector firms remained

relatively flat at less that 5 percent throughout the 1980s. However, that percentage grew noticeably during

the early- and mid-1990s. Currently, it is over 25 percent. This upswing in a relatively narrowly defined

__________________________________

Pavitt (1985), patent data may capture more relevant technology activity for service sector firms than R&D data alone.

(This positive aspect of using patent data to analyze service sector behavior has to be balanced against the general

understanding that the service sector’s propensity to patent is low.)

26 The results presented in Figure 2-1 are for 47 service sector firms in the MIT database with significant patenting activity.

This database is discussed in Chapter 4. A patent is said to be IT-related if it is classified (in whole or in part) in any of

three International Patent Classification codes (Computing, Calculating, Counting; Information Storage; or Transmission of

Digital Information).
19

technology area (as defined, IT-related international patent categories comprise just 3 of one hundred or so

patent categories) is probably indicative of a more significant shift to IT-related technology than the

percentage indicates. Looking at all U.S. patent activity — manufacturing and non-manufacturing — IT

intensity has risen from 2-3 percent to 9-10 percent over the period 1981-1996. Based on these data, the

service sector firms represented in Figure 2-1, and perhaps service sector firms in general, are especially IT

intensive.

Figure 2-1. Growth of IT Intensity: Selected Service Sector Firms vs. All Patent Holders

0.00

0.05

0.10

0.15

0.20

0.25

0.30

1981198219831984198519861987198819891990199119921993199419951996

IT-Intensity (47 Service

Sector Firms)

Percent IT

IT-Intensity (All US Patents)

 

Source: CHI Research, Inc., 1996b

2.3 TECHNOLOGY FLOWS INTO SERVICE INDUSTRIES

2.3.1 An Estimate of “Imported” Information Technology

The central importance of IT to the service sector comes even more sharply into view when we

consider the IT embodied in equipment purchased from outside the sector. IT is the technology that has

brought about the most pervasive and dramatic changes in the growth of the service sector. As Quinn et al.

(1994, pp. 1-2) notes:

As IT becomes less expensive, more portable, better integrated and interconnected, and

embedded in [an even] wider variety of devices, new applications in [the fields of

transportation, financial services, banking, insurance, retail and wholesale trade,

telecommunications, health care, and professional and personal services] and whole new

industries ó such as interactive multimedia systems for business, home entertainment, and

communications purposes ó are likely to evolve and to have profound effects on industry

structures, employment, and economic growth. Moreover, the U.S. economy revolves

increasingly around various important white-collar service industries (e.g., research,

design, financing, education, accounting, marketing, logistics planning, communications,
20

and information management) rather than blue-collar shop floor production. These

activities are central to the individual service industries and are critical in producing value

within manufacturing and other goods-producing companies. The effectiveness with which

IT is deployed in services thus strongly influences U.S. standards of living and

competitiveness in world trade.

Table 2-2 contains the data needed for a benchmark estimate of imported technology (i.e.,

technology flows into) versus indigenous technology (i.e., RDT&E-based) in service industries. The

implicit assumption underlying the analysis that follows is that information technology purchased by

companies in the service and non-manufacturing industries is a lower-bound estimate of the total

technology that is imported into those industries. Certainly, companies in service industries purchase other

capital equipment that has embodied in it non-information technology and, as pointed out at the beginning

of this chapter, there are many external sources of technology available to firms.

Table 2-2. Comparison of Value Added, Information Technology Investments, and Company

Performed R&D: 1991

(in $ billions)

INDUSTRY Value Added IT

Investments

R&D

 Non-Services $1,178.7 $26.7

 Agriculture, forestry, and fisheries $90.9 $0.0

 Mining $36.7 $0.9

 Construction $210.1 $0.5

 Manufacturing $841.0 $25.3 $67.6

 Services $3,391.2

 Private $2,691.8 $126.8

 Transportation $140.8 $3.8

 Communications $95.3 $21.1

 Electric, gas, and sanitary services $99.0 $8.0

 Wholesale trade $266.0 $17.0

 Retail trade $403.3 $17.9

 Finance, insurance, and real estate $685.0 $38.7

 Other private services* $1,002.4 $20.3

 Government $699.4 $45.0

 Private Non-Manufacturing $3,029.5 $128.2 $22.9

__________

* Includes hotels; personal services; business services; auto repair; services, and parking; miscellaneous repair

services; motion pictures; amusement and recreation services; health services; legal services; educational services;

social services; membership organizations; museums, botanical, zoological gardens; engineering and management

services; private households; and services not elsewhere classified.

Source: Quinn et al. (1994) and National Science Foundation (1996).
21

The data in Table 2-2, albeit conservative in terms of its characterization of imported technology

into the service sector, show that 82.6 percent of 1991 investments in IT hardware was by private service

sector industries.27 Included in these estimates of information technology investments are expenditures for

office, computing, and accounting equipment; communications equipment; instruments; and photocopy and

related equipment.

2.3.2 Making Information Technology Work

While imported information technology into the service sector is approximately 83 percent,

information technology requires significant adaptation costs that may not have characterized imported

technologies in the past. In fact, there is reason to believe that these costs of adapting and implementing

information technology exceed the costs of the imported hardware that embodies the R&D of its

developers.28 Including the service sector's expenditures for implementation of information technology in its

technology bill reverses the notion that the preponderance of service sector IT is purchased.

The International Data Corporation (IDC) provides a breakdown of the various costs of using

information technology for basic types of information technology sites.29 For small centralized sites, there is

the cost of the operation staff (54 percent), applications development staff (20 percent), software (12

percent), hardware (9 percent), and support (5 percent). For large distributed sites, IDC reports that there is

the cost of the operations staff (38 percent), the central site location (17 percent), software (25 percent),

hardware (17 percent), and support (5 percent).

Based on these estimates, if a representative service sector company spends $100.00 on

technology, $83.00 of which is for imported information technology hardware, and if that $83.00

represents 17 percent of its total cost to make the information technology operable, then the total cost for

using the information technology is $488.00. As has been observed:30

 

27 This percentage equals ($126.8/(126.8+$0.9+$0.5+$25.3)), or total private service sector investment divided by the sum of

total private service sector IT investment and total non-service sector IT investments.

28 International Data Corporation (1996) provides the recent statistics demonstrating that implementation costs exceed the

hardware costs. Greenwald et al. (1994) emphasize the investments that companies must make above and beyond the cost

of IT hardware in order to ensure the productivity of information technology.

29 See International Data Corporation (1996).

30 See International Data Corporation (1996).
22

[W]e are heading for a wired workplace, a wired marketplace, even a wired society.

However, there is a price to be paid for all this connectivity. The nearly universal

implementation of client-server systems requires living with new levels of complexity and

new hardware and software that people must be trained to use. Moreover, highly skilled

personnel must be hired to install, manage, maintain, and administer these far-flung

networks. The result is that staffing costs have become the largest contributor to total

networked computing costs, regardless of the size of the installation.

Many of these costs come about because of market barriers and frictions related to the effective

identification, transfer, and assimilation of information technology. The scale of these barriers and their

nature is the subject of Chapters 4 through 8.

2.4 THE STRATEGIC INTENT OF IT PURCHASES

The preceding analysis leads us to conclude that approximately 83 percent of the technology

purchased by service industry firms is information technology. And, the cost to service industry firms to

adapt and implement this technology is often greater than the initial hardware technology by a factor of five.

In an effort to gain greater insight into the service sector’s strategic reasons for purchasing IT, specific

questions were added to the 1996 InformationWeek survey of the 500 largest domestic users of IT.31 The

questions posed in the survey are presented in Table 2-3.

Our goals for this survey were (1) to better understand the strategic importance of information

technology in major corporate enterprises, and (2) to gain insight into factors that are important to firms

when they purchase new information technologies or information systems. Understanding the strategic

importance of how the technology is used is an important step in identifying barriers to their wider use.

2.4.1 The Strategic Importance of IT to Service Sector Firms

Table 2-4 shows the responses from service sector firms to the first question (why your organization invests

in information technology). The mean response was greater than 5.5 (the median value on a response scale of

1 to 10) for eight of the 10 choices indicating that service sector IT executives attached a relatively high

 

31 See Brynjolfsson and Hitt (1996a). InformationWeek expressed interest in conducting a broad-based survey of IT users and

contacted Brynjolfsson and Hitt to design the survey instrument. Two questions were added to the survey to gather specific

information for this study (see Table 2-3). Of the 500 surveys administered by InformationWeek, 189 were returned. Of

these, 103 were from service sector firms; however, not all of these 103 firms responded to both questions.
23

importance to many factors. However, customer satisfaction was the dominant response, followed by

timeliness, product quality, and reduced costs.32

Table 2-3. InformationWeek Survey Questions

Question 1:

Please rate the importance of each of the following as reasons as to why your organization invests in

information technology. (Please rate each on a scale of 1 to 10, where 10 = Extremely Important and 1 = Not

At All Important.)

Improve customer service

Improve flexibility (e.g., customization)

Improve managerial information systems

Improve timeliness (e.g., faster time to market)

Improve product quality

Learn about new technologies

Maintain state-of-the-art IS shop

Provide IT infrastructure

Reduce costs

Support reengineering or business process redesign

Question 2:

Please rate the importance of each of the following factors in guiding your organization's selection of new

information technologies/systems. (Please rate each on a scale of 1 to 10, where 10 = Extremely Important and

1 = Not At All Important.)

Adherence to open (non-proprietary) standards

Availability of service and support

Compatibility with existing systems

Functionality

Low initial cost

Low training costs

System reliability

2.4.2 New Information Technology Performance

Table 2-5 reports the responses from service sector firms to the second question (IT factors that

guide purchasing decisions). Again, respondents attached a great deal of importance to all the options (all

had a mean response greater than 5.5). However, the dominant factor is system reliability.33

 

32 Separate correlations were calculated for measures of firm size (sales and net income) and the mean responses shown in

Table 2-4. With the exception of the response category “reduce cost,” which is correlated positively with firm size (at a .01

level of significance), firm size is unrelated to response scores.

33 Separate correlations were calculated for measures of firm size (sales and net income) and the mean response shown in

table 2-5. Uniformly, firm size is unrelated to the response scores.
24

Table 2-4. Service Sector Firms' Responses to Survey Question 1

Please rate the importance of each of the following as reasons as to why your organization invests in

information technology. (Please rate each on a scale of 1 to 10, where 10 = Extremely Important and 1 =

Not At All Important.)

Response Category Mean

Improve customer service (n=99) 9.52

Improve timeliness (e.g., faster time to market) (n=99) 8.84

Improve product quality (n=98) 8.57

Reduce costs (n=99) 8.52

Improve flexibility (e.g., customization) (n=99) 8.36

Improve managerial information systems (n=99) 8.06

Support reengineering or business process redesign (n=97) 8.00

Provide IT infrastructure (n=97) 7.48

Learn about new technologies (n=98) 5.37

Maintain state-of-the-art IS shop (n=98) 5.28

Table 2-5. Service Sector Firms' Responses to Survey Question 2

Please rate the importance of each of the following factors in guiding your organization's selection of new

information technologies/systems. (Please rate each on a scale of 1 to 10, where 10 = Extremely

Important and 1 = Not At All Important.)

Response Category Mean

System reliability (n=98) 9.42

Functionality (n=99) 9.16

Availability of service and support (n=98) 8.99

Adherence to open (non-proprietary) standards (n=99) 8.30

Compatibility with existing systems (n=99) 7.91

Low initial cost (n=99) 6.48

Low training costs (n=99) 6.34

2.5 CONCLUSIONS

The manufacturing sector still performs the lion’s share of R&D, but the service sector now

develops more technology than it did two decades ago. Indeed, the growth in service sector R&D has been

quite dramatic. Service sector R&D is dominated by the communication services and computer services

industries. Together they account for almost 50 percent of all service sector R&D. Systematic analysis of

the trade press, R&D expenditure data, and patent data all confirm the centrality of IT to service sector

development. The importance of IT to the service sector suggests that it makes sense to consider this broad
25

technology as a focal point for the development of an initial technology policy in support of the U.S. service

sector.

Over and above the importance of IT in the internal innovation process of the service firms, these

firms acquire far more technology embodied in purchased capital equipment. But significantly, the full cost

of implementing IT is more than four times as great as IT purchase costs. These high implementation costs

suggest the presence of significant barriers to IT implementation. A survey of service sector technology

managers indicates that firms are driven to invest in IT as a means of improving customer satisfaction and

that IT system reliability is the most effective way to achieve customer satisfaction through IT.

Reflecting some of these findings, Figure 2-2 modifies the technology-based economic growth

model to reflect the importance of IT to the service sector “production function” and to improving service

sector performance (value added) in the market place.

The following chapters will estimate the scale of the barriers that prevent service sector firms from

procuring more IT in efforts to improve their quality: cost performance; to determine the nature of the

barriers that cause underinvestment in IT; and to determine the appropriate policy response by NIST.
26

Figure 2-2. The Role of Embodied IT in Service Sector Growth.34

LABOR

IT

CAPITAL

STRATEGIC

PLANNING

INNOVATION

NEW PRODUCT & PROCESS

TECHNOLOGIES; NEW MARKET &

ORGANIZATIONAL STRATEGIES

PROPRIETARY

TECHNOLOGIES

MARKET

DEVELOPMENT

VALUE

ADDED

PRODUCTION

NONCIATPITAL

 

34 According to information obtained in the case studies presented in Chapters 5-8, proprietary technologies for service firms

include a large measure of test and evaluation activity. To the extent that these test and evaluation activities are

standandardized or shared, infratechnologies would also come into play at this point.
27

3. THE CONCEPT OF MARKET FAILURE AND ITS APPLICATION

3.1 INTRODUCTION AND OVERVIEW

This chapter explains the concept of market failures and presents examples of various causes of

market failures from the literature concerning the development and use of technology in the service sector.

It is important to fully explore the concept of market failures and the related concepts of “barriers to

investment” and “underinvestment.” They will be essential to our detailed case study investigations in later

chapters of this report.

After a brief overview of the relationship of these concepts and their policy relevance, we proceed

to a detailed discussion and explanation of the various barriers to technology and the associated market

failures. This is followed by a brief discussion of the appropriate policy response to broad categories of

barriers to technology. (Readers familiar with the various barriers to technology and the appropriate policy

instruments are advised to turn to the presentations of the various types of evidence of market failure

presented in the following chapters. Chapter 4 presents firm-level statistical evidence of the degree of

market failure in the service sector. Chapters 5 through 8 present case studies that explore the market

failure implications of technological developments in each of three industries.)

3.1.1 Overview of Market Failures

Because the existence of market failures is the chief economic rationale for government

involvement in technology development activities, it is important to understand this concept. Equally

important, the policy instruments available to policy makers must be matched to the specific type of

technology barrier to have the desired effect. (Tassey 1995, 1997)

We will discuss eight types of barriers and their impact on firm’s expectations regarding their

ability to capture the fruits of their investments (“appropriability”) or realizing planned returns (risk).

These barriers, and the underinvestments they can cause, are best addressed by specific technology policy

instruments. The policy instruments available to NIST for mitigating barriers to technology investment

include support for generic technology development (through the Advanced Technology Program) and the

development of “infratechnologies” for measuring compliance with voluntary standards or standard

methods.
28

These distinctions will be very important for the discussions of case study evidence and for the

policy discussion that concludes the report. Before proceeding with a review of the various barriers to

technology, and the associated market failures, it is important to understand the broader relationships

among barriers, underinvestment, and market failures. This relationship is depicted in Figure 3-1.

There are two general causes of market failure: 1) risk and uncertainty or 2) difficulties capturing

(appropriating) the returns from an investment. These basic difficulties manifest themselves in various

barriers to technology that result in the failure of market place incentives to induce the level of investment

that would likely take place if those barriers did not exist.

Figure 3-1. Barriers, Market Failures, and Underinvestment

Specific Barrier

Mechanisms

Barriers to

Technology Development

& Implementation

Market Impact of

Barriers

Spillovers Recognition

Information/Asset

Sharing Difficulties

System

Interoperability

Long Time to

 Market

Excess Competition

Among Users Infratechnologies

APPROPRIABILITY:

Reduced Ability of Firms

To Capture (Appropriate)

Fruits of Investment

RISK:

Divergence Between Social

 & Private Perpectives That

 Expected =Actual Returns

Private Perspective = Higher Hurdle Rate

(Underinvestment)

Social Perspective = Lower Hurdle Rate

(Policy Action)

Market

Failure

Evidence: Underinvestment

Spillovers Recognition

Information/Asset

Sharing Difficulties

System

Interoperability

Long Time to

Market

Excess Competition

Among Developers

Excess Competition

Among Users Infratechnologies

A company’s overall exposure to risk from a particular technology investment project will depend

on the collection of projects in the company’s portfolio. A large firm with a diversified portfolio of

investment projects might find a particular project less risky than a small firm. Similarly, from a social or

government policy point of view, society may perceive less risk than an individual firm, large or small, and

technology policy is implemented from a social point of view to induce a higher level of technology

investment.
29

Barriers to technology cause essentially two types of market failure in service industries. First,

barriers are likely to cause underinvestment for new technology.35 Second, barriers can prevent the full and

efficient use of available technology. Facing barriers, private firms find that the costs of additional

investment exceed the anticipated benefits. The private sector will find the additional investments

unprofitable, because those investments are risky and the returns are difficult to appropriate (capture). If

barriers to technology were reduced, causing higher appropriation of returns and lower risk, the private

value of additional investment would more closely approach its social value. Thus, reducing barriers to

technology would stimulate additional desirable investment.

3.1.2 Sources of Market Failure: Discussion and Examples of Barriers to Technology

This section describes specific examples of barriers to technology acquisition, development and use

that should be of special concern for the service sector.36 Here, following brief definitions of appropriability

and risk and building upon Tassey (1995), we define and illustrate the prominent barriers to technology and

the associated market failure. By relating the types of barriers to situations involving the development or

use of technology in the services sector, it is hoped that the meaning and import of these barriers will

become clearer to the reader.

Appropriation of returns. If a company cannot realize all of the returns from an investment,

because some returns leak to other firms in the form of knowledge and ideas, and to consumers who would

be willing to pay higher prices than the market charges, appropriability difficulties result in a level of

investment that is less than optimal from society's standpoint.

Risk. Risk is a measure of the extent to which actual outcomes may deviate from the expected

outcomes. More precisely, risk is the estimated probability of return on investment falling below the

minimum acceptable hurdle rate. The end results of technology development may be very poor or perhaps

considerably better than the expected outcome. Thus, a firm is concerned about the risk that its investment

 

35 "Investment" is interpreted in the broad sense, encompassing investment for new IT hardware, embodying imported R&D,

and investment originating in the service sector and pointed at developing, testing and implementing new technology.

36 Overviews of the barriers from the perspectives of the managerial literature, the industrial organization economics

literature, and the public policy and technology literatures can be found respectively in Teece (1980), Baldwin and Scott

(1987), Tassey (1995). These sources review the barriers to both the creation of technology by R&D investment and the

transfer of technology from its creators to others who apply it.
30

will fail technically, or even if technically successful, that the investment may not be profitable.37 When

private companies either cannot accurately estimate risk or risk becomes excessive along absolute or time

dimensions, the decision-makers will use higher discount rates than the public would apply.38 From

society's standpoint, the market would fail to provide enough investment.

Risk and appropriability difficulties are often confounded in the problems causing a barrier to

technology. Some project circumstances will both shift the probability distribution for project outcomes—

changing its expected value—and change the aspects of the distribution that affect the project's risk. With

an understanding of what is meant by appropriability difficulties and risk, we turn to examples of barriers

and the associated underinvestment in IT.

Spillovers. Returns from one firm's investment in technology may spill over to other firms. A firm

decides how much to invest based on its assessment of private benefits, which does not capture those

spillovers. Society would prefer more investment, which would occur if the firm based its decisions on a

higher marginal benefit schedule that captures all returns—in the form of knowledge and ideas—to that

investment. According to Tassey (1995, p. 43), spillovers are likely to result when "the nature of the

technology...is such that the assignment of intellectual property rights is difficult." Also, Tassey (1995, p.

44) observes that appropriability will be difficult, and underinvestment may result, when the buyers of

technology can bargain for lower prices or if imitators successfully compete with the innovator.39

Spillovers of knowledge are typically pervasive whenever technology is being developed and

applied; services are no exception. The most prominent example is undoubtedly the concern about

appropriability of returns to the production of knowledge made available on the Internet. Phillips (1995)

discusses the potential for publishing on the Internet, and the major problems to be dealt with such as

concerns about copyrights and the proprietary nature of information.

Transaction Costs: Information-Sharing and Asset-Sharing Difficulties. Teece (1980) explains

the implications of the paradox of information and opportunistic behavior by firms attempting to share the

 

37 Often the term "uncertainty" is applied when knowledge is insufficient to form a probability distribution of returns.

38 A firm's decision-makers will likely perceive the risk of investment differently than would society. From society's

perspective, the risk from the pooled collection of investments typically implies lower discount rates.

39 See Baldwin and Scott (1987) for a complete set of references and discussion of these appropriability difficulties.
31

information and facilities needed for the exchange and development of technology. The paradox of

information is that without telling a potential customer about the technological and managerial know-how a

seller of technology believes will be productive for the customer, the customer cannot value the information

and hence is unlikely to pay an appropriate amount for it. Yet, if the seller reveals the information, the

buyer will have it and won’t need to pay for it. Patent laws and legal contracts surmount some of these

problems, but patent laws provide imperfect protection and contracts can be expensive, unwieldy, and

ineffective. Such information sharing problems reduce investment by making it more difficult to realize the

full benefits of the investments. These information-sharing difficulties can necessitate internal financing of

R&D and other investments in technology because the paradox of information will inhibit full disclosure of

information to creditors and other outside investors, thus increasing the cost of outside investment funds.

As a result, very capital intensive investment projects (Tassey, 1995, p. v) may take a prohibitively large

portion of the investment budget, and again, worthwhile investments may be lost.

As Teece (1980) explains, the successful transfer of technology from one firm to another requires

careful teamwork with active interaction between the seller and the buyer of the technology. In such

circumstances, both the seller and the buyer are exposed to hazards of opportunism. For example, sellers

may fear that buyers will capture the know-how too cheaply or use it in unexpected ways to become a

competitive threat. Buyers may worry that the sellers will fail to provide the necessary support to make the

technology work in the new environment, or that after learning about the buyer's operations in sufficient

detail to transfer the technology successfully, the seller would back away from the transfer and instead

enter the buyer's industry as a technologically superior competitor.

Teece (1980) emphasizes that when the barriers to technology development and acquisition become

too severe to be handled by arms-length transactions in the market or by detailed contracts specifying the

obligations of the buyer and the seller of the technology, the selling and buying organizations will merge, or

the seller or the buyer will expand internally and acquire a new line of business to allow the interactive

sharing across activities to take place within a single firm (thereby avoiding the hazards of opportunistic

behavior and the transaction costs of dealing in markets or with contracts). One suspects that the recent

movement (Wolfe 1995) of manufacturing firms into the service industries is caused by the need to transfer

technology from its originators to the service industries. That shift fits well with Brian Quinn's (1992)

observation that manufacturing firms are increasingly devoting much of their activities to the provision of

services. Barriers to technology transfer dictate that an intrafirm solution to the sharing of technological
32

and managerial know-how will improve performance over what would occur if the sharing were done at

arms length in the market or with contracts between independent firms.

Tassey (1995, p. 43) emphasizes the barrier to technology that results when "the complexity of the

technology makes agreement with respect to product performance between buyer and seller costly." Sharing

R&D and technology may be especially difficult when (Tassey, 1995, p. 42) "the evolving nature of

markets requires investment in combinations of technologies that, if they exist, reside in different industries

that are not integrated." Tassey observes (1995, p. v) that "technical risk, especially in the early phases of

development can become prohibitive because . . . . requirements for conducting R&D . . . demand

multidisciplinary research teams, unique research facilities not generally available within individual

companies, or "fusing" technologies from heretofore separate, non-interacting industries. Investment in the

early (generic) phases of many emerging technologies is adversely affected by such conditions." Tassey

goes on to observe (1995, p. v) that "High technical risk can translate into high market risk when the

required R&D is capital-intensive, so that the minimum cost of conducting the research is high relative to a

firm's overall R&D budget." As Teece explains (1980), the possibilities for opportunistic behavior in "thin"

markets may make it impossible at reasonable cost for independent firms to share the capital assets even if

there were no R&D-information sharing difficulties to compound the problems.

Although the use of IT is growing in the magazine industry, Wilson (1995) reports that only 11

percent of editors and 6 percent of reporters have CD-ROM drives; 50 percent of art departments still

require submissions as photos or slides. Some publishers have successfully deployed the new IT and could

presumably sell their expertise to other publishers. However, the hazards of opportunistic behavior may

prevent that—the publisher with IT sophistication could pirate the authors of the publisher paying for its

consulting services. An intra-firm solution effected via merger could transfer the knowledge without such

risk; thus, one reason for mergers among publishers would be to share knowledge about the successful use

of IT.

Recognition. Firms may fail to appropriate social returns because they do not recognize potential

applications of their technology. Tassey (1995, p. 42) emphasizes the case where "the scope of potential

markets is broader than the scope of existing market strategies, so that individual firms do not project

economic benefits from all potential market applications of the technology".
33

The returns from innovation cannot be appropriated if innovators do not recognize the

opportunities. In part for that reason, Meltzer (1993) reports that a workshop of concerned practitioners

from industry, academia, and government who addressed ways to improve the assimilation and productivity

of information technology concluded that collaborative R&D to develop appropriate IT products, services,

and environments is a key to good performance. Baldwin and Scott (1987) review articles hypothesizing

that diversified firms will have good R&D performance because of their ability to recognize applications of

knowledge in the different environments with which they are involved. Collaboration can achieve such

benefits of diversification.

Long Time to Market. As discussed above, private decision-makers may perceive more risk in

their investments than the public does, and therefore discount the value of returns at a higher rate than

would the public. The lag between an initial investment and its returns, through the discount rate, reduces

the present value of those expected returns. (Tassey 1995, p. 41).

Investments in IT are often risky, with payouts uncertain and coming long after the initial

investment. Kim (1995) notes that by committing the company to a hybrid fiber/coaxial (HFC) architecture

as the approach for delivering all residential IT services over a single pipe, Pacific Bell faces the risk that a

different residential broad-band architecture will win the day. As a whole, society can be happy with the

winning solution to the residential broadband architecture, but individual companies will win or lose

depending on how their choices fare. Pacific Bell has taken steps to mitigate the risk, however. It has paid

attention to the scalability of its investments in HFC.

With IT, there is the need to wait for aspects of the system that uses the new technology to be in

place. Although satellite television broadcasters know that new channels will soon be digital, broadcasting

companies are worried about the risks involved in launching digital services, so they wait and even launch

new packages of channels using analog TV (New Media Markets 1995).

Interoperability of Systems. The costs of adoption and use of new technology are dramatically

lower for independent users who successfully coordinate the standards and hence the compatibility of their

technologies. Individual firms pursuing their own self-interests in a market setting with uncertainties about

the evolution of technologies are unlikely to succeed in coordinating a network. For just one empirical

example, Brynjolfsson and Kemerer (1994) conclude that "[b]ecause of network externalities, the success
34

of a software product may depend on the creation of, or conformance to, industry standards, in addition to

the value of its intrinsic features."

Tassey (1995, p. vi) observes that

"Most technology-based products in today's complex market place are part of larger systems of

products (examples are an automated factory and a communications network). Under such

industry structures, if a firm is contemplating investing in the development of a new product

but perceives a risk that the product—even if successful technically—will not "fit" or

"interface" with other products in the system, the additional cost of attaining compatibility or

interoperability may reduce the expected [rate of return] to the point that the project is not

undertaken. Similarly, multiple sub-markets may evolve, each with its own interface

requirements, thereby preventing economies of scale or network externalities from being

realized."

With IT, compatibility or interoperability problems are pervasive. For example, the growth of

wireless communications requires cellular carriers to arrange interoperability of their systems. Wetli

(September 1, 1995) reports that GTE and Ameritech announced an interoperability arrangement which

would allow their customers to maintain service while traveling between the two carriers’ coverage areas.

Wetli (February 15, 1995) provides an example of the uncertainties for new technologies that require

standards in order to work within a network. The new analog display services interface (ADSI) standard is

a communications protocol developed by Bellcore. The development standardizes products and services in

networks with screen phones. ADSI services have been slow to develop as providers wait for customers to

buy the screen phones, but of course the customers haven't been buying the phones since there are not many

ADSI services available.

Excessive Competition Among Technology Developers. If competition in the development of new

technology is very intense, each firm, knowing that the probability of being the successful innovator is low,

may project that its returns will not be sufficient to cover costs. Further, even if the firm innovates, it can

still face intense competition in application because of competing substitute goods, whether patented or not.

Especially when the costs of imitation are low, firms will not anticipate sufficient returns to cover the R&D

investment costs.

However, despite the concern about excessive competition, when considered separately from the

other barriers (interoperability problems for example could be compounded when there are many sources of

technology development), competition appears to be spurring technology development rather than retarding
35

it. For a prominent example, providers of local and long distance telephone service, cable TV, and

broadcast satellite providers are all competing to provide the bandwidth that customers want at a

reasonable price (Stuck 1995). However, there are types of technology development—such as

nonproprietary infratechnology—where competition may be a barrier to technology.

Nonproprietary Infratechnology. Tassey (1995, p. 45) illustrates the foregoing idea that

competition can be too intense by discussing the market risk and appropriability problems associated with

the decision to develop a test method that will be a part of an industry's nonproprietary infratechnology.

Tassey (1995, p. vi) observes that infratechnology—those elements (often provided by the federal

laboratories) of an industry's technology that must be shared among the industry's firms to support the

industry's performance (e.g., a test method)—must be widely available to buyers and sellers in order to

have a significant economic impact:

"The nonproprietary or public good character of such infrastructure (resulting from common

use) leads to underinvestment by individual firms because insufficient benefits are captured.

This capturability or externality problem is accentuated by the prospect that, if several

companies develop alternative infratechnologies (different approaches to performing the same

test), only one version or a hybrid of several versions is eventually accepted as the industry

standard. Investments in the other versions have to be written off."

Thus, an early test-method innovation may be supplanted if an alternative method is selected as the

industry standard. Privately anticipated benefits may not exceed the costs; from a social point of view, the

result may be an underinvestment in infratechnology. Further, competition in the development of

infratechnology can result in several competing test methods. In such cases, the market will generate

confusion and additional product assessment costs by potential buyers. These 'transaction costs' add to the

overall cost of the new product and slow its market penetration. (Tassey, 1995, p. 44)

IT development and commercialization can be inhibited in part because the necessary

infratechnology is nonproprietary. For example, Haber (1995) reports that the purchasers of asynchronous

transfer mode (ATM) services will face difficulties because of evolving standards and limited functionality

and services. As Terzian (1995) explains, the newness of ATM has meant that carriers and end users must

frequently pioneer the evaluation of the technology. Development of the testing involved is the sort of

infratechnology that markets may not provide very well.
36

Excessive competition among technology implementers. In order to adopt new technology,

service firms must invest in organizational changes, training, and software as well as in new information

technology hardware. It may be difficult to recover the costs of such investments when technology is

changing rapidly. Prices of services tend to be low because of the competition in service industries, and the

overhead costs of maintaining cutting-edge information technology may result in costs that exceed unit

prices in highly competitive dynamic environments. The shortfall of price is especially likely for the first

firms to adopt a new technology if imitators are able to observe those innovators and thereby reduce their

overhead costs for adopting the new technology. Because it is difficult to secure sufficient returns to cover

the costs of introducing the new technology, firms will underinvest in the deployment of the already

available technologies.

Despite these concerns, competition in technology acquisition and use appears to be promoting

good performance from a social standpoint, if not from the standpoint of some individual competitors.

Describing the banking industry, Llewellyn (1995) reports both the immense pressure of increased

competition and the developments in technology that are changing the ways that financial services are

delivered. Holland et al. (1994) actually argue that the competitiveness of banking in the United States has

caused U.S. banks to be more innovative in their uses of IT. Schwarzwalder (1994) reports that the

database industry shows increasing competition among data banks, yet the result has been an increase in

the scope of existing services and new products and better choice of access for the corporate and academic

customers of on-line information services. According to Caldwell (1994), the new IT is generating a burst

of productivity on Wall Street. Competition in the use of the new IT is keen, and that competition has

caused firms to deploy technologies to cut costs and increase speed and flexibility.

3.2 TECHNICAL PERFORMANCE: A USER PERSPECTIVE ON TECHNOLOGY

BARRIERS

Insight into the sources of market failure can also be gained by assessing today’s IT applications

against IT performance criteria considered ideal by technical experts. In other words, we might ask of

today’s IT implementations, “Why is this IT implementation not operating as it should or as you would like

it to behave?” or, to put it another way, “What are the technological barriers to IT implementation?”

Information technology experts (Perine et al., 1996) regard the following five performance attributes as

essential to effective IT systems implementation:

• Usability (easy to learn and remember, productivity enhancing, error resistant, and friendly).
37

• Interoperability (two or more systems are able to interact with one another and exchange data

according to a prescribed method in order to achieve predictable results).

• Scalability (the system can be made to have more (or less) computational power by

configuring it with a larger (or smaller) number of processors, amount of memory,

interconnection bandwidth, input/output bandwidth, and amount of mass storage).

• Reliability (the system can be counted upon to perform as expected).

• Security (the ability of organizations and individuals to use information technology with the

assurance and trust that the confidentiality, integrity, reliability, and availability of information

resources are protected).

Accordingly, we draw examples from the literature representing these key attributes and illustrate

the pervasiveness of the IT implementation barriers in shaping the evolution of new IT technology across

the service sector. As we demonstrate below, each of these five IT performance attributes is important to

both suppliers and users of IT. While only selected examples are provided below, these were drawn from

an extensive review of hundreds of trade press articles and case studies extracted from a broad literature

review. Analysis of this literature suggests the persuasiveness of barriers to the realization of satisfactory

IT performance, across the 5 attributes and across the scores of industries that comprise the service sector.

Usability: Users of a technology must find the technology accessible, useful, and reasonably easy

to use. For example, Kirchner (1995) emphasizes that communications from personal computers are too

complicated. Transactions such as sending electronic mail or linking with the World Wide Web have

become less difficult recently, but users still cannot take these services for granted. Churbuck (1995)

reports that computer retailers face a staggering number of calls from users of computers needing

assistance. He reports that there is simply not enough profit in a commodity PC or in a CD-ROM to pay

for all of the assistance that unsophisticated customers need. Thus, technology and marketing are on a

collision course. The users of personal computers are demanding more sophisticated equipment, but the

new technologies have gone beyond the technical competence of typical users.

Scalability: Information technology is changing so rapidly that successful and efficient users must

be flexible and able to let their capabilities evolve with the changes in information technology without the

need for completely replacing existing technology with each new development. Thus, an information

technology environment must be scalable if the purchasers of the technology are to have the confidence to

invest in technology that will surely need to be upgraded regularly as IT evolves. For example, Wilken

(1995) reports that the provision of Switched Multi-megabit Data Services (SMDS) technology to the

printing industry by the regional Bell operating companies provides the scalability that printing firms need

to support the future applications because SMDS can be integrated with existing frame relay and Integrated
38

Service Digital Network (ISDN) technologies plus with the emerging technologies such as asynchronous

transfer mode (ATM). Thus, with SMDS technology Denigris (1994) observes that a telecommunications

company can help the users of its services plan to avoid the rapid obsolescence of systems purchased today.

Interoperability: Information technology must be interoperable to function in networks. The

growth in size and importance of networks increases this challenge. For example, Means (1995) observes

that the interactive broadband operations support systems (OSS) to manage billings for the proliferation of

products offered by cable and telephone companies will have to inter-operate with other network

components such as network management systems, various types of set-top boxes, and various types of

video and other database servers.

Reliability: The productivity of the information technology requires reliable equipment and

networks. For example, Terzian (1995) explains that the newness of asynchronous transfer mode (ATM)

technology requires that carriers and end-users pioneer the evaluation, installation, tune-up, and

maintenance of equipment. Each of these phases of ATM technology deployment requires specific testing to

meet requirements and to ensure success. Terzian describes several such tests — cell address verification,

ATM bit error rate tests, and traffic congestion tests — that service providers must use to determine

whether the quality levels specified in their contracts with customers are met and how the reliability

problems caused by traffic congestion can be treated with the tests described.

In other examples of the requirement for reliability, Levitt (1995) reports that integrated services

digital network (ISDN) is worth the additional cost relative to older telephone service because, among other

things, it is more reliable, and Rimmler (1995) discusses the need for new capabilities for testing to support

the functionality, reliability, and performance of a mature telecommunications network with advancedintelligence network services.

Security: The complete use of information technology's potential and its successful use requires

security in an information exchange. For example, Phillips (1995), in the context of a discussion of on-line

publishing, emphasizes major problems of authorship, copyright, confidentiality, privacy, and the

proprietary nature of information when placing it on publicly accessible computers. In another example,

Calem (1995) describes the large technological investment (in a neural net computer system that detects

patterns) being made by Visa International in order to develop effective monitoring of credit card activity to

reduce fraud. Flint (1995) observes that for ticketless travel to become widespread in the airline industry,

the electronic ticketing must, among other things, be protected from fraud. Chief among the hurdles to

secure electronic ticketing are passenger resistance, creation of various standards, airport egress/security
39

issues, fraud protection, and travel agent opposition. Experts warn that electronic ticketing contains

loopholes that could allow for fraudulent ticket purchases using stolen credit cards.

An information security survey conducted by InformationWeek/Ernst & Young (CMP Media, Inc.

1996) found that security is one of the biggest concerns among corporate Chief Information Officers and

that while most companies are using the Internet or intranet for vital business functions, many feel that the

information security measures for both are ineffective.

In summary, information technology that is not usable, scalable, interoperable, reliable, and secure

creates barriers to the acquisition and implementation of IT in service industries. Further, the provision of

these attributes is subject to the market failures discussed above because their providers face economic

barriers in technology, development, and implementation. An extensive literature review, and quantitative

estimates of service sector under investment reported in Chapter 4, suggest that the barriers discussed

above are being experienced throughout the service sector. Our case studies of specific industries (Chapters

5-8) further indicate that these barriers are causing significant underinvestment in IT.

3.3 PUBLIC SUPPORT OF THE TECHNOLOGY INFRASTRUCTURE

We have described a number of types of barriers to the acquisition, development, and use of IT and

provided examples of each type. Public policy can reduce these barriers and thereby improve the

development and transfer of technology. Effective public policy reduces barriers to technology by

improving appropriation of returns and reducing risk. Even if the private sector makes a maximum effort to

deal with IT in an infrastructure-poor environment, market failures could not be completely removed.

Market failure occurs in the dynamic sense because of the divergence of private and social perspectives

concerning the expected returns to investment. Private firms do not appropriate all of the returns to their

investments and they perceive more risk than society perceives; hence, they underinvest in the new

technology that could create the environment for a better use of IT.

Formulating public programs to support technology infrastructure requires a three-part process:

the development of policy rationales; strategic planning (involving government and industry); and economic

impact assessment. Identifying and characterizing systematic market failures is central to the first part of

this process. (Tassey, 1997)

Having established in Chapters 1 and 2 that the service sector contributes significantly to economic

growth, and that service sector outputs are increasingly technology-intensive, the next step is to identify and
40

characterize the nature and magnitude of underinvestments that occur as a result of the specific barriers to

technology development and implementation discussed above.

Once identified, it is also important to categorize barriers according to the most appropriate policy

response. Some types of market barriers are very general, affecting all technology development and

implementation activity. These types of barriers can be effectively addressed through R&D tax credits or

capital gains taxes. NIST, however, is particularly interested in identifying barriers that arise from a

market's or a technology's immaturity, its degree of publicness, or its potential to reduce market transaction

costs. The source of the barrier determines the appropriate policy response. (Tassey, 1977)

Underinvestments that arise from spillover barriers, interoperability barriers, information sharing

barriers, and barriers arising from the necessarily shared nature of test and verification techniques are most

effectively addressed through direct government funding of infratechnology development programs. Joint

government-industry funding, on the other hand, is the most effective policy response to underinvestments

that arise from recognition barriers, time-to-market barriers, and barriers associated with excessive

competition among developers or users. This policy response framework will inform much of the case study

analysis presented in chapters 5-8.

Once barriers are identified and characterized, their significance needs to be assessed. Industry

participation is essential at this stage because industry is the principle source of market insight and viable

technology programs require industry support. It is often very difficult to convey the nature and importance

of the technology infrastructure to policy makers. While this infrastructure is central to the competitive

strength of industries, it is often only appreciated by those with a detailed and sophisticated appreciation of

the institutional system that sustains technology development and implementation. Industry participation in

the process of identifying and characterizing the focus of technology programs, as well as their costs and

benefits, add immeasurably to the credibility of program planning and, ultimately, the viability of program

execution.

The following chapters are intended to support NIST's policy formulation process with a detailed

assessment of specific barriers to technology development and implementation in the service sector. The

scope of service sector's underinvestment in IT is estimated and specific barriers are identified and

characterized through detailed case studies involving senior technology managers in high-tech service

industries. It is our intention to make a contribution to the development of policy rationales for NIST's
41

engagement with the service sector and to do so in a manner that at least facilitates progress toward the

second stage of the policy analysis, strategic planning.

3.4 CONCLUSION

The role of the market failure concept is central to the analysis of public policy. This is especially so

regarding public technology policy because of the widely shared understanding that investments in science

and technology are subject to serious barriers and market failures. We have reviewed the concepts of market

failure, underinvestment, and barriers to technology, and explained their relationships. We discuss eight

distinct barriers to technology development and use, and provide examples from across the service sector as

well as technical performance barriers. Finally, these barriers can be related to the technology policy

instruments available to NIST. The conceptual apparatus developed in this chapter is core to the in-depth

analysis of sources and uses of technology in the three industries selected for case study. (Chapters 5-8) It is

also central to the policy discussions and recommendations that follow the case studies. (Chapter 9)
42

4. STATISTICAL ANALYSIS OF ECONOMIC PERFORMANCE AND MARKET

FAILURE IN THE SERVICE SECTOR

4.1 INTRODUCTION

Available statistics and trade literature provide a useful overview of the broad dimensions of

technology development and implementation in the service sector. Based on this information we are able to

articulate a number of important issues:

• Information technology appears to be at the heart of technological change in the

service sector.

• Technology development occurring within the service sector appears to be dominated

by the communications services and the computer services industries. IT and ITrelated technologies comprise an important element of the complete portfolio of

technologies developed within these two service industries so that as much as half of

all service sector R&D is devoted to IT.

• The vast majority of technology used in the service sector originates in the

manufacturing sector and significant service sector resources are expended to

implement this technology.

• The professional trade literature describes pervasive technology development and

implementation barriers that can be interpreted from both a market incentives

perspective and the user’s perspective.

However, while available statistics and literature are often suggestive of the seriousness of barriers to

technology faced by service sector firms, they are insufficient for assessing the nature and extent of the

barriers to technology in the detailed and systematic fashion necessary for NIST planning purposes.

In this chapter, we begin to “drill down,” systematically, to understand the extent to which service

sector firms are experiencing barriers to technology and to understand what effect, if any, these barriers are

having on the competitive performance of service sector firms. As part of our statistical analysis, we

explore the usefulness of various types of data for capturing important aspects of technology development

and use in the service sector.

The statistical analyses presented in this chapter are rich is some dimensions and wanting in others.

We are able to suggest the possibility of an underinvestment in IT, but we are also able to show that this

underinvestment trend is not characteristic of all service sector firms. In fact, we provide some evidence

that barriers to the adoption and implementation of IT may be overcome, in part, by firms through certain

institutional activities and arrangements. However, we conclude that definitive answers cannot be
43

determined from a broad-based statistical analysis, such as we present here, without specific case-based

information The combination of the analysis in this chapter together with the in-depth case-based

information in Chapters 5-8, begins to develop a relatively detailed picture of the barriers to technology that

exist in the development and implementation of IT.

There is a growing literature documenting the increase in investment in information technology and

the lack of a measurable productivity response. This is especially the case among service industry firms. As

Brynjolfsson (1993, p. 67) notes:

The relationship between information technology (IT) and productivity is widely discussed

but little understood. Delivered computing power in the U.S. economy has increased more

that two orders of magnitude since 1970 ... yet productivity, especially in the service

sector, seems to have stagnated.

In this chapter, we estimate the IT-to-productivity relationship using a large cross-sectional and

time series of data assembled by Brynjolfsson and Hitt, arguably the most complete and widely-cited data

base related to IT in service sector firms. We ask, based on these data, if statistical-based analyses are

capable of quantifying an underinvestment in IT. 40,41 If so, then we ask if such an econometric approach is

sufficiently robust to identifying particular technology barriers at a level detailed enough to inform

technology policy decisions on NIST’s part.

For readers who are only interested in the outcome of the statistical investigation, the following

section 4.2 provides a brief summary of the statistical analysis and its conclusions. The reader so inclined

can skip from section 4.2 to the case study analysis presented in Chapters 5-8. For those interested in the

more detailed methodological aspect of the analysis, these are presented in sections 4.3 - 4.5.

 

40 We use the term "statistical-based" to refer to conclusions reached through traditional econometric analyses germane to

economic studies. Our use of that term is not intended to suggest that case-based studies are neither systematic in design

nor quantitative in nature. In fact, the primary conclusions set forth in this report are derived from case analyses. Rather,

we segment the empirical investigations in this report into two broad categories: statistical (econometric) in this chapter

and case-based in Chapters 5-8.

41 In sections 4.4 and 4.5 we supplement the Brynjolfsson and Hitt data set with information from other data sets related to

patenting activity and collaborative research activity, respectively.
44

4.2 INVESTMENTS IN INFORMATION TECHNOLOGY: ANALYSIS IN BRIEF

4.2.1 Quantifying the Barriers to IT Investment

Using standard statistical techniques and detailed data from 300 service sector firms we can make

some important observations about the nature and significance of barriers to IT investment in the service

sector.

Our analysis shows that a $1 investment in IT capital contributes substantially more to value added

than a $1 investment in non-IT capital. A $1 increase in investment in IT capital yields a $1.96 increase in

value added in each period. In other words, these results imply that the rate of return on IT capital is 196

percent. A $1 investment in non-IT capital yields $0.11 each period, or a rate of return of 11 percent.

This finding is interpreted to suggest that firms in service industries are, on average, realizing

sizable positive returns to their investments in IT. Certainly, 196 percent is greater than the hurdle rate used

in most private sector firms for R&D investment decisions, perhaps by a factor of about 16. If, following

best practice, firms choose sequentially from a potential list of investment projects — first those with the

highest rate of return, then the next highest rate of return, etc. — a rate of return on IT capital projects of

196 percent (relative to 11 percent on non-IT capital), suggests that “something” is preventing firms from

making highly productive investments in equipment embodying IT.

The statistical analysis that supports this finding is based on traditional production theory drawn

from the economics literature and begins with a model of how various resources affect the economic

performance of the firms being studied. We begin by statistically estimating the values of ρo through ρ3 in

the following model:

ln(VA) = ρ0 + ρ 1 ln(L) + ρ 2 ln(ITK) + ρ 3 ln(NITK) + ε

In this model, competitive performance is measured as value added (VA); the resources used to

create VA are labor (L), IT capital (ITK) and non-IT capital (NITK). We statistically estimated the values

of ρo through ρ3 and used that information to calculate the productivity of IT and non-IT capital. We find

that the $1 invested in IT capital is significantly more productive than $1 invested in non-IT capital and

that the discrepancy suggests barriers to greater investment in IT capital. This finding is perfectly

consistent with the evidence presented in preceding chapters describing barriers to the development and
45

implementation of IT; barriers that are preventing the greatest utilization of technology, and therefore, we

believe, barriers to the fullest growth and development of the service sector.

4.2.2 Quantifying the Strategic Response to IT Barriers

Having established a quantitative measure of the scale of the barriers faced by service sector firms,

we asked what standard statistical techniques could tell us about the effectiveness of actions taken by firms

to overcome investment barriers. What makes this question most difficult is the paucity of reliable

indicators of firms’ strategic behavior in the realm of technology.

Firms react to technology barriers in a number of ways: they invest time and resources to cope with

the problems thrown up by the barriers; they increasingly invest in internal technology development

projects; they engage in collective R&D efforts with other members of their industry; and they become

involved in industry-wide activities such as standard-making and industrial association events focused on

addressing technology issues. In an attempt to quantify some of these activities, and to understand their

competitive impact, measures of collaborative research and patenting practices were introduced into our

statistical analysis.42

Research Joint Ventures. Our analysis shows that service sector firms engaged in research joint

ventures (RJVs) perform more competitively, and are investing more in IT, than firms that are not so

engaged. This suggests that firms are using collaboratively-generated R&D knowledge to increase the

efficiency with which they utilize all forms of technology, IT included.

To explore whether service sector firms are systematically relying on collaborative research

relationships to eliminate elements of risk associated with the acquisition and implementation of IT, we

estimate the following version of our statistical model:

ln(VA) = ρ 0 + ρ 1 ln(L) + ρ 2 ln(ITK) + ρ 3 ln(NITK) + ρ 4 D_RJV + ε

where the value of D_RJV is 1 if the firm participated in an RJV in a particular year, and 0 otherwise.

 

42 Neither patenting activity nor RJV membership are thought to be the only response to the technology barriers faced by

service sector firms. We regard them merely as readily quantifiable evidence that firms are engaged in self-conscious,

strategic, conduct to mitigate barriers to technology development and use. We suspect that if they are so-engaged, they are
46

The estimated coefficient on D_RJV (ρ 4) is positive and statistically significant as is the estimated

coefficient on IT capital (ρ 2). In fact, ρ 2 increased nearly 70 percent over a baseline calculation indicating

that the productivity of IT capital increases substantially for service sector firms involved in collaborative

research. We also observe that firms engaged in RJVs invest more in IT than firms not so engaged (2.86

percent of value added compared to 1.98 percent). This suggests that service sector firms that are involved

in collaborative research relationships have found some solutions to IT barriers that makes their more

intensive investment in IT profitable when compared to service firms that are not involved in collaborative

efforts.

Patents. Patents are another indicator of firms’ attempts to overcome barriers to technology

development, especially the appropriability problems that plague such efforts. Our analysis indicates that

systematic and focused technology development efforts by firms (as indicated by clusters of inter-related

patents) has a positive impact on firm performance. However, the relationship between such technology

development activities and IT investment cannot be adequately explained.

To explore whether service sector firms are systematically relying on internal innovation efforts to

overcome barriers to IT investment we examined the total amount of patenting activity as well as the

integral nature of that activity. Accordingly, the following statistical model was evaluated:

ln(VA) = ρ 0 + ρ 1 ln(L) + ρ 2 ln(ITK) + ρ 3 ln(NITK) + ρ 4 SELFCIT + ρ 5 ln(TP) + ε

where SELFCIT represents the percent of all citations in a company’s portfolio of patents that link to its

own prior patents, and ln(TP) represents the total patents issued to a firm.

The results of our statistical analysis show no evidence that the total amount of patenting activity

(or the underlying R&D activity that patenting behavior represents) contributes, in a statistical sense, to

firm performance (in terms of VA). The coefficient (ρ4) for self-citation is positive and statistically

significant. The direct productivity impact of self-citing activity on IT capital could not be discerned.

In summary, we have quantified the economic impact of barriers to IT investments by service

sector firms and find the rate of return on IT capital several times higher than expected. This indicates that

__________________________________

also engaged in other mitigating activities with respect to technology.
47

firms are somehow being prevented from investing in IT. Otherwise investment in IT projects would have

proceeded and pushed the rate of return on such projects closer to the typical return on investment project.

We can also distinguish types of conduct on the part of service sector firms that appear to mitigate these

barriers to IT investment. Service sector firms that systematically attempt to protect their investments in

technology development, and those that participate in collaborative R&D activities, are investing more in

IT capital than service sector firms that do not engage in such activities.

While these results are important and constitute a logical first step in policy assessment, statistical

analysis of even the best available firm-level data is insufficient to provide the detailed level of insight into

technology barriers and their causes required for NIST planning purposes. For this, in-depth case study

analysis is required. The following chapters provide such analysis for selected services sector industries.

4.3 INVESTMENTS IN INFORMATION TECHNOLOGY

4.3.1 The Empirical Model

Our analysis begins with a general conceptual representation of the functional relationship between

a firm's inputs and its output. We characterize output as value added, VA, and inputs as labor, L, and

capital, K, in the following way:

 (1) VA = F (L, K)

where VA can also be viewed as a measure of the economic performance of the firm.

This is a common starting point is the empirical literature related to productivity growth and

returns to investments in technology. Equation (1) is no more than a stylized representation of the fact that

a firm combines labor (L) and capital (K) to produce output or to add value (VA) in production. In fact, in

a general sense, equation (1) is simply the production stage of the technology-based economic growth

model originally presented in Figure 4-1.

As is common in the economic, and particularly in the productivity growth literature, a specific

functional form is assumed for equation (1). A mathematical specification is needed in order to derive

certain economic properties of the general production function. The mathematical specification often used

is called a Cobb-Douglas production function:
48

(2) VA = A Lα Kβ

where A is a disembodied shift factor, and α and β are the relative share of income distributed to

labor and capital, respectively.43 Our choice of this Cobb-Douglas specification is not arbitrary. The

mathematical form of the production function in equation (2) represents the simplest and most commonly

used specification. Labor’s relative share of income is α, and capital’s relative share is β. These are

referred to by economists as “elasticities,” meaning measures of responsiveness.) Alpha represents the

percentage change in value added attributable to a given percentage change in labor (i.e., a 10 percent

increase in labor, all else remaining constant, leads to an α percent increase in value added). A similar

interpretation holds for capital’s relative share, β. So defined, quantitative estimates of L and Κ will be

related to statistical measures of the productivity of labor and capital, respectively. (In equation (6) below,

the value of ρ 1 corresponds to α and the values of ρ 2 and ρ 3 correspond to β.) 

Fundamental to this study is the fact that the stock of capital used in service sector firms is not

homogeneous as represented by the variable K in equations (1) and (2), rather, the stock of capital is

heterogeneous being separable into capital that embodies information technology, ITK, and capital that

does not (non-information technology embodied capital), NITK, thus:44

(3) K = ITK + NITK

This distinction is captured in Figure 4-1.

Based on equation (3), equation (2) can be rewritten as:

 (4) VA = A Lα ITKβ

1 NITKβ2

 

43 See Link (1989) for a review of the relevant literature. The Cobb-Douglas specification is discussed here for ease of

presentation. However, generalized transcendental logarithmic (translog) production functions are frequently referred to in

the literature. While the econometric results presented below are for the Cobb-Douglas model, translog estimates were also

made (not presented). The findings from the latter provide little if any additional insight into the question at hand.

44 For a more detailed discussion of these concepts, see Brynjolfsson and Hitt (1995, 1996b, 1996c).
49

Figure 4-1. Disaggregation of Capital Stock in Service Sector “Production” Model

LABOR IT

CAPITAL

STRATEGIC

PLANNING

MARKET

DEVELOPMENT

VALUE

ADDED PRODUCTION

NON-IT

CAPITAL

And as with equation (2), β1, is the relative share of income distributed to information technology

capital and β2 is the relative share of income distributed to non-information technology capital.

Taking the natural logarithm of both sides of equation (4) for the purpose of deriving a relationship

that can be estimated econometrically:

 (5) ln(VA) = ln(A) + α ln(L) +β1 ln(ITK) + β2 ln(NITK)

and introducing a normally distributed random error term, ε, into equation (5), an econometric specification

results:

 (6) ln(VA) = ρ0 + ρ 1 ln(L) + ρ 2 ln(ITK) + ρ 3 ln(NITK) + ε

Equation (6) is a common starting point for a statistical analysis. Given a set of firm data on value

added, labor, information technology capital, and non-information technology capital, one can estimate the

values of ρo through ρ3. One can then infer the productivity impact of investments in IT on the basis of the

size and statistical significance of the estimated regression coefficient on the regressor ln(ITK), namely ρ2.

From equation (6), ρ2 is the relative share of IT capital also known as the output elasticity of the stock of

IT capital, the percentage change in value added divided by the percentage change in IT capital. This

estimated elasticity, multiplied by the ratio of VA to ITK yields a calculated value of the marginal product

of IT capital. Calculating the marginal product of IT capital using mean values of VA and ITK is:

MPITK = ρ 2 (VAmean / ITKmean)
50

Certainly, if investments in information technology are at a level that enhances the performance of

service sector firms, then the estimated coefficient on ln(ITK), ρ2, will be positive and statistically different

from zero.

4.3.2 The Data and Empirical Results

Our data was constructed from information contained in the Standard and Poor’s Compustat data

file. That file consists of production and financial data for all publicly-traded companies in the United

States, assembled from primary information reported in companies’ annual reports, 10-K forms, and

similar public documents. Each firm is also assigned a 4-digit Standard Industrial Classification (SIC) code

which was used to segment the firms by sector.

For the purposes of this study, data in the Compustat file relate to firms’ inputs and outputs,

specifically, value added, the firm’s stock of labor, and the firm’s total capital equipment investments.

These reported data were supplemented with survey data collected by Brynjolfsson and Hitt.

The Brynjolfsson-Hitt data set, arguably the most complete and widely-cited data set related to

investments in information technology, is a quasi-balanced panel across service industries. Data exist for

nearly 300 firms covering the years 1987 through 1994.45 Hence, the final data set captures cross-service

sector firm performance over a period of 8 years. Table 4-1 shows selected descriptive statistics on the

variables defined by equation (6).46,47 And, Table 4-2 shows the number of observations in the panel, by

year. Hence, our estimation of equation (6) utilizes 2,247 observations (where each year of data is

controlled for, in a statistical sense, by a time dummy).

 

45 A complete discussion of database construction issues is found in Brynjolfsson and Hitt (1995, 1996b, 1996c).

46 To preserve the proprietary nature of this data set, Brynjolfsson and Hitt performed the statistical analyses described below.

47 While the value of ITK may appear low relative to other values, recall from Chapter 2 that direct investments in IT

represent only a small part of the total IT-related expenditures. In fact the literature suggests that, in general, IT-related

implementation costs can be 5 times direct IT cost.
51

Table 4-1. Brynjolfsson-Hitt Data Set: Descriptive Statistics

(n=2,247)

Variable Mean

VA $915.99

L 492.75

K $1,772.24

ITK $14.01

NITK $1,737.15

__________

Note: Value added and both capital stock measures are in millions of $1990; labor is in units.

Table 4-2. Description of the Brynjolfsson-Hitt Panel, by Year

(n=2,247)

Year No. Observations

1987 235

1988 241

1989 257

1990 261

1991 277

1992 294

1993 324

1994 358

The least-squares regression results from the estimation of equation (6) are in Table 4-3. The

regression results clearly demonstrate that all three of the inputs into production have, averaged across all

firms in the data set, a productive impact. In other words, ρ1, ρ2, and ρ3 from equation (6) are not only

positive but they are statistically significant. Of particular emphasis is the statistical importance of

investments in IT on firm's performance. The estimated coefficient on the IT capital stock variable, ρ2, is

positive and statistically significant at the 0.01 level. Also held constant in the version of equation (6)

estimated and presented in Table 4-3 are industry and time dummy variables. Industry dummies correspond

to the two-digit SIC service industry of the firm, and time dummies account for the year of the observation.

Compared to a regression corresponding to equation (2) above in which the capital stock is not

decomposed into information and non-information technology, the estimated coefficient on ln(NITK) in
52

Table 4-3 is only slightly less than that on ln(K), 0.21 from equation (6) compared to 0.22 from equation

(2); and correspondingly, little overall explanatory power is gained from the decomposition of the capital

stock as evidenced by R2 remaining virtually unchanged. (The reader is warned not to infer from this any

information about the relative productivity impact of IT. To do that, calculated marginal products, rather

than estimated elasticities are needed, as discussed below.)48

Table 4-3. Least-Squares Regression Results for Equation (6)

(t-statistics in parentheses; n=2,247)

Variable Equation (6)

ln(L) 0.69

(65.33)

ln(ITK) 0.03

(4.82)

ln(NITK) 0.21

(21.67)

industry dummies yes

time dummies yes

R

2

0.93

We hypothesize the regression results in Table 4-3 as the baseline results from which we generalize

about service sector firms' investments in IT and resulting productivity gains. Not only is the estimated

coefficient on ln(ITK) positive and significant, but also the results indicate that a $1 investment in IT

capital contributes substantially more to value added than a $1 investment in non-IT capital, ceteris

paribus. The calculated marginal product for IT capital, based on the regression results in Table 4-3, is

1.96 compared to 0.11 for non-IT capital. A $1 investment in IT capital yields $1.96 each period, or if

there were no depreciation that yield would continue in perpetuity, and hence in that sense the literature

would sometimes refer to this results as implying that the rate of return on IT capital is 196 percent. A $1

investment in non-ITK yields $0.11 each period, or for the case of no depreciation, a rate of return of 11

percent. This finding is interpreted, to suggest that firms in service industries are on average realizing

sizable positive returns to their investments in IT.

 

48 As discussed at the end of the previous section, additional information (the ratio of VA to ITK) is needed to understand the

productivity impact of IT investments.
53

Absent information on the long-run return on investment in IT, we cannot say with certainty

whether firms are underinvesting in IT. Compared to the rate of return earned by manufacturing firms on

their self-financed R&D capital however, 196 percent is high, by a factor of four, thus suggesting that

service sector firms are indeed underinvesting in the technology.49 And certainly, 196 percent is greater than

the hurdle rate used in most private sector firms for R&D investment decisions, perhaps by a factor of

sixteen.

In an effort to examine in greater detail the nature of the market failure that leads to this quantified

underinvestment in IT, two alternative market concepts are investigated: participation in research joint

ventures, viewed as an industry mechanism to overcome barriers to the development and use of new

technical knowledge; and patenting behavior, viewed as an effort by firms to develop and exploit

marketable technology. Participation in research joint ventures is considered in the following section.

Patenting behavior in considered in section 4.5.

4.4 COLLABORATING IN RESEARCH AS AN INDICATION OF MARKET

FAILURE

Economic theory as well as case-based literature suggests that firms participate in collaborative

research ventures in an effort to, among other things, increase the speed with which generic technological

information is created. All members of the venture, and generally non-members from the industry, benefit

from having this information sooner, and at a lower cost, than if each member conducted research on its

own.50

More specifically, Link and Tassey (1987, pp. 10-11) hypothesize that RJVs are formed as part of

an overall strategy for technology-based competition:

Technologies are evolving, penetrating, and maturing faster. This comes from more rapid

advances in generic technology by foreign industries based on government support and

cooperative industrial research, as well as from more intense world competition which

brings about a faster penetration and maturation of products. Similarly, cycles are

evolving at faster rates. . . . In other words, firms can no longer rely solely on an

innovative strategy based on internal R&D. A broader strategy is needed. . . . [S]uccessful

technology-based strategies . . . must rest more and more on the realization of economies

 

49 For one summary of the R&D rate of return findings in the literature, see National Science Board (1996).

50 See Link and Bauer (1989) on this point.
54

of scope . . . [T]he functional areas within the firm must be efficiently integrated and the

firm must be integrated within a complex infrastructure which includes other firms in its

domestic industry.

And, there is growing evidence that in the absence of this type of arrangement, competitiverequisite research might not be conducted by anyone, or if so it might not be done in a timely manner.51 As

such, collaborative research efforts are important not simply for U.S. industries to continue to compete, but

for them to compete more effectively in technologically-progressive global markets.52 Thus, the formation

of an RJV can be interpreted as an institutional arrangement designed to overcome selected barriers in

technology that could lead to market failure.

Meltzer (1993) notes that some service sector firms, in an effort to overcome the aspects of

technology-specific risk, are of the opinion and practice that collaborative R&D development of

appropriate IT products, services, and environments is essential for generating sustained economic growth.

Congress approved the National Cooperative Research Act of 1984 (PL 98-462) and its 1993

amendment, the National Cooperative Research and Production Act (PL 103-42) in an effort to stimulate

collaborative research.53 Firms seeking antitrust indemnification under these Acts are required to file

notification of their collaborative intentions with the Department of Justice, and this information is made

public through notices in the Federal Register. RJVs gain two significant benefits from such voluntary

filings: if subjected to a criminal or civil antitrust action, they are evaluated under a rule of reason that

determines whether the venture improves social welfare; and if found to fail a rule-of-reason analysis, they

are subjected to actual rather than treble damages.

The COllaborative REsearch (CORE) database on research joint venture (RJV) activity was

constructed from information in Federal Register filings for use by the National Science Foundation.54

Through the end of calendar year 1995, 561 separate RJVs have been filed with the Department of Justice

as reported in the Federal Register.55

 

51 See Link (1996b) for documentation of this for selected RJVs.

52 See Link and Tassey (1987).

53 See Link (1996a) for background information on these initiatives.

54 See Link (1996a) for a detailed discussion of the construction of the CORE data base.

55 RJVs must re-file if their membership changes or if the scope of their activity changes. Such refilings are not treated as new
55

An inspection of these filings, by sector, reveals that the prevalence of RJV activity is greater

among manufacturing sector firms compared to service sector firms. But, there is year-by-year variability

in the percentage of RJVs filed by firms in each sector. See Table 4-4,

Table 4-4. RJVs Formed by Year

(n=561)

Year % Service Sector

1985 26% (of 50 filings)

1986 6% (of 17 filings)

1987 27% (of 26 filings)

1988 32% (of 31 filings)

1989 26% (of 27 filings)

1990 37% (of 46 filings)

1991 27% (of 62 filings)

1992 32% (of 59 filings)

1993 26% (of 72 filings)

1994 8% (of 63 filings)

1995 16% (of 108 filings)

__________

Source: CORE database

To explore, in a rather general fashion, whether service sector firms are relying on collaborative

research relationships in a purposeful way to eliminate elements of risk associated with the acquisition and

implementation of IT, we estimate the following model:

 (7) ln(VA) = ρ 0 + ρ 1 ln(L) + ρ 2 ln(ITK) + ρ 3 ln(NITK) + ρ 4 D_RJV + ε

where D_RJV is a binary variable equal to 1 if the firm participated in an RJV in a particular year, and 0

otherwise.56

__________________________________

collaborative research arrangements in the CORE data base.

56 The RJV data come from the CORE data base and supplementary information provided by Vonortas (forthcoming). Recall

that the sample of firms is a cross-sectional sample, pooled by year.
56

For the sample of service sector firms, about 7.2 percent have been involved in at least one RJV

over the relevant years, as based on information in the CORE database.

Owing to the binary nature of the D_RJV variable and its systematic cross-industry variability,

equation (7) was estimated with a constant term rather than a vector of industry dummies. As shown in

column (1) of Table 4-5, the estimated coefficient on D_RJV is positive and statistically significant at the

0.01 level, as is the estimated coefficient on IT capital. In fact, the estimated regression coefficient on

ln(ITK), and hence the marginal product of IT capital, has increased nearly 70 percent over that calculated

from the baseline model in equation (6) (Table 4-3) ó 0.03 compared to 0.05.

Table 4-5. Least-Squares Regression Results from Equation (7)

(t-statistics in parentheses; n=2,247)

Variable Equation (7) Equation (7a)

ln(L) 0.71

(81.17)

0.71

(81.01)

ln(ITK) 0.05

(6.82)

0.05

(6.75)

ln(NITK) 0.18

(27.47)

0.18

(27.46)

D_RJV 0.10

(3.22)

0.10

(31.04)

ln(ITK)*D_RJV — 0.00073

(0.04)

constant 0.94

(20.13)

0.94

(20.00)

time dummies yes yes

R

2

0.91 0.93

Regarding the significance of the estimated coefficient on D_RJV, the results shown in Table 4-5

support the view that collaborative research does indeed contribute to value added.57 We interpret the

calculated increase in the value of the marginal product of IT capital to suggest only that equation (7) is

possibly better specified than was equation (6). Again, statistics confirm that service sector firms are

underinvesting in IT as evidenced by apparently above normal returns to IT capital.

To explore further the relationship between RJV activity and the productivity of IT, we reestimated equation (7) with an interaction term, ln(ITK)*D_RJV, as an additional regressor so that

 

57 Link and Bauer (1989) documented the productivity gains and R&D efficiency gains associated with collaboration.
57

separate marginal products can be compared for each subset.58 The results are shown for equation (7a) in

Table 4-5. The regression coefficient on the ln(ITK)*D_RJV variable was not statistically significant,

owing perhaps to multicolinearlty with the D_RJV term. Hence, these regression results are inconclusive.

But, we did compare the mean level of investment in IT by service firms participating in RJVs. For

RJV-active firms (n=161) the mean annual investment level in IT is 2.86 percent of value added compared

to 1.98 percent for the other firms (n=2,086). This suggests that service sector firms that are involved in

collaborative research relationships have found some solutions to IT barriers that make their more intensive

investment in IT profitable when compared to service firms that are not involved in collaborative efforts, or

that these firms are using the collaboratively-generated R&D knowledge to increase the efficiency with

which they utilize all forms of technology, IT included.

4.5 APPROPRIATING TECHNICAL KNOW-HOW: AN INDICATION OF

MARKET FAILURE

The new information technologies that are affecting the performance of firms in the service

industry, as evidenced from the literature discussed in Chapter 2, are typically developed by manufacturing

firms. According to the case studies reported in Chapters 5-8, service sector firms purchase that technology

and then augment it through their own RDT&E investments. Patenting activity is a means by which a firm

can appropriate the benefits of these investments. The ability to appropriate technical information has been

shown in studies of the manufacturing sector to enhance productivity growth.

The Brynjolfsson-Hitt data set can accommodate only a cursory examination of patenting activity

in service industries. Only about 35 of the 300 or so service sector firms in the data set patented inventions

over the 1987-1994 period (resulting in 270 of the 2,247 panel observations); thus, because we do not have

relevant information to determine the extent to which this sub-sample is representative of overall service

sector patenting behavior, the conclusions that follow are at best tentative. Albeit a small subset of the

population of service industry firms, it nevertheless does facilitate an exploratory statistical examination in

 

58 The “interaction term” is an extended version of regression equation (10). It’s use facilitated our investigation of the effect

of RJV participation on both value added and on the marginal product of IT for RJV-active firms compared to the marginal

product of IT for non-RJV-active firms. From an econometric perspective, it is more efficient to examine both of the latter

effects in a single equation. An “interaction term” is defined as the multiple of the product of two regressors. When D=0,

ln(ITK)*D_RJV=0; when D=1, ln(ITK)*D_RJV=ln(ITK). When D=1 the impact of IT on VA in the sum of the regression

coefficient on ln(ITK) plus the regression coefficient on the interaction term, ln(ITK)*D_RJV.
58

an effort to glean some indication of the nature of the patenting activity undertaken and the possible

implication of that activity on investments in IT.59

To investigate such purposeful appropriability efforts among service sector firms, we estimate

equation (8), a variation of equation (6):

 (8) ln(VA) = ρ 0 + ρ 1 ln(L) + ρ 2 ln(ITK) + ρ 3 ln(NITK) + ρ 4 ln(TP) + ε

where ln(TP) represents the total patents issued to a firm.60

The range of patents for these service sector firms over this time period is 5 to 2,638 with a mean of about

29.61

As reported in Table 4-6, the estimated coefficient on ln(ITK) for equation (6), for the sub-sample

of patent-active service firms, is 0.20. This estimated coefficient is not significantly different from zero.

(The reader should note that this is the same specification of equation (6) as above with a sub-sample of

only 270 observations from patent-active service firms.) The regression results for equation (8) show no

evidence that patenting activity (or the underlying R&D activity that patenting behavior represents)

contributes, in a statistical sense, to output. In addition, these regression results show that the estimated

coefficient on IT capital is statistically insignificant. In other words, patent-active service sector firm that

invest in IT capital are either overinvesting in the technology, thus driving the marginal product of IT

toward zero, or are using what technology they have in a grossly inefficient manner. If the former

conjecture is valid, then firms in this sample are, on average, overinvesting in IT owing to their ability to

appropriate the economic benefits from such investments. Stated differently, the inability of service sector

firms to appropriate the benefits of investments in R&D needed to make information technology productive

creates a market failure, and an underinvestment in IT results.

 

59 And, to our knowledge this represents the first empirical effort of this type.

60 Underlying equation (8) is a production function like: VA = ALα

ITKβ1NITKβ2TPα where α is the relative share of the stock

of patents. The intuition behind such a production function is that a firm’s patent portfolio captures an independent -

synergistic - aspect of its technological capabilities, and these capabilities add value in production.

61 Patent data were provided by CHI Research, Inc. (1996c).
59

In an effort to explore this result in more detail, an alternative patenting measure was constructed,

namely an index of self-citations. A firm’s patents typically cite prior academic literature and other patents,

including its own prior patents. According to Narin (1991):

[H]ighly self-citing networks of patents are a sign of company strength. In analyzing

citation networks it is quite apparent that when a company has an important technological

advance it will attempt to patent around that advance, to obtain defensive patents on the

periphery of the advance, and to extend its scope by building on the invention in the key

patent. Important patents are usually apparent not only as a single highly cited patent, but

as clusters of patents, and companies that have a well-organized technology seem to have a

larger number of highly linked patents. In this sense, at least, self-citation at the corporate

level appears to be an indicator of strength in corporate technology policy, and certainly

not one of weakness.

Thus, based on this observation by Narin, and his supporting research, we hypothesize that service

sector firms that have a high self-citation ratio are those that are systematically engaging in patenting

activity to appropriate new technology, recalling that the dominant technology in the service sector is IT.62

Accordingly, we estimate the following two models:

 (9) ln(VA) = ρ0 + ρ 1 ln(L) + ρ 2 ln(ITK) + ρ 3 ln(NITK) + ρ 4 SELFCIT + ε

 (10) ln(VA) = ρ 0 + ρ 1 ln(L) + ρ 2 ln(ITK) + ρ 3 ln(NITK) + ρ 4 SELFCIT + ρ 5 ln(TP) + ε

where SELFCIT is the percent of the total citations of each firm's patents received that are attributable to

the firm's citations of its own, previously patented technology.63

In the sub-sample, the mean self-citation ratio is 0.075 with a range of 0 to 0.67.

As shown in Table 4-6, the estimated regression coefficient on SELFCIT for equation (9) is positive,

but only marginally significant. However, when the total patenting activity of each firm is also held constant

ó as specified in equation (10) ó the size and the level of significance of the self-citation variable increases.

 

62 Self citations are the percent of the total citations a firm's patents receive that are attributable to the firm's citations of its

own, previously patented, technology. If a firm's portfolio of patents receives 100 citations and 20 of those citations are

from the company's patents citing previously patented technology, then self-citation ratio is 0.20.

63 These data were calculated by CHI Research, Inc. (1996c).
60

This increase is not due to collinearity, as evidenced by an insignificant correlation coefficient. As reported

for equations (10) and (8), the productivity impact of IT capital cannot be distinguished from zero.

Table 4-6. Least-Squares Regression Results for Equations (6), (8), (9) and (10)

(t-statistics in parentheses; n=270)

Variable Equation (6) Equation (8) Equation

(9)

Equation (10)

ln(L) 0.58

(8.31)

0.57

(8.27)

0.58

(8.21)

0.57

(8.13)

ln(ITK) 0.02

(0.84)

0.02

(0.67)

0.01

(0.45)

0.01

(0.26)

ln(NITK) 0.37

(5.90)

0.36

(5.82)

0.38

(6.60)

0.39

(6.17)

ln(TP) — -0.01

(-0.66)

— -0.02

(-1.22)

SELFCIT — — 0.31

(1.40)

0.40

(1.72)

industry dummies yes yes yes yes

time dummies yes yes yes yes

R

2

0.94 0.94 0.94 0.94

We offer two possible explanations for the overall pattern of results in the regressions reported in

Table 4-6 regarding self-citations. If indeed the technology being appropriated by the self-citing firms is

related to IT, then the insignificance of the IT variable may suggest that these patent-active service firms,

compared to all service sector firms ó Table 4-3 ó are able to overcome, through their purposeful

technology development, barriers to the effective acquisition and implementation of IT.

Thus, we tentatively conclude that the results in Table 4-6 are suggestive of the fact that these selfciting firms are, in response to self-developed appropriable technology boundaries, overinvesting in

information technology, thus driving its marginal return toward zero. Alternatively, the appropriable

activities of self-citing firms are such that they drain the resources needed to effectively adopt and use IT,

and thus the IT that is in place is simply unproductive.

While these competing interpretations cannot be resolved from this small sample of patent-active

firms ó or from any data set that we are aware ó we do observe from the underlying data that the mean

level of investment in IT by patent-active service sector firms is over two times that of non-patent-active

service sector firms. That is, patent-active firms allocate, on average, a larger portion of their output to IT

ó 2.27 percent of their value added to IT compared to only 2.11 percent in non-patent-active firms. This is
61

consistent with the interpretation that firms that are systematically engaged in protecting technology

development efforts with patents are overinvesting in IT.64

4.6 CONCLUSIONS

The statistical findings presented in this chapter complement the findings presented in earlier

chapters. Whether one surveys the literature or examines econometrically broad-based data sets, available

facts all point to the conclusion that, by and large, service industry firms are underinvesting in information

technology, presumably due to various technology barriers.65 Both sources lead to the same conclusion that

to determine specific technology barriers that bring about these underinvestments, survey information and

case-based information are needed. The following chapters are focused on developing such information for

several key service sector industries.

 

64 Why they would be overinvesting is a perplexing question. It could be that service sector firms with well-developed

research programs have more of a focus on the future; that they are operating in a more dynamic mode, as if they had

already captured the revenues and market share their relatively high investments require to be economical. In economic

terms these firms may be operating on their long-run average cost curve rather than their short run cost curves. This is a

view that conforms to a Schumpeterian/Chandlerian view of the dynamics of technological competition. (See Lazonick,

1993) That the evidence in question pertains to the innovative activities of firms supports this perspective. A more

conventional perspective would be that a marginal product of zero simply indicates that firms have overinvested, made bad

investments, misused the investments made, or simply have not yet figured out that their returns are negative. The latter

seems quite plausible given the pace of technological change and the difficulties associated with measuring the return on IT

investments. (Brynjolfsson, 1993)

65 The analysis presented above concerning firms’ strategic conduct in the face of technology barriers (operationalized for

statistical purposes as systematic patenting and participation in collaborative R&D organizations) suggests that service

sector firms engaged in innovative activities are investing more in purchased IT capital than service sector firms that are

not so engaged. But given that the vast majority of service sector firms have historically acquired their IT embodied in

capital equipment, it seems prudent to make the generalization that service sector firms are underinvesting in IT.
62

5. CASE STUDY: BARRIERS IN TECHNOLOGY DEVELOPMENT AND

IMPLEMENTATION IN THE RETAIL BANKING INDUSTRY

5.1 THE SIGNIFICANCE OF THE RETAIL BANKING SECTOR

In 1993, retail banking (conservatively measured as depository institutions) accounted for

somewhat more than 3 percent of total private service sector employment. A broader slice of related

industries, finance, insurance, and real estate (“FIRE”) totaled 10.4 percent of service sector employment.

(U.S. Department of Commerce, 1994)

Quinn, et al. (National Research Council), 1994, pp. 80-85) emphasize that the banking industry is

a major factor in the economy. Updating and developing the statistics reported there, we find that the

industry generated revenues (operating income) of $331 billion in 1994. Real U.S. commercial bank assets

grew from $3.2 trillion in 1979 to $3.9 trillion in 1994; loans have grown from $1.8 to $2.3 trillion; and

deposits have grown from $2.6 to $2.8 trillion. Concentration in the U.S. banking industry continues, as the

number of banking organizations has steadily declined from approximately 12,500 in 1979 to 7,900 in

1994. Over the same period, the number of commercial bank offices grew from approximately 50,000 to

almost 66,000; and the number of automated teller machines (ATMs) grew from nearly 14,000 to almost

110,000. Total employment has remained constant over the last 15 years at about 1.4 million employees.

Profitability has improved. Return on equity for all banks was 14 percent in 1979, 10 percent in 1986, and

15 percent in 1994. (Berger, Kashyap, and Scalise, 1995)

Over and above its direct importance to the economy, the retail-banking sector has an indirect

significance that makes it extraordinarily important. With other segments of the financial sector, banking

mobilizes savings and allocates credit across space and time. It provides services that enable all firms and

households to cope with economic uncertainties by hedging, pooling, sharing, and pricing risks. An efficient

financial sector reduces the costs and risks of producing and trading goods and services and thus makes an

important contribution to raising standards of living. (Herring and Santomero, July 1991, p.1)

Banks mediate a wide range of commercial and personal transactions involving the

exchange and investment of money, providing such services as loans, deposits, and trust

services to individuals, small businesses and corporations. (National Research Council,

1994, p. 80)

The banking sector's intermediation in such transactions reduces their costs; and many of these

transaction costs reflect attempts to overcome imperfect information and risk that cause market failures.
63

Moreover, the barriers to technology discussed in Chapter 3 cause underinvestment in technology in the

banking sector. Thus, technological improvements in the banking sector hold the potential for reducing

transaction costs associated with market failures throughout the economy. Actions taken to reduce the

barriers and frictions to the development and implementation of technology in banking can provide

considerable leverage in reducing transaction costs in the economy as a whole and thereby perfecting the

workings of markets.

Banks have long been among the most prodigious consumers of information technology. Early on,

Scherer observed that the financial services sector was among the major consumers of information

technology “exported” from the manufacturing sector. (Scherer, 1982). A recent review reports a number

of estimates of the level and rate of technology investment by the retail banking industry. According to one

estimate, the level of investment in technology by commercial banks during the 1980s grew at a compound

annual rate of 13 percent, then dipped to 2 percent from 1990 to 1992 and increased again to 6.5 percent in

1993. Total expenditures by banks on IT in 1993 is estimated at $15.3 billion. A separate survey shows

that the compound annual rate of growth in investment in information technology by the entire banking

industry from 1981 to 1989 was 27.9 percent, substantially higher than all but one of the other service

industries surveyed. It has been reported that the financial services industry accounts for some 16 percent

of the dollars spent globally on technology and information systems. (Whaling, 1996)

5.2 THE NATURE OF RETAIL BANKING TODAY

The retail banking industry in the United States is undergoing a dramatic restructuring, brought on

primarily by competitive forces unleashed by deregulation and technological change. (Steiner and Teixeira,

1991) The banking industry was subjected to intense regulation (primarily the Pepper-McFadden Act of

1927 and the Glass-Steagall Act of 1933) enacted around the time of the Great Depression to stabilize the

financial sector. These regulations prohibited interstate branching by national banks and gave each state

control over intrastate branching. These regulations also imposed interest rate ceilings and separated

commercial banking from investment banking.

This regulatory framework began to unravel in the late 1970s. Increased competition from “nonbanks” caused consolidation, a restructuring of the business mix, a shift to consumer credit (vs. business

loans), and a dramatic rise in technology investments to streamline banking processes.
64

The growth in bank non-interest income and non-interest expenses reflects many of these changes.

Between 1979 and 1994, non-interest income rose from approximately 8 percent of operating income to

approximately 26 percent, and non-interest expenses rose from approximately 32 percent of total expenses

to 56 percent.

Banking analysts argue that non-interest expenses are a critical factor in banking industry

dynamics, representing the industry’s critical competitive resource. (Steiner and Teixeira, 1991, p. 18)

Moreover, of non-interest expense categories, systems expenses are growing most rapidly. The number of

ATMs — which are among the most obvious manifestations of these rising system technology expenses —

has grown from 13,800 in 1979 to 109,080 in 1994. (Berger, Kashyap, and Scalise, 1995)

Accompanying these changes, banks have been changing their business mix, moving away from

heavy reliance on business loans toward more profitable consumer lending and fee-based financial services.

This type of consumer-oriented banking demands mass-information processing capability. Information

technology is particularly effective at streamlining manually repetitive data-intensive tasks — exactly the

kind found in the back offices of banks. Consolidation of banking assets among a smaller number of banks

is another manifestation of these competitive changes. (Steiner and Teixeira, 1991)

Banks have focused on creating value with these system investments. Many new services depend

on such investments. For example, rapid reporting of a corporate customer’s global cash position, demand

deposit account services including ATMs, the ability to shift between multiple accounts, and overdraft

privileges are all linked to systems technology. These systems generally display economies of scale so that

increasingly automated lines of consumer-oriented business are supporting fewer and fewer large

commercial banks.

The banking industry is experiencing the third stage of its technology absorption — the stage that

directly affects the bank-customer interface. The previous stages saw automation of, first, the back office

and, secondly, the front office of banking operations. While the changes brought about in the first two

stages have been dramatic, and are by no means complete, observers consider the third stage to be

competitively critical. (Steiner and Teixeira, 1991) While the first two phases focused more on reducing the

cost of bank operations, the latter focus on providing new and improved services to customers.

Systems investments already are increasingly focused on “retail delivery” (the bank-customer

interface). Retail delivery infrastructure accounts for the largest single item of non-interest expenditure for
65

most retail banks. (Bank Administration Institute, 1995) According to one estimate, approximately 33

percent of banking IT investments went to retail delivery, more than went to any of the major “back office”

functions, such as data centers, departmental systems, telecommunications, and item processing.

To summarize, banking markets that were kept geographically localized by regulation and prior

technology have been transformed into national and international markets. The transformation is occurring

in what was a highly fragmented industry, oriented towards proprietary technology solutions. For banking

industry technology managers, this has led to a multitude of incompatible bank technology offerings and

serious “legacy” system integration challenges. (Whaling, 1996)

While investment in system technology has been substantial, industry watchers observe that banks

have just begun to tap the potential of current and projected technologies to facilitate the shift toward an

increasingly customer-driven industry. For example, while the use of Internet sites by banks has grown

rapidly, customer confidence, generally, and security concerns, specifically, limit all but a relatively small

number of banks to offering information and simple inquiry facilities for now. According to a recent

banking industry study, while the majority (58 percent) of bank customers do interact with banks

“remotely” (via phone and mail), 32 percent interact physically through a branch or an ATM, and only 10

percent interact electronically. (Bank Administration Institute, 1995) As we discuss below, all this is

quickly changing as banks appear to be gearing much of their leading technology initiatives toward getting

to the customer in a manner that preserves and expands the relative position of the retail banking segment

of the larger financial services industry.

5.3 MAJOR COMPETITIVE ISSUES

Despite years of consolidation, retail banking is still highly fragmented. This fragmentation is

perceived by industry representatives as a major factor affecting investment behavior of financial

institutions. In our interviews with technology managers in the banking industry, fragmentation and an

industry culture not experienced with cooperative strategies were frequently mentioned.

This fragmentation complicates the industry’s competitive response to the serious competitive

challenge posed by the entry of non-bank financial firms, such as credit card companies and non-financial

firms like software providers or utility companies with sophisticated bill payment capabilities, into markets

historically served by banks. This competitive challenge — referred to as “disintermediation” — is

considered quite serious by retail bankers — so much so that some industry analysts worry about the
66

“long-term decline” of retail banking. While some counsel that the industry must “act or die.” Others,

acknowledging market share loss to nonbanks of a quarter to a third in major debt markets, point to the

tremendous offsetting growth in these same markets as a positive sign for banks. (Whaling, 1996; Berger,

Kashyap, and Scalise, 1995)

So fragile is the competitive situation in retail banking that the leaders of even some of the largest,

most successful banks are afflicted by concerns about “fading into oblivion” as the result of the wrong

move, or bad timing, with respect to technology decisions and investments. (Wall Street Journal, July 25,

1996)

What is perceived by bankers as the competitive onslaught from outside the banking industry

comes at a time when the industry is entering a new phase in the long life cycle of its implementation of IT,

and proceeding at what The Economist characterized as “warp speed.” The profound nature of the

challenges of coping with disintermediation and nonbank market entry, while also making critical

technology choices, can be summed up by a fundamental strategic question that the banking industry is

grappling with: what is a bank?

Enabled by new information and communications technologies, banks are attempting to reorient

their focus toward customers — attempting to provide financial services wherever consumers are located.

This requires implementation of very new capabilities — like assuring security of electronic banking over

the internet and the reorientation and rethinking of existing systems and capabilities, such as accessing

segregated databases using client-server technologies and developing new mathematical models for

predicting risk.

Technology managers face a dizzying array of alternatives and options just in an attempt to “keep

up” with currently available technologies, let alone tracking and planning for tomorrow’s technologies. Of

course technology is not standing still. The major competitive challenges for banks include:

• Anticipating customer requirements that are highly uncertain

• Solving cutting edge technology issues — such as internet security — in a manner that

affords the reliability and confidence to which customers have become accustomed (as

with telephone technology)

• Employing vintage technology in new ways

• Integrating all these potentially divergent thrusts into effective systems.
67

Despite a historical disinclination to collective action, banks now appear to be adopting new

vertical and horizontal organizational strategies in order to confront competitive pressures and complex

technological challenges. This is done, in large part, to tap all the capabilities that are required in the kind

of technologically convergent environment represented by the evolving banking industry.

Many industries are faced with increasingly merging and overlapping technologies. With

multiple technological strands converging, it is incumbent upon firms to stay on top of

these developments. A firm will succeed to the extent that it can cover a wider range of

innovative activities, whether alone or in partnership with other firms. ... In a study of

commercial banks it was found that the scope of new information technologies is

contingent on the firm having developed linkages, particularly with firms whose industries

provide complementary knowledge. (Harianto and Pennings, 1994)

Leading bank industry analysts argue that competing with technology is a very complicated

undertaking and involves much more than simply trying to improve technology by keeping up to date with

new computers. And in a fragmented industry like banking, with so many competitors and so much

technology available from outside vendors, the competitive positioning of what is done with technology is

all important. (Steiner and Teixeira, 1991, p. 192) This was emphasized by NationsBank CEO, Hugh

McColl: “This thing,” he says, referring to technology, “is like a tidal wave. If you fail in the game, you’re

going to be dead.” McColl is convinced that if he makes the wrong bet, or the right bet at the wrong time,

his bank will fade into obscurity. (Wall Street Journal, 1996)

5.4 THE R&D FUNCTION IN BANKING

R&D strategy is increasingly important to the banking business. Banks have long been important

users of IT and, as discussed above, technology has become one of the most important factors in the

ongoing transformation of the banking industry. Still, the vast majority of technology utilized by banks is

acquired as embodied technology in purchased equipment and software.

Banks have been important commercial customers for IT developers and have always been among

the earliest users of IT. Key users of technology are often the originating source of the innovation process.

(von Hippel, 1988) While the banking sector has not traditionally been a major source of IT innovation,

they have been, and continue to be, involved in the development and implementation of technology. For

example:

Magnetic Ink Character Recognition (MICR) began in 1960 and allowed the first

automated handling of checks. Bank of America developed the first MICR technology
68

based on a study by Stanford Research Institute. Early computers of the 1960s (NRC 315s

and 316s) could then sort checks and capture the check data automatically. (Steiner and

Teixeira, 1991, p. 33)

Involvement in IT development appears to be increasing. Interviews with technology development

managers of several large U.S. banks indicate that they now play an important instigating role as codevelopers of technology.66 They often serve to “get the ball rolling.” For example, the R&D function of

one large bank developed the software code for a voice data application. As part of a co-development

arrangement, a major communications equipment manufacturer developed the corresponding hardware. The

resulting hardware was implemented and also used as the basis for a formal voice data-related standard.

While technology development efforts such as this may be qualitatively important, they are

quantitatively insignificant, according to interviews with bank representatives. With important current

exceptions, banks tend to follow in the development of technology of all kinds, rather than lead. As

discussed earlier, this problem of being outside the main locus of IT development activity contributes to the

uncertainty banks face in formulating their technology strategies in response to changing market realities.

If we categorize all IT-related activities as either development or implementation, most IT-related

activities in the banking industry are implementation related. One estimate put the ratio of implementation

to development dollars at 30 to 1. And if “development” is understood to involve research & development

(R&D) on the one hand, and test and evaluation (T&E), on the other, technology “development” in banking

appears to be heavily weighted toward T&E.

According to one estimate, system expenses represent as much as 20 percent of total expenditures

for large banks. (Steiner and Teixeira, 1991, p. 22) For 1994, that represents some $50 billion dollars.67

Banks split their systems budgets into about 1/3 for hardware, 1/3 for software development and

maintenance, and 1/3 for everything else. Most software development funding goes into maintenance

leaving no more than 10 percent of total systems budgets for truly new initiatives. (Steiner and Teixeira,

 

66 Interviews were conducted with technology managers of the following major banks and banking organizations: Bankers

Roundtable; ANSI, X9; Bank Administration Institute; Bank of Boston; Chase Manhattan; Huntington Bank; Citibank;

CommerceNet.

67 Berger, Kashyap, and Scalise, 1995, Table A.2 reports operating expenses for all commercial banks in 1994 as $253

billion.
69

1991, p. 34) This estimate of 10 percent for truly new initiatives is consistent with estimates from our

interviews with large banks, where RDT&E was estimated at approximately 2 percent of total IT-related

development and implementation expenditures.

The R&D-related activities of large banks are highly oriented toward pre-acquisition test and

evaluation of IT hardware and software. In interviews with bank technology managers, evaluation and

integration planning were persistent themes. Considerable effort is devoted to “kicking the tires” of existing

IT hardware and software products, assessing and monitoring software service agreements, evaluating the

applicability of IT protocols developed by standards-related organizations, and generally keeping abreast of

a wide array of technological activities across an even wider array of technological specialties. In a large

bank, an “advanced technology” group may consist of 15-20 employees.

Because of the volume of transactions that could be affected by mis-steps or errors in the

implementation of an IT innovation, all process and product innovations are extensively tested and then

piloted in various locations. The organizational interface between testing and piloting seems to be the

functional boundary of the formal R&D functions within banks.

It also appears that an increasing amount of time is being spent in some form of collective industry

activity, such as co-development efforts with hardware and software providers, and participation in

collective technology development and coordination efforts. The Banker’s Roundtable estimates that there

are currently approximately 46 of these banking-related collective technology development and standardsrelated activities.

5.5 THE TECHNOLOGY LANDSCAPE

Our research did not discover anything that could be described as a banking industry technology

“roadmap.” While we can report on individual technology “visions,” the industry has not articulated any

kind of high-order consensus on where it is headed technologically, what it will cost to get there, nor what

organizations “own” the responsibilities for what parts.

In retrospect, perhaps this is not surprising. Bank technology managers see the pace of

technological change as so fast and furious that at best they can only “navigate rather than plan.” A large

number of separate banking-related collective organizations engaged in technology development and

standards efforts may also be evidence of the uncertainty that grips the banking industry as a whole.
70

While trends indicate greater emphasis on technology at the interface of the bank and the customer

(as is consistent with the characterization of banking as in a “third stage” of technology absorption),

technological opportunities continue to occur at a rapid pace across the spectrum of applications, including

innovations in back-office and front office processes as well as customer access new “product” offerings.

As mentioned above, this very broad spectrum of technology opportunities presents new demands

on banks’ resources and causes complex integration problems as new technologies must be made to

interoperate with “legacy” systems as well as other new applications. For example, banks need to

understand and integrate technological advances that will allow customers more ready access to electronic

banking. Today only 10 percent of today’s banking customers access banking services electronically, so

that advances in “human-centric technologies” (such as speech recognition, 3-D graphics and animation,

speech translation, pen device support, hand-writing recognition and touch screens) are expected to be

needed to allow greater electronic access to a broader customer base, and provide them with new products

and services.

Table 5-1 presents three broad categories of technology focus: customer channel access

technology, customer information technology, and back-office technology. In each category we have

allocated specific technologies that have been highlighted in our review of recent banking literature or in

interviews with representatives of the banking industry.
71

Table 5-1. Banking Technology Focus Areas

Channel Access

Technologies

Customer

Targeting

Technologies

Back-Office

Innovation

Technologies

• Authentication

• Bank internet payment

• Cryptography

• Data compression

• Electronic checks

• Electronic commerce

• Firewalls for internet tools

• Fraud/biometrics

• Java applications

• Next-generation internet

• Quality of service for multimedia applications

• Screen phones

• Set-top boxes

• Speech recognition

• Client-server (integration of

dispersed data bases)

• Data-mining

• Groupware applications

• Software agents

• Transaction-by-transaction

targeting

• Distributed databases

• Electronic supply chains

• Hierarchical mass storage

• Image technology

• Open systems software

• Workflow software

While all three categories of technology are obviously very important, and interrelated, in our

interviews with banking technology managers, the emphasis seems to have been primarily on technologies

that operate at the interface of the bank and the customer. Our interviews were conducted within the

context of a hypothetical role for NIST in serving the banking industry so, to some extent, the emphasis

speaks to the areas where banks feel there is scope for “outside” support. Lending support to this

interpretation, we found that in reviewing technologies that fall into the customer targeting category —

such as modeling, simulation, and mathematical algorithms — we obtained the sense that these were areas

where the banks themselves had developed a great deal of expertise.

Within the broad category of channel-access technology, bank technology managers stressed

security and network monitoring and control. Like the access technology generally, the objective of security

and network control is confidence-building to improve and assure customer utilization of electronic

channels.
72

An emphasis on channel access technology is also consistent with the view that the information

technology that banks are grappling to implement is increasingly shifting the initiative for financial services

from the bank to the consumer. In the “networked economy,” as one observer calls it, where electronic

channels are the standards for all types of transactions, banks perceive a need to provide banking services

wherever the customers are to be found.

As the consumer becomes more technologically sophisticated and accustomed to accessing

on-line services, she will determine which channels to use to access her desired financial

services, at her convenience. The banks must provide service on these channels or they risk

being invisible to the customer. The customer will choose the products, services, and the

channels she wants, from whichever provider best meets her requirements, with little or no

loyalty to a particular financial institution. (Howe, 1996)

In such an environment, banks need two things overall: access to customers (hence the emphasis,

we believe, on access technology) and product content. The latter, only the individual banks and their

suppliers can provide. To be effective, the former requires collective effort.

The second important qualitative observation is that the banking industry appears to be especially

interested in a number of specific technologies that have been identified by NIST as important to the

development and implementation of IT and that are currently the focus of NIST activities, such as

computer security, computer networking, and monitoring and control for large networks.

Table 5-2 presents the industry respondents’ rankings of a list of important IT areas. Technologies

were ranked according to the frequency with which they were identified as critical to the industry’s future.

Although small, the sample is comprised of senior technology managers. Consistent with the technology

policy framework developed in Chapter 3 (regarding the appropriate policy response to the various types of

market failures), it is possible to interpret the ranking of technology areas in terms of requirements for

generic and infratechnology support.68

 

68 The list of technology areas ranked by industry technology managers contained ones in which NIST technical specialists felt

there was an appropriate role for NIST and in which NIST was engaged in technical support activities. The list also

contained technology areas that were considered more appropriate to private sector activity and where private sector

activities were ongoing. Only technology areas that were considered critical to more than one company are included in the

table presented here.
73

Table 5-2. Banking Industry IT Priorities by Technology Area and Type69

Technology Type Technology Area Rank

Monitoring & control for large networks 1

Set top boxes for interactive TV 2

Generic Technology Design for speech recognition hardware/software 2

Electronic commerce applications 2

Distributed databases 2

Operating systems and utilities 3

Data management 3

Cryptographic standards 2

Firewalls & Internet-based tools 2

Conformance test for crytographic standards 3

Infratechnology Advanced authentication technology 3

Network scaling 3

Wireless communication 3

Data compression 3

We make the following observations about these results. First, it appears that many of the priorities

of the retail banking industry are shared by entertainment and health care industries. We suspect that the

emphasis on interacting with the customer — for both entertainment and banking, the focus is “in the

home”— is the source of this similarity. Both sectors appear to be focusing a great deal of attention on the

Internet as a tool for communicating and transacting with the customer base. The policy significance to

NIST of our findings concerning banking industry technology will be considered together with findings

concerning the home entertainment and health care industries in Chapter 8.

As discussed in Chapter 3 (section 3.2), insight into technological impediments can be gained from

knowledge about users’ functional priorities regarding IT. Table 5-3 presents a banking industry

perspective on the priorities assigned to IT performance characteristics.70

 

69 Respondents were asked to indicate which of 49 technology activity areas (identified in Perine, et al., 1996) were of critical

importance to their industry’s future. We emphasize that interviews were informal and covered a broad range of topics

within a very limited interview period. Technical areas are ranked according to the cumulative number of times they were

indicated as critical to the retail banking industry’s future by interview respondents.

70 Banking industry contacts did not respond to questions concerning the ranking of IT performance attributes. Table 5-3 is

presented for purposes of consistency with the case studies of the home entertainment and health care industries presented

in Chapters 6 and 7 respectively. The ranking is based on the authors’ judgments following detailed interviews with
74

Table 5-3. Banking Industry Ranking of IT Performance Attributes

Characteristic Rank

Usability 1

Security 2

Reliability 3

Interoperability 4

Scalability 5

5.6 BARRIERS IN TECHNOLOGY DEVELOPMENT AND IMPLEMENTATION

This section discusses phenomena in today’s banking market place that are consistent with the

logic of market failure. Serious information uncertainties and network or system integration problems

pervade the banking industry and present significant barriers to technology implementation.

The sentiments expressed by NationsBank CEO McColl of acute uneasiness in the face of rapid

technological change and rapidly-evolving IT system choices were echoed in our interviews with banking

industry technology managers and is evident in the literature. The difficulty technology managers have in

seeing past an 18-month planning horizon clearly affects the investments they make and how they make

them. Coupled with what was characterized in our interviews as persistent problems of R&D project cost

overruns (which can be reasonably interpreted as resulting from efforts to minimize cost projections to

achieve acceptable projected hurdle rates), a picture emerges of a technology investment planning

environment that is fraught with uncertainties and risks that make long-term technology issues very difficult

to identify, much less to plan for and to allocate sufficient resources to.

An abundance of collaborative activities of various sorts is currently underway, to pool knowledge,

to aid in the coordination of technological initiatives among horizontally- and vertically-related

organizations, and to spread the costs and risks of technology planning and investment. At the root of these

perceptions of high technological and business risk are a number of phenomena that result in uncertainty of

about banking’s technological future: the convergent nature of IT; the related fact that the locus of

technological change is driven by forces outside the banking industry; organizational inertia in the banking

industry itself; the inability to accurately predict customer response to “the networked bank;” and the host

__________________________________

banking industry technology managers.
75

of technological issues that continue to confuse IT development and implementation planning: technology

specific challenges, technology insertion, interoperability, security, and usability. Clearly, the information

inadequacy that accounts for a large class of market failures is at work in the retail banking industry. The

“fog” that prevents a clear view of the banking industry’s the technological future, the intense competitive

environment, and the resulting redefinition of banking services are creating a very risky technology

investment environment.

The root of the uncertainty confronting bank technology managers is the technological and

industrial convergence that is part and parcel of the IT revolution, compounded by the systems nature of

technology implementation in banking. For example, a recent analysis by the Bank Administration Institute,

argues that banks are in the precarious position of being unable to anticipate technological and behavioral

changes because they are reacting from the periphery, outside the industrial locus of IT development. (Bank

Administration Institute, 1995) And in response, some of the most technologically innovative banks have

organized numerous interorganizational alliances to pool technological knowledge and experience.

(Harianto and Pennings, 1994) The IT convergence phenomenon is even reflected in the priorities of

technology managers who regard their most important technological challenge to be one of integrating

technology from disparate sources.

While increasingly in evidence today, interorganizational collaboration has been slow to materialize

in the banking industry, according to industry sources. The historical experience of the banking industry

has been partly responsible for the slow acceptance of collaboration. In addition to the regulatory

framework that segregated markets geographically for many years, the industry’s specific experience with

ATMs was not a promising one. ATMs are still not considered as user friendly as they should be, and the

interoperablilty of bankcards and ATMs is far from ideal. This same experience confronts forward-looking

visions of the future of electronic banking. The “wildly inaccurate” projections of past waves of innovation

have cultivated a “careful attitude” toward such novel opportunities as Internet banking. (Economist, 1996)

While technological convergence contributes to the uncertainty facing technology managers, the

emerging “networked banking” highlights another important source of uncertainty: the presence of network

externalities and system integration problems.

The bank can be described as a physical network, with nodes and branches. Increasingly, the

banking network has transformed itself into a physical network of interoperating electronic information
76

systems.71 The future of banking appears to be a movement further in this direction with an increasing need

for interorganizational interconnectivity, first within the banking and financial services industries and,

increasingly, with other segments of the economy as well. Bankers’ concerns about fragile dominance in the

face of rapid technological change, interoperability, coordination, being “stranded” by investments in the

wrong network, and anticipation of an uncertain consuming population are textbook indicators of an

economic environment prone to network externalities and systems competition issues. With the

consolidation that had been taken place in the banking industry, these networks are growing. And if the

“networked bank” is to become a reality, banking organizations must be increasingly interoperable in a

wider and wider set of technological applications. This involves important intrabank as well as interbank

issues.

The larger the network, the greater the benefit to the consumer of joining the network. So

anticipating the consumer rush to the emergent standard service network, banks are precariously perched

between advancing their proprietary positions (while solving the difficult integration problems that the

continuous upgrading of legacy IT systems requires) and building a more open, interoperable, secure, and

reliable electronic banking infrastructure that will promote consumer confidence and greater usage.

Standard drawbacks to such an environment are underinvestment in experimentation and the rush

by consumers to the standard solution rather than to the best solution. (OECD, 1991) For example, some

bank industry representatives worry that not enough experimentation is taking place or that commercial

financial software (such as Quicken or Intuit) may be emerging standards for customer-financial service

provider interface. Yet these software products are far from achieving the “user friendly” attributes that

banks feel will be needed to bring the majority of the consuming population into the orbit of electronic

banking. Moreover, such proprietary software is not necessarily in the competitive interest of banks as

providers of financial services access and may lead the way to technology companies entering the financial

services market as direct competitors to banks. (Economist, 1996)

 

71 Economists distinguish between physical and metaphorical networks in their analysis of network externalities. Banks have

long had attributes of both. The back-office to front-office relationship between the main office and its branches is

maintained through a physical network while the relationship between the branch (or ATM) has been a metaphorical

network. The concept of the networked bank appears to be moving in the direction of a thoroughly physical network

requiring the electronic transfer of information throughout the value-added chain from financial service providers, and their

suppliers, to the households of final consumers (equipped with screen phones, personal computers, and set-top boxes).
77

Banks are increasingly sensitive to the uncertainties of what the consumer will choose. The stakes

of the wrong choice are high. On the one hand, every bank wants to become the standard service provider,

or at least part of the dominant network of financial service providers. On the other hand, if investments are

made in one direction and the consumer moves in a different direction, the previous investment — and time

— is lost and the switching costs can be enormous.

The basic problem is that there are so many choices emerging for consumers of financial services,

and so many technology application paths for banks to follow, that they are reluctant to “bet the company”

on one direction or another. Of course, at the same time, they must move forward technologically, waiting

for consumer preferences to clarify.

In Chapter 8 the nature and scale of barriers to IT investment in banking will be considered along

with those in the other case study industries. This allows for a more complete picture of service sector

market failures and the appropriate policy response.
78

6. CASE STUDY: BARRIERS IN TECHNOLOGY DEVELOPMENT AND

IMPLEMENTATION IN THE HOME ENTERTAINMENT INDUSTRY

6.1 THE SIGNIFICANCE OF THE HOME ENTERTAINMENT SECTOR

However it is defined, the home entertainment industry is very large, economically and culturally

influential, and a major user of technology.72 For the most obvious core of the home entertainment industry

— radio, television and motion pictures — over the decade from 1984 to 1993, growth rates in employment

were 55 percent for radio and television and 87 percent for motion pictures. Employment in radio and

television and in motion pictures represents somewhat more than 1 percent of the employment in the private

service sector. As we explain below, technological convergence across communications industries,

publishing, movie making, and computing suggests a somewhat broader definition, and hence somewhat

more employment, for the home entertainment industry.

Employment and sales statistics alone fail to capture the cultural significance of this segment of the

economy. For decades, the television has served as the American household’s conduit to the outside world.

For 50 years the home entertainment and information experience has been shaped by television

programming. From Howdy Doody Time to the Muppets to Michael Jordan; from the civil rights marches

in the U.S. South to Tiananmen Square; from Vietnam to the night raids on Baghdad, television has had a

pervasive influence on American (and worldwide) culture, consumer preferences, and perceptions.

In the home entertainment industry, the use of IT entails the investments made by households in

technology such as televisions and computers, by the cable television and satellite communications

industries, by the television industry, the movie industry, and in telecommunications industry in general.

Industrial statistics for 1992 alone, show the combined IT investments for motion pictures (SIC 78) and

 

72 The rapid convergence of various forms of communications, entertainment, and computing technologies leaves the

definition of the "home entertainment" sector somewhat indeterminate. We shall employ a very broad working definition of

the home entertainment industry as including SIC 4833 (terrestrial broadcasting); SIC 4841(cable television); SIC 4899

(satellite communications); SIC 4812 (cellular/PCS); SIC 7812 (movie production) and SIC 2711 (news production,

newspapers). How much one aggregates to reach a definition of a home entertainment industry is of course somewhat

subjective. Certainly one would start with SIC 4833 and SIC 4841 and then add the “traditional” content of SIC 7812.

Then, one could maintain that because of convergence it makes sense to add SIC 4899 and SIC 4812 and some fraction of

the telecommunications/telephone industry. Then, with advances in computer technology, it becomes increasingly possible

to access the content of newspapers on line and all the major papers and magazines are indeed providing “cyber editions,”

so adding a portion of the publishing industry is also supportable.
79

radio and television (SIC 483 + 484) to be approximately $4.87 billion, $1.37 billion and $3.50 billion

respectively.

But the technological support for the home entertainment and information experience is changing

rapidly, converging with telephone communications, with computer technology, and with networking

technology. These technological changes could have profound effects on the structure of the entertainment

services sector and the nation’s cultural experience.

6.2 THE NATURE OF HOME ENTERTAINMENT TODAY

The “home entertainment” industry, like many services industries, is being transformed by the IT

revolution. To understand this transformation requires that we consider not only the devices with which

consumers receive electronic information and entertainment service “content,” but also the variety of

distributional modes by which the content is delivered.

The initial focus of this case was “television entertainment.” It quickly became obvious that this

distinction was untenable. Televisions and computers — two very different technologies — are today vying

for a position as the centerpiece of home entertainment in the future. To refer to television entertainment is

too narrow a focus. Industry representatives see two somewhat different technology scenarios following

independent development tracks and merging at various points along the way.

A traditional distinction between these two technologies and industries — one delivered

entertainment, the other information — has become increasingly blurry, and will become moreso in the

future.

Between the content provider and the home receiver equipment, be it computer, television, or some

hybrid device, are four basic video signal broadcast modalities: i) terrestrial — a transmission tower on the

ground sends a picture directly to a television antenna ; ii) coaxial or fiber optical cable — television

signals travel through an underground cable; iii) microwave — a multi-channel, multipoint distribution

system carries signals from a television studio to a microwave transmitter and then to rooftop receivers;

and iv) satellite — a broadcaster uplinks a signal to a transponder on a satellite, which re-transmits to a

receiver dish.
80

In the following section we will discuss how the development and implementation of IT is affecting

the competitive nature of the many industries that are integral to the production and delivery of home

entertainment. The essential dynamic is one of technological and industrial convergence. Content providers

have merged with cable companies; traditional broadcast companies have merged with major content

providers, and are increasingly looking for involvement in cable transmission and the Internet; cable

broadcasting and telephone companies are angling to serve each other’s traditional markets for cable

programming, on the one hand, and telephone service on the other.

The market turmoil that this convergence generates — and the implications for generating

uncertainty that may lead to underinvestment — is succinctly summarized in what one analyst calls the

Negroponte Switch: “What currently goes by air, chiefly broadcast video, will soon switch to wires (fiber

optics and coaxial cable), while what currently goes by wires, chiefly voice telephony, will massively move

to the air.”73 Industries that have been the mainstay of home entertainment for decades are giving ground to

industries rooted in alternative digital technologies; and industries that we have long thought of as distinct

are merging together to provide multiple information and entertainment services. “In the long term,”

according to one account, “the distinction between long-distance carriers, telephone companies, cellular

service companies, satellite services, cable television providers, and other communications and electronics

industries will become blurred. Companies in different industries will merge, or form partnerships, resulting

in a ‘high-tech stew’ of interactive communications services that handle voice, data, and video.” (Gale

Research, 1994)

Figure 6-1 shows the value chain relationship among selected service sector industries being

affected by this convergence.

Several burgeoning services appear to be the common objective of these converging industries:

• Support for digital television (HDTV, 500 channels, interactive television, video-ondemand, home shopping, games)

 

73 Nicholas Negroponte is Director of MIT’s Media Laboratory. Gilder (1994) asserts that Negroponte’s formula “brilliantly

captures the key vectors of change” regarding the industrial and technological transformations stimulated by the digital

revolution.
81

• Support for video game systems and multimedia CD players (games, linking game

players via telephone lines)

• Support for on-line games and entertainment services (games, bulletin boards and chat

services, on-line shopping, the World Wide Web)

• Support for digital audio systems (on-line digital music distribution, interactive music,

home digital audio recording)

• Other emerging services: video telephones, digital film and video processing, digital

art. (Kinney, 1995)

Figure 6-1. The Convergence Value Chain 74

Content

Origination

Customer

Equipment

Transport &

Delivery

Packaging &

Navigation

Multimedia PCs

Televisions

Set Top Boxes

CD Players

PDAs (Personal 

Digital Assistants)

Video Game Players

Screenphones

ATMs (Automated

Teller Machines)

Terrrestrial Broadcast

Cable TV Franchises

Telephone Networks

Satellite Networks

Transportation Businesses

Bank Branches

Publishers

TV/Cable Programmers

TV/Networks

Film Studios

Computer Operating

Systems

Online Service Providers

Financial Advisors

Books

Newspapers

Magazines

Software

Movies

Online Information

Financial 

Products /Services

To some degree the following service industries are, or intend to be, involved in the provision of

entertainment and information to the home: terrestrial broadcasting; cable television; satellite

communications; telecommunications; cellular/PCS; movie production; newspapers; and magazines. While

historically distinct, many believe that in the years ahead their distinctiveness will fade. After briefly

reviewing industrial and technological trends in each of these industries, we will highlight the key

technology areas and the barriers to their timely development and implementation as identified by industry

representatives.75

 

74 Source: (Bank Administration Institute/Boston Consulting Group, 1995)

75 Unless otherwise indicated, the following industry overviews are drawn from (Gale Research, 1994) and from interviews

with industry representatives, including ABC, CBS, NBC, CNN, Time Warner Cable, and The Walt Disney Company.
82

6.2.1 Terrestrial Broadcasting

The television broadcasting industry is a study in convergence, the process by which hitherto

separate industries — broadcasting, information and entertainment content, telecommunications and

computers — merge into a single industry. (Laven, 1996) There appears to be a general consensus that

convergence of the traditional broadcasting industry is occurring, but the shape the industry will take is still

quite uncertain. Evidence of industrial convergence brought about by the IT revolution can be seen in the

alliance of Microsoft Corporation and NBC to produce MSNBC, a Web-based news site, and by Walt

Disney’s acquisition of ABC, to name just two illustrative developments.

From the time TV came into widespread use through the 1960s, home entertainment was more or

less synonymous with the large TV broadcast networks — ABC, NBC, and CBS. But the IT revolution —

the development of new technologies to handle digital video — is transforming TV entertainment into a

“high-tech stew” combining traditional broadcast technology with cable television, interactive media, and

satellite technology as new modes of entertainment content distribution. Traditional TV broadcasting faces

an uncertain future, certainly a more complex future, and is part of a great industrial and technological

reshuffling that is one manifestation of the IT revolution. For the generations of Americans growing up in

the 1950s through the 1980s, it is difficult to imagine a home where the television is not one of the central

conduits to the outside world. Today 98 percent of US households own TV receivers (67 percent own 2 or

more); 63 percent of TV households receive 30 or more channels; and for 70 percent of the U.S. public,

television is the main source of news. (National Association of Broadcasters, 1997) And yet, the potential

scope of the technological and industrial convergence that is underway in the home entertainment industry

is succinctly grasped in the vision of one technology futurist as a “life after television.”76

While regulatory issues, per se, are beyond the scope of this case study, the regulatory environment

does significantly shape the supply and demand for entertainment services. In fact, changes in U.S.

 

76 “Life After Television” is the title of a book by highly regarded technology futurist George Gilder. (Gilder, 1994) Gilder

develops the logic of industrial transformation that follows from the explosive growth in bandwidth made possible by fiber

optic technology; the continuation or Moore’s law in microelectronics technology; and the power of distributed computing

enabled by the Internet. Gilder foresees an industrial morphology marked by the death of telephone and television

technology, and of the industries that support them, and of the rise of the “teleputer”-- a home entertainment/information

receiver based on the progressive scan technology of the computer screen rather than the interlace technology of the

television picture tube. The “entertainment” industry that reaches the home through Gilder’s teleputer is structured like

today’s book and magazine industries -- multiple niche-oriented content providers (of video and print) -- rather than today’s

entertainment industry with its entertainment megaliths (such as Time Warner or Disney). All this varied “content” is
83

telecommunications laws have played an important role in transforming the identity of what were for years

the giants of the television broadcasting industry. Anticipation of these changes was instrumental in

Disney's acquisition of Capital Cities/ABC, Westinghouse's takeover of CBS, and Time Warner's purchase

of Turner Broadcasting. (Council on Competitiveness, 1995)

In addition to competition from cable and direct broadcast satellite service providers over a decade,

the traditional broadcasting firms have faced competition from new terrestrial broadcasters as well. Fox

Broadcasting has become a significant presence over the period of a decade and in 1994 lured a large

number of stations away from the traditional rivals. Its capture of the rights to NFL broadcasts (from CBS)

signaled to some a fundamental shift in the network “picking order.” Over and above its competitive

struggle with rival entertainment delivery modalities, some in the terrestrial broadcasting industry feel that

the industry is playing an ineffective role in technological matters affecting key technology suppliers. In

part because the manufacturing base for much electronic equipment has moved offshore and in part

because new entrants into the broadcast world bring a different industrial culture (shorter product cycles),

representation from content providers and broadcasters is perceived to be weak. According to the British

Broadcasting Corporation’s Laven,

The 'new entrants' to the broadcasting field, such as telecommunications operators and

computer manufacturers, are very active in promoting their technologies and standards.

This is apparent in the meetings of DAVIC (Digital Audio Visual Council), an

organization that has been set up to develop specifications on a world-wide basis for

emerging audio-visual applications and services, such as video-on-demand. Although

DAVIC is clearly addressing the future of broadcasting, few of the active participants are

content providers, and even fewer are broadcasters. (Laven, 1996)

According to industry representatives, broadcasters are bolstering their core broadcasting business

by developing the interactive “back channel” technology (the capability of the viewer to communicate back

to the broadcaster) while at the same time they are diversifying into “a far more interactive experience” that

is Internet-oriented and interfaces with more computer-like in-home equipment. Broadcast industry

representatives foresee what is today largely two distinct in-home equipment interfaces — one with the

television and one with the computer, typically in different rooms — merging into a single in-home device

that allows the user to view broadcast news and cable television programming and also conduct banking

__________________________________

delivered (“narrowcasted” in Gilder’s terminology) to a viewing audience, that could be as small as one, over the Internet.
84

transactions and e-mail. This transformation is expected to occur over a ten-year period. A consistent

theme in industry interviews was the importance of digital compression technologies.

Broadcasters are also upgrading their “back-office” IT. An essential operational function is the

tracking and billing for programming to affiliate local stations. IT is being implemented to achieve

electronic payment and imaging, to simplify billing, to incorporate full-motion video for advertising, and, of

course as software upgrades to achieve multitasking capabilities.

Finally, broadcasters have large stocks of analog film. As re-runs and vintage movies are a major

source of programming revenue, considerable investment is being made to “digitize” that film stock to

make it compatible with an increasingly digital infrastructure.

6.2.2 Cable Television

Cable television was developed in the 1940s to serve small communities unable to receive

conventional television signals. In the 1950s, cable only served 14,000 subscribers. By the early 1990s,

cable systems were serving 62 million subscribers and a distinct industry of “cable broadcasters” (whose

major or sole market was cable broadcast systems) had developed. The average cable system provides

some 30-50 channels.

The cable television industry is maturing. Demand for basic cable service has essentially reached

its limit, and future industry growth is expected to derive from new services and expanded channel

availability, rather than from growth in the customer base.

With the upgrading of cable systems to incorporate new technology, such as fiber optics and

interactive capabilities, cable television firms are planning to expand their services offerings (e.g.,

expanding to the legendary “500 channels”) and enter the once separate world of telecommunications. The

ongoing upgrading of cable television’s infrastructure to fiber optic cable will expand channel capacity and

improve the capacity to carry voice, data, and video simultaneously while improving interactivity between

the programming service providers and their customers.

Optical fiber technology offers immense data carrying capacity. Data rates of 2 gigabits per second

and higher may be achieved using this medium. This kind of data transmission capacity can transmit the

equivalent of 750,000 pages of text (stored on a CD-ROM) in under a second, or 1,200 channels of

digitally compressed broadcast-quality television. Cable TV companies have converted much of their
85

transmission infrastructure to optical fiber and plan to deliver digital video to the home in this mode.

(Kinney, 1995)

The cable television and telecommunications industries are still highly regulated. While regulatory

issues are beyond the scope of our case study investigation, regulatory developments can affect the demand

and supply of cable television services and telecommunications services. (Both industries increasingly

utilize fiber optical cable as a transmission medium but have long been prevented from carrying each

other’s service. According to cable industry representatives, the wall of separation is beginning to come

down with local and regional experiments allowing cable television firms to carry telecommunications

traffic and telecommunications firms to carry cable television traffic.) In any event, leading

telecommunications, cable television, computer and software manufacturing firms, and even utilities, are

positioning themselves to provide information and entertainment services as regulatory restrictions ease.

Leading cable service firms are engaging in a wide variety of strategic alliances to achieve

capabilities across the technological spectrum, from telecommunications, to information and entertainment

content, to the Internet. Their focus for the near future appears to be the provision of more channels,

interactive media and cable modem technology. Underlying many of these efforts is a commitment to the

development and implementation of next generation digital compression technologies. For news-oriented

cable organizations, there is considerable interest in low-earth orbital satellite technology. This technology

is believed to be capable of transforming news gathering and transmission to provide “on-the-scene”

coverage of news events more easily and cheaply than current technologies permit.

The core business of cable service providers is the integration of broadcast, satellite, and cable

signals; the insertion of commercial advertising content; and the distribution of cable signals to end-users.

A primary technical concern is to perform the integration and distribution as fast as possible. To that end,

cable companies are investing in high-speed network technologies and high-speed data servers. Because the

home computer is growing in popularity, the incorporation of cable modem services is a key object. The

cable industry representatives, like their terrestrial broadcasting counterparts, are focused on providing

service to their core customer base of cable viewers and diversifying to meet the growing demands of the

computer-equipped home. Industry representative are confident that for the near future they will position

themselves to serve three relatively distinct populations: TV-only; computer-only; and both. According to

one cable industry technology officer, “It’s not like 100 million viewers are going to just pick a single

modality.”
86

6.2.3 Satellite Communications

From its inception in the 1960s, the satellite communications industry was dominated by

government agencies, the military, and international organizations. In the last decade or so, new

technologies and trends toward privatization have resulted in new commercial applications of satellite

technology.

New satellite television broadcast technologies utilize higher frequencies than the traditional Cband frequencies. Combined with the positioning of the satellites, new technologies (referred to as Direct

Broadcast Satellites (DBS)) utilize advanced digital compression technologies to expand the anticipated

number of channels available to consumers. Total anticipated capacity is between 128 and 256 channels.

The first national digital television service will likely rely on these advanced technologies. (Kinney, 1994)

As a transmission technology, satellites compete with, and complement, fiber optic technology

because both transmit digital data. It is expected that over time the cost of transmitting data via satellite

will fall close to that of cable. And as in the cable television industry, digital compression technologies are

being developed and implemented to compress multiple programs onto a single channel, driving down the

program transmission costs.

A new generation of satellites was launched in the early 1990s. The new satellites contain twice as

many transponders as the preceding generations of satellites and with compression technologies each

transponder is capable of carrying several channels of video. It is these transponders which are leased or

owned by television and radio networks and cable companies. Satellite services are provided by a handful

of major operators whose revenues come largely from video transmissions for news feed services, cable

television networks, and terrestrial broadcast networks.

6.2.4 Cellular/Personal Communications Services (PCS)

The telecommunications industry is somewhat peripheral to our focus on home entertainment.

However, these more or less distinct sectors are growing together technologically and in terms of customers

and the services they provide. PCS is envisioned by cable broadcasters as an alternative to gaining physical

access to the home over local telephone wires. It has been suggested that PCS represents an early

manifestation of the fully integrated digital home service industry. (Gale Research, 1994)
87

Telephone paging and beeper services have become familiar in many occupations. For some

industries, such as sales and medical services, they have significantly changed peoples’ day-to-day

practices. The cellular phone industry is of very recent origin, the first cellular system being installed only

in 1979. Cellular services grew rapidly in the late 1980s and into the 1990s. In 1993, 14 million

subscribers produced revenues of some $10 billion.

Most standard cellular systems use analog technology, although many are being converted to

digital. Increasingly, personal communication services (PCS) provide an alternative to conventional cellular

systems. PCS utilizes digital technology to deliver greater sound quality, and promises the more efficient

use of limited (publicly regulated) radio frequencies. Cable companies plan to use PCS technology to

convert their networks (designed primarily for one-way communication from the station to the user) into

two-way communications channels that could deliver telephone services, interactive data, and video. PCS

could also be used by cable television companies and long-distance carriers to bypass local and regional

telephone lines.

Several initiatives are underway for global satellite communications networks that would vastly

expand the reach of terrestrial PCS and could eventually allow satellite systems to dominate global

communications. For example, Motorola’s Iridium project would allow customers to call or be called

(phone, fax, or page) anywhere on earth, any time, using hand held wireless telephones. As well, a

consortium of more than 150 local telephone, cellular, cable television, and utility companies was initiated

by MCI to build a nationwide PCS network. Other industry leaders include GTE, AT&T Wireless

(formerly McCaw Cellular, the nation’s largest provider of cellular telecommunications in the early 1990s),

BellSouth, Southwestern Bell, Bell Atlantic, and NYNEX to name a few.

“Content” providers too are looking to be involved with PCS. For example, a few years ago, The

Washington Post took a strong equity position in American Personal Communications, a PCS start-up, and

Time Warner entered into a strategic alliance with U.S. West to engage in PCS trials. Of course, computer

manufacturers are designing and producing PCS-related equipment.

Arguably, PCS represents an early manifestation of the technological dynamic underlying the

convergence of the home entertainment and telecommunications sectors. Besides allowing cellular users to

utilize the same phone number for wireless and land line communications devices, PCS promises to deliver

data transmissions as well. PCS technology may be used to deliver video services or allow highly mobile
88

employees (such as a sales force) to tap into office computers and FAX machines. Summarizing the

potential role of this technology, one observer notes: “wireless telecommunications will transform the

prevailing paradigm of human interaction.” (Gale Research, 1994)

6.2.5 Telephone Communications

Like cellular communications technology, the telephone communications industry is somewhat

peripheral to our home entertainment focus. However, like PCS, it is relevant because of the convergence

of industries and technologies noted elsewhere. To the extent that today’s networked home computer is

competing with television as the home’s interface to the outside world, the delivery infrastructure is

primarily telephonic. The traditional, or “wire line,” telephone communications industry includes firms that

provide electronic communications over networks of wires or fiber optic lines. Into the mid-1990s, the

industry was characterized by continued deregulation, increasing competition, an emphasis on data

communication and digital technology, and globalization. The distinctions between long-distance carriers,

local telephone companies, cellular service companies, satellite services, cable television providers, and

other communications and electronics industries are becoming increasing blurred.

Most telephone networks transmit voice and data using analog technology, which sends sound

waves over the phone line. In the early 1990s, only about 50 percent of the local telephone service

providers (Bell Operating Companies, or “Baby Bells”) were served by digital central offices and only a

fraction of those lines were equipped to handle digital integrated services digital network (ISDN)

technology. This technology enables the local telephone operating companies to more fully utilize the vast

installed base of local copper wire (designed to transmit analog signals) to transmit digital data much more

rapidly than would otherwise be possible. The expansion of ISDN digital services, once thought to be a

very promising solution to the constraints of analog telephone technology, has been considerably slowed by

upheaval in the telecommunications industry caused by the divestiture of AT&T’s Bell telephone system,

regulatory prohibitions of all sorts, and very effective competition from rival technologies. (Marx, 1994) In

the mid-1990s, local wire line services providers were investing heavily in these rival cable and wireless

service capabilities.

6.2.6 Motion Picture and Video Tape Production

As discussed in Section 6.2, the emerging “home entertainment industry” has two roots, one in

entertainment and one in information. At the base of one spur in the home entertainment value chain is

motion picture “content:” the production of stories and their presentation through acting or animation.
89

Of course movie production precedes the television age, dating from the turn of the century through

the 1920s through 1940s, it was the dominant entertainment medium in the U.S. — and played an

important part in exporting American culture and values throughout the world. The rise of television

dampened the demand for movie theater offerings throughout the late 1940s and 1950s. Meanwhile,

established movie companies, such as Columbia, Walt Disney, and MGM, created telefilm production

subsidiaries. Independent production companies — such as DesiLu Productions — were established

specifically to produce television programming. By 1963, almost 70 percent of prime-time television

programming was produced in Hollywood.

A revolution in television and film production took place in the early 1980s as new television

technologies became commonplace. Videocassette recorders, cable television, and satellite broadcasting led

to an increasing demand for entertainment content — and fundamentally changed the economics of movie

production. Revenues from motion picture production today are distributed thus: approximately 35 percent

from theater box offices; 25 percent from television; and the remainder from videocassettes.

Conglomerate mergers have resulted in vertically integrated firms that control entertainment and

information content production and a range of distribution modalities. Time Warner, for example, controls

both movie (Warner Brothers Studios) and news (Time Inc.) content and a number of distribution

modalities including cable services and movie theaters. By the same token, Walt Disney is a leading

producer of entertainment content and controls important delivery capabilities such as ABC, ESPN, the

Disney (cable) channel, and several hundred trade periodicals.

IT is dramatically affecting the production as well as the delivery of movie content. The television

and the computer serve as the final interface between content producer and final consumer of entertainment

services. Increasingly, the content provider is also affected by a digital interface. That is, digital technology

is transforming the supply side of content as well as the demand side. For example, industry representatives

describe the digitization of movie production, beginning in the early 1990s. While the popular movie “Toy

Story” is recognized as a wonder of digital technology, end-to-end digital was pioneered much earlier, in

the Rescuers Down Under” movie.

The lengthy process of casting is also being affected by IT as video data bases are used to pare

down the time and expense of casting “cattle calls.” New systems provide digitized portfolios of video
90

auditions to the desktop of casting professionals that perform additional sorts, depending on the casting

criteria. (Amdahl, 1995)

Industry representatives describe video compression technologies, digital television, antenna design,

analog film digitization, and next-generation compact disk technologies as important areas of technological

concern. Like others in the home entertainment value chain, movie industry representatives foresee personal

computers in the home as a wave of the future and are interested in “developing navigational schemes (user

interfaces) that appeal to the public’s sense of exploration.”

For the longer term, entertainment content producers are interested in developing “tools” that allow

creative people to better express themselves in a new digital medium. The industry is puzzling over the

uncertain institutional base for developing such talent. While there are numerous film production schools,

they say, there are fewer institutionalized sources of “story telling” talent equipped with the knowledge of

what is required to appeal to the public’s sense of exploration in a digital age.

6.2.7 Newspaper Publishing

As a daily source of political, economic, and cultural “information content” the newspaper

publishing industry has long had a special role in our society.77 Yet the print media has been locked in a

protracted competitive struggle with the broadcast industry, and more recently the cable news industry, for

decades. The full embrace of IT by newspapers may have significant competitive ramifications.

While newspapers compete among themselves in local areas, their major rivals are other producers

of information services. Increasingly, newspapers are merging with communications companies. From

1960-1990, newspapers were fundamentally transformed from large family-run companies to components

of large multi-media companies:

By 1989, Washington Post, Times-Mirror, New York Times, Gannett, and Knight-Ridder

combined were responsible for approximately one fourth of the newspapers read each day

in the United States. (Gale Research, 1994)

 

77 In the words of Supreme Court Justices Hugo Black and William Douglas, (New York Times vs. United States, 1971): “In

the first amendment, the Founding Fathers gave the press the essential protection it must have to fulfill its role in our

democracy.” (Irons and Guitton, 1993)
91

By linking the newspapers in distant cities, the corporations that controlled them produced a

standardization of content and style. These corporations began to branch out into related industries, such as

book publishing and marketing. With time, then, newspapers have become components of communication

systems rather than the independent, self-contained entities that they have long been. To some extent these

trend toward concentration and standardization appear to move in an opposite direction of the current trend

toward personalization being enabled by new forms of IT.

In the mid 1990s newspapers are becoming electronic information suppliers, with optional

electronic editions fast becoming the norm. With the rise of the Internet, many of the integrating and

intermediate content control functions performed today by telecommunications companies, broadcasters,

and cable firms can be performed by the end user. Some experts believe that this technological evolution

puts increased emphasis on the development of content, and that, in fact, the content industry itself will

undergo profound structural change over time because content providers (individual analysts, writers and

artists) can now have a direct connection — through the Internet — to end users. (Roberts, 1995) MIT

Media Lab Director Nicholas Negroponte envisions “The Daily Me” — a personalized paper filtered from

the floods of information by agents programmed to pursue individualized interests. Today, a company

called Flat Panel produces a “display tablet” or “newspanel” (a portable tablet with laser printer resolution

and hundred of megabits of solid state or hard disk memory) that Gilder calls, “a token of a technology that

will sweep the world.” (Gilder, 1994)

The age of electronic text, experts observe, depends entirely on the development of screens with the

definition of a laser printer (some 200 to 300 dots per inch). While this is regarded as overkill for images,

screens of this resolution could provide the first display tablets with screens as readable as papers. The

delivery of electronic news — without the centralized manufacturing and printing cost or the distribution

costs — could be 50% of current cost. (Gilder, 1994)

6.3 MAJOR COMPETITIVE ISSUES

This section describes the major competitive issues facing home entertainment industries today.

Many of these issues were introduced in the previous section. It is noteworthy that virtually every

significant competitive issue mentioned in the entertainment industry literature and in industry interviews

has an important technological component. The single most important competitive issue for the home

entertainment industry is a persistent theme in the preceding section: strategic posturing for technological
92

and industrial convergence. It appears that firms are positioning themselves horizontally (in all the delivery

modalities — broadcast, satellite, cable, and the Internet) as well as vertically (from content to delivery),

through mergers and alliances to take advantage of the bandwidth that is increasingly available.

Certainly from the perspective of those who deliver content to the home — terrestrial broadcasters,

cable firms, satellite transmission services, Internet providers — competition for advertising dollars is

among the most important competitive issues. But underlying this is a deeper technological issue: the

expansion of bandwidth; the substitution of regulated bandwidth scarcity to a cornucopia of bandwidth

brought about primarily by the shift to fiber optic cable and technologies — like digital compression or

ISDN— that effectively increase the bandwidth (signal carrying capacity) of the existing infrastructure.

Also, industry representatives uniformly report uncertainties in coming to terms with the potential

of the Internet. Maintaining the proper strategic balance among the delivery modalities is crucial to home

entertainment firms. Based on a number of interviews with senior technology officers across the home

entertainment industry, it appears that they are moving rapidly in the direction of developing and refining

Internet capabilities.

Regulatory issues are also critically important to the industry. Many regulatory issues have

important technological dimensions. For example, in November of 1996 the Federal Communications

Commission announced a digital television standards agreement among television broadcasters,

manufacturers, and the computer industry that would enable them to “start planning huge new worlds and

uses of TV in a digital world.” (Platt, 1997) The agreement adopts 18 digital TV format standards, some of

which are incompatible with the requirements of computer technology. (Platt, 1997; Ness, 1996)

Reportedly, this agreement is the first in a series of FCC determinations concerning digital television. The

standards-making processes that led to the 1996 agreement produced friction between television

broadcasters and television equipment manufacturers, on the one hand, and computer manufacturers on the

other. The conflict is essentially one between the two technology scenarios (a computer-centered,

“progressive scan” technology on the one hand, and a television-centered, “interlace technology” on the

other) discussed throughout the preceding section.78 It has been observed that interlace technology poses

 

78 Interlace technology is bandwidth-saving technology. An interlaced system transmits odd-numbered scan lines to a TV tube

in one sweep, then even-numbered scan lines in the next sweep so that only half the picture needs to be sent at a time.
93

serious problems for viewing text and multimedia. (Gilder, 1994) To the extent that these technology

standards indicate sharp differences between markets for entertainment and markets for information, they

appear inconsistent with the increasingly converging markets described by industry representatives from

across the home entertainment industry.

Finally, interviews with industry representatives uniformly cite standards issues as a primary

competitive issue. The most often mentioned standards-oriented organizations are CableLabs, DAVIC,

MPEG, and the DVD consortium.79 As key users of IT, service sector firms seems chiefly concerned with

developing widely-applicable standards, anticipatory standards if possible. In addition to their interesting

maintaining a broad vendor base, they appear interested in assuring that consumers are free from system

compatibility choices where it benefits the consumption of their entertainment and information services.

Furthermore, they believe that their leverage as buyers is an important — perhaps decisive — factor in

obtaining resolution of the differences among equipment manufacturers vying for market advantage.80

6.4 THE R&D FUNCTION IN THE HOME ENTERTAINMENT INDUSTRY

As we have found in other case studies, the R&D function within the entertainment industry is

heavily oriented towards “development” and perhaps could be more accurately described as test and

evaluation.81 Even very large multimedia firms reported relatively small R&D staffs, on the order of 15-25

__________________________________

Progressive scan technology, on the other hand, transmits scan lines -- from the top of the screen to the bottom, as with a

graphic image displayed on a computer screen -- in an unbroken sequence, creating an entire single frame of a TV/monitor

picture.

79 CableLabs (Cable Television Laboratories Inc.) is a research and development consortium of cable television system

operators. focused on the assessment, development, and implementation of technologies by cable system operators. DAVIC

(Digital Audio Visual Council) is an international organization aimed at promoting the success of digital audio-visual

applications and services based on specifications that maximize interoperability across countries and applications. MPEG

(Motion Pictures Experts Group) is a group that meets under the auspices of the International Standards Organization to

generate standards for digital video and audio compression with emphasis on the definition of a compressed bit stream. The

DVD consortium is a group of 10 or so large electronics, television, computer and entertainment companies that have

contributed technology, and developed standards and cross-licensing arrangements for the introduction of the next

generation of compact disk technology - digital versatile disk technology.

80 With reference to the DVD consortium, one industry representative argued that a “third party” standards negotiator

function (implicitly, “like NIST”) would not be effective in such a negotiation. He believed that effective anticipatory

agreement among competing manufacturers was only achieved with the real “carrot and stick” and that only the large

entertainment industry buyers like Time Warner or Walt Disney were capable of such inducements.

81 This finding is consistent with National Science Foundation (NSF) surveys. Link (1995) reports that firms reporting large

expenditures of “development” funds believe that “development” is defined too narrowly by NSF.
94

direct reports for a Technology Officer, Chief Engineer, or Information Officer of even very large

organizations.82

Industry representatives suggest that as IT moved from “back-office” functions (where it

predominates in television broadcasting and cable services, for example) toward service content and

delivery (as is occurring with the incorporation of video servers, and the development of interactive

Internet services), the internal staffs required to maintain these services, and the fraction of staff time

dedicated to such “front-office” concerns, is likely to grow steadily.

Industry representatives also report that while they do not develop technologies internally, they do

exert some leverage on the R&D activities of equipment vendors and are increasingly involved in

collaborative technology efforts such as CableLab, the DVD consortium, as well as standards-oriented

organizations like MPEG and DAVIC. It is the digitization of otherwise relatively stable technologies

(e.g., television, coaxial cable, film production) that is driving both vendor co-development and

collaborative endeavors.

Today, much of the entertainment industry’s IT investment is concentrated in operations and

“back-office” functions. This focus appears to be changing with the expansion of bandwidth (brought

about by the move to fiber optical infrastructure and bandwidth-economizing technologies) and the

demand for “more interactive experiences.” There is every reason to believe that these trends will continue

and that the RDT&E functions in the entertainment industry will continue to grow.83

 

82 For very large organizations, this number undoubtedly under-reports the number of personnel dedicated to technology

development test and evaluation. Some industry representatives reported a committee structure for integrating technological

issues across multiple divisions. Nevertheless, only a few of multiple divisions were reported to have significant in-house

technology activities and the staffs of these divisions would also be relatively small.

83 George Gilder (Gilder, 1994) has formulated a rule of thumb analogous to the microelectronics industry’s Moore’s Law

(according to which processing microchip processing power doubles every 18 months). Gilder, and others (Roberts, 1995)

put forward a “Law of the Telecosm,” for the optoelectronics industry, according to which bandwidth triples every year for

the next 25 years. If Gilder’s rule of thumb accurately reflects technological trends, growth in the RDT&E function to

accommodate improvements in service content and delivery could be rapid.
95

6.5 THE TECHNOLOGY LANDSCAPE84

Throughout the preceding sections we have distinguished two technology scenarios with a third

option formed by the progressive merging of the two. In this section we first attempt to better articulate the

basis for the two scenarios and to identify industry technology priorities in that context. We then discuss

the correspondence between the entertainment industry’s technological priorities and ongoing and planned

NIST IT programs and activities. In the following section barriers to the realization of progress for selected

technologies are discussed and quantitative estimates of the degree of underinvestment caused by these

barriers are presented.

The development of new information and entertainment services is predicted to take place along

two broad fronts associated with two families of user interface equipment: the television and associated

technologies (set-top boxes and multimedia CD players) on the one hand; and information access via a

general purpose personal computer on the other hand.

It is widely believed in the entertainment industry that for the foreseeable future computers and

entertainment-oriented devices will continue to develop as related but separate digital system families,

rather than converging into a single family. Entertainment systems will continue to have image and sound

processing capabilities superior to those of the average general-purpose computer system. Entertainment

systems makers who do supply support for keyboard input are likely to continue to emphasize joystick or

remote control interfaces.

While the merging of the two into “information appliances” or “teleputers” is believed likely, most

considered it to be a decade away for the average household. While entertainment-oriented products have

adopted many of the features of computers, for the most part they lack the basic capabilities required by

computer users, i.e., a keyboard input. Also, conventional wisdom in the consumer electronics industry

says that entertainment-oriented products will not sell if they seem too much like computers.

In Table 6-1 the basic characteristics that differentiate the computer user from the entertainmentoriented user are highlighted. Information services targeted for computer-oriented users are expected to

emphasize the first set of features by supporting keyboard-based, word-searching for information retrieval

 

84 Unless otherwise noted, this section draws heavily from (Kinney, 1994).
96

and downloading and/or printing of files, and by focusing on text and still images as opposed to video. Online information service providers while assuming most users will use the dial-up public telephone network

at low transmission rates will also employ piggy-backing on new two-way cable systems at rates in the

megabits per second range.

Driving the design of services for the entertainment-oriented devices will be a simple interface for

the remote control or joystick. This suggests content that can be easily retrieved through menus, maps,

diagrams or other visual schemes. To fully utilize powerful sound and graphics capabilities, many

information services are likely to incorporate extensive sound, live-action video, and animation. Providers

of on-line information services for use with entertainment-oriented devices will need to work closely with

device manufacturers and delivery systems operators (cable systems) to ensure compatibility with specific

systems.

Underlying these technology scenarios are three important technological trends:

• Digital data transmission systems

• Digital data compression techniques

• Multimedia hardware allowing steady decompression.

Digital data transmission: Optical fiber technology offers immense data carrying capacity. Data

rates of 2 gigabits per second and higher may be achieved using this medium. This kind of data

transmission capacity can transmit the equivalent of 750,000 pages of text (stored on a CD-ROM) in under

a second, or 1,200 channels of digitally compress broadcast-quality television.
97

Table 6-1. Entertainment-oriented vs. Information-oriented Technologies

Computer users:

• Interaction through a keyboard

• Communication with user-specific and varied text strings and commands

• Easy access to printer and digital storage media

• Many systems do not yet support full motion video

• Access to many on-line systems through a telephone modem

• If cable operators open up to two-way use via cable modems, computer users

will enjoy higher data rates

Entertainment-oriented devices:

• Interactive with computer systems but using relatively simple equipment

• No keyboard, rather remote control and joystick

• No printers or storage devices

• Good image and sound processing capabilities

• Interface technologies (i.e., head-mounted virtual displays will become

standard, affordable, home-use elements before they are widely available for

computer systems

• While incorporating telecommunications links, these tend to be specialized

and proprietary, permitting users to communicate in certain ways

Telephone and cable television companies have converted much of their transmission infrastructure to

optical fiber and plan to deliver digital video to the home in this mode.

By comparison, telecommunications technologies such as ISDN (Integrated Services Digital

Network) provide a data rate up to 144 Kbps and, more recently, ADSL (Asymmetrical Digital Subscriber

Line) can achieve data rates of 1 Mbps over local copper pairs. Satellites are capable of transmitting at

rates of 100 Mbps and greater. Conventional TVs require about 1.5 Mbps and HDTV requires something

on the order of 20 Mbps.

While optical fiber will play an important part in “the back channel” of a future interactive home

entertainment systems, the delivery of video to the home will be via coaxial cable, wireless transmission,

and telephone wire. The transmission capacity of coaxial is in the 10-500 Mbps range. Satellites and

microwave support transmissions in the hundreds of Mbps.
98

Digital data compression: Compared to text, uncompressed graphic data requires very large

computer storage space. If a typical page of text can be stored in a file size of 3 kilobits or less, an

uncompressed digital image could easily occupy 10 megabytes.

While it may be possible to distribute uncompressed digital video over optical fiber (due do its

tremendous transmission capacity), current technologies (such as cable, local telephone connections,

satellites transmissions, and CD-ROMs) do not have sufficient capacity for the task. The industry is,

therefore, acutely interested in digital compression technologies. These technologies make it possible to

transmit video data via cable, CD-ROM, and satellite connections. Widely discussed digital compression

schemes include MPEG-1 and MPEG-2. MPEG-1 is designed to support CD-ROM players. MPEG-2

allows compression of studio quality video. In addition to these nationally endorsed standards, many

proprietary compression schemes still compete with these “standards.”

Multimedia hardware for digital decompression: Computer storage and manipulation of

multimedia data — combinations of digitized text, sound, and images — is made possible by the

incorporation of digital signal processing chips (DSP). While today’s users of word processing programs

and on-line information services appear to tolerate periodic slowdowns in response time, such performance

would be unacceptable for the satisfactory consumption of video and audio information. DSP technologies

are, therefore, central to the “set-top boxes” through which digital television is produced.

These three technological areas support four major forms of burgeoning home entertainment

services:

• Digital TV (HDTV, 500 channels, DBS, interactive TV)

• Video games and multimedia CD players

• On-line entertainment services

• Digital audio.

We have discussed two IT scenarios that are part of the conventional wisdom among entertainment

industry representatives, as well as a variation that foresees a merger of these two scenarios 5-10 years

hence. There is a third scenario emerging, centered on the Internet. In this scenario, computer hardware

(memory and processing power) and operating systems (software) become subordinate to a public, fiber

optic-based, computer network. The network becomes the operating system. Coupled with open and
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network accessible programming languages, like Java, experts foresee a profound change in the way

computers, and the information they command, are used. (Gilder, 1995; Myhrvold, 1995) The value of any

network device, they argue, rises exponentially with the increase in the number of other such devices it

reaches. According to a proponent of this view:

The computer hollows out, and you no longer are concerned with its idiosyncrasies, its

operating system, its instruction set, even its resident applications. Instead, you can focus

on content—on the world rather than on the desktop architecture. If you want to run a

helicopter model on your screen, you don't have to worry about whether you have

AutoCAD on your hard drive. You can run a video of the helicopter without owning the

right decoder, whether Indeo (Intel's standard) or MPEG-4 (designed for portable

appliances) or dynamic JPEG. The helicopter flies over the Net with its own executable

code. The network is no longer a threatening place. If you want to use a program from

Finland, you don't have to worry that it will introduce a malignant virus to your machine.

Your computer will never be the same. No longer will the features of the desktop decide

the features of the machine. No longer will the size of your hard drive or the database in

your LAN server determine the reach of your information processing. No longer will the

programs in your machine determine the functions you can perform. The network is the

computer. The computer becomes a peripheral to the Internet and the Web.

Suddenly, the entire world of new software is potentially available to every computer

owner. Rather than being restricted to the set of programs you own, you can use any

program on the Net, just as now you can tap any information on the Net. You not only

have data at your fingertips; you have programs at your fingertips. (Gilder, 1995)

Of course, this view has its skeptics. Like the industry representatives who see two parallel

technology scenarios coexisting, rather than merging (because, they argue, the convergent path is too far

off in the future), critics point out that this third paradigm is based on the fallacy that high bandwidth

communications will be available to everyone in a timely manner. Critics argue that even in 10 years the

communications infrastructure will still be comprised of a patchwork of partial solutions: ISDN, cable

modems, and ATM networks, rather than a widely available, high bandwidth “superconnection.” (Grove,

1995). Others argue that, technology infrastructure aside, the average consumers will not derive utility

from the capabilities that the proponents of the Internet/Web-based paradigm foresee. Consumers don’t buy

bandwidth, it is argued, they buy services. What the average user wants is, “access to a broad range of

content, packaged and presented in a friendly, useful, engaging manner, priced simply and affordably, with

a strong underlying sense of community.” (Case, 1995)
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While industry representatives are aware of this emerging new paradigm, in the sense that they are

very much focused on the utility of the Internet in providing entertainment services, whether they yet fully

comprehend the practical ramifications of this new Internet-based paradigm — indeed, if anyone does — is

unclear.85

Key technology areas identified in interviews with technology officers of large entertainmentoriented companies are itemized in Table 6-2.

Digital compression technology — specifically, “going beyond MPEG-2” with practical, widely

adaptable standards — was perhaps the most consistently discussed area requiring technological advance.

Compression technology appears to be important throughout the home entertainment value chain, from the

expansion of programming channels through more effective use of limited (though rapidly expanding)

bandwidth, to the conversion of large stocks of vintage analog film and the production of next-generation

CD-ROMs (DVD technology).

Table 6-2. Key Entertainment Technologies

• Digital content creation

• Digital copyright protection

• Digitization of analog

• High-speed networks for fast down-loading

• In-home (user interface) equipment (PC, TV, DVD)

• Internet improvements (protocol improvements, content management tools,

navigational schemes)

• Network management and transaction-basis billing

• Practical digital compression

• Video servers

 

85 Interviews with industry representatives were far-ranging and primarily focused on identifying technological areas of

concern, barriers to the more complete implementation or development in broad technological areas, and on estimating the

magnitude of underinvestment associated with those barriers. Speculations concerning various technology scenarios were

not pursued in depth and are, therefore, based on the authors’ judgments. While this third Internet/Web-based paradigm

was not the specific focus of discussion with industry representatives, proponents of this paradigm (Gilder, 1994, 1995; and

Barlow, 1995) believe that it represents a technological shift that challenges the technology strategies — indeed the very

existence — of firms focused on interactive television (such as the broadcasting and cable firms interviewed for this case

study).
101

Improvements in user interface equipment are of critical importance to the entertainment industry,

especially as this relates to the development and implementation of widely adaptable standards for set top

boxes, digital television sets, and hybrid devices that combine features of the computer with features of the

television. Interest in these hybrid devices was apparent in several industry interviews.

Cable service operators were particularly concerned about network management, transaction-basis

billing, and more effective video servers. As mentioned above, the downstream end of the home

entertainment industry is operations-intensive. The shift to new digital technology, and especially the

preparation for video-on-demand, appear to be taxing conventional cable and broadcast operations. This

shift of the technological “cutting edge” from back-office operations to “front-office” operations is

expected to affect the nature of the internal R&D function as it is currently organized. As discussed above,

technology managers foresee their staffs growing to accommodate the increased demands for IT that

impacts service content and delivery.

Digital copyright protection is a pervasive and fundamental concern to the entertainment industry.

Simply put, “[w]hen copies multiply, value collapses.” (Bethell, 1997) It appears that a whole generation of

relatively young and sophisticated personal computer users typically share their computer games as e-mail

attachments. Industry observers question what will happen when the memory and bandwidth exist to share

any artistic creation in a similar fashion. Industry representatives express similar concerns as they look

forward to video-on-demand. “We envision the specter of perfect digital reproductions, of programs downloaded from a digital TV, showing up on the Internet.” As well, encryption technologies are used to secure

the services that content distributors provide to their customers. Technological means are becoming

available to ensure protection such as digital watermarks (i.e., information embedded in pictures, sounds,

and videos that cannot be seen or heard without a special decoder) and encrypted electronic envelops (i.e.,

secure means of sending data objects to specific recipients). (Kurzweil, 1997) Industry representatives

express interest in further development and implementation of these technologies.

In addition to the identification of key technologies, industry representatives indicated which of

several areas of information technology were critical to the entertainment industry’s future. In Table 6-3,

these technologies are ranked in according to the cumulative number of responses by industry

representatives. While the number of people surveyed was small, they represent some of the largest firms

involved in the home entertainment industry. Their responses provide a good cross section of industry

technological concerns. Consistent with the technology policy framework discussed in Chapter 3 (regarding
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the appropriate policy response to the various types of market failures), it is possible to interpret the

ranking of technology areas in terms of requirements for generic and infratechnology support.86

Table 6-3. Entertainment Industry IT Priorities by Technology Area and Type87

Technology Type Technology Area Rank

Video servers 1

Set top boxes for interactive TV 1

System integration 4

Electronic commerce applications 4

Generic Technology Distributed databases 4

Hierarchical mass storage systems 4

System management 5

Monitoring and control for large networks 5

Virtual reality 5

Firewalls and Internet-based tools 2

User Interfaces and Information Access 3

WWW and IPv6 security 3

Multimedia protocols 4

Infratechnology Data compression 4

Compression algorithms 4

Network scaling 4

Next-generation Internet protocol 5

Quality of service for multimedia and real-time

applications

5

Cryptographic standards 5

It appears that many of the priorities of the entertainment sector are shared by the banking sector.

We suspect that the emphasis on interacting with the customer — for both entertainment and banking, the

focus is “in the home”— is the source of this similarity. Also both sectors appear to be focusing a great

deal of attention on the Internet as a tool for communicating and transacting with the customer base. In our

 

86 The list of technology areas ranked by industry technology managers contained technology areas in which NIST technical

specialists felt there was an appropriate role for NIST and in which NIST was engaged in technical activities. The list also

contained technology areas that were considered more appropriate to private sector activity and where private sector

activities were ongoing. Only technology areas that were considered critical to more than one company are included in the

table presented here.

87 Respondents were asked to indicate which of 49 technology activity areas (identified in Perine, 1996) were of critical

importance to their industry’s future. We emphasize that interviews were informal and that these results are

impressionistic. Interviews covered a broad range of topics within a very limited interview period. Technical areas are

ranked according to the cumulative number of times they were indicated as critical to the home entertainment industry’s
103

interviews with entertainment industry representatives, it was not uncommon for a service scenario to

include the idea of the consumer viewing entertainment programming “and doing their banking” on the

same computer/television hybrid in-home device.

Home entertainment shares a different set of common technology concerns with the health care

industry. These include concerns with Internet protocols and security, multimedia applications, and systems

integration and management.

Finally, while it often proved extremely difficult for industry respondents to uncouple and prioritize

the five top IT performance characteristics (usability, interoperability, reliability, security, and salability) it

was possible to ascertain a ranking on the basis of several interviews. Table 6-4 presents this prioritization.

88

Table 6-4. Entertainment Industry Ranking of IT Performance Attributes89

Characteristic Rank

Interoperability 1

Usability 2

Reliability 3

Scalability 4

Security 5

The policy significance of our findings concerning technology priorities in the home entertainment

industry will be considered in Chapter 8, together with our findings concerning other service industries.

6.6 BARRIERS IN TECHNOLOGY DEVELOPMENT AND IMPLEMENTATION

Based on our analysis thus far of entertainment technology trends, and the framework for

understanding market failures and underinvestments developed in Chapter 3, in this section we discuss the

sources of risk and the that various market failures issues related to technology development and

__________________________________

future by interview respondents.

88 The rankings presented reflect the average response. With a larger sample, industry differences would probably emerge.

For example, security is undoubtedly a more important issue for cable system operators and for movie content providers,

than for a terrestrial broadcaster.

89 Respondents were asked to rank these IT performance qualities as 1=most important and 5= the least important. Rankings
104

implementation that are consistent with the logic of market failures. Where possible, evidence is presented

concerning the scale of the underinvestments that these sources of market failure entail.

The technological convergence between once-distinct industries is highly pronounced in the

entertainment sector. This convergence produces significant market uncertainties, that go beyond

reasonable levels of risk. Where risk implies predictability, uncertainty connotes the inability to predict; the

absence of a relevant base of experience from which to make informed judgments. If, as argued here, risks

lead to barriers, and barriers lead to underinvestment, then uncertainty leads to a greater degree of

underinvestment.

This uncertainty has many facets. For example, the development of informational and

entertainment services are based on adaptations of technologies originally developed for other purposes.

This clearly makes “the fog” of strategic planning thicker than it might otherwise be for entertainment

industry decision-makers. Two cases where such unplanned modifications have led to significant industrial

changes are the use of public telephone networks to support on-line databases, and the development of the

CD-ROM as an information distribution medium. (Kinney, 1995) Since “learning-by-doing” is widely

regarded as fundamental to successful innovation (Dosi, 1988), if current technologies will be employed to

provide services for which current experience provides no concrete guide — as suggested by the

“Negroponte Switch” (discussed above) — reduced innovativeness is likely to result.

In addition to uncertainties, new applications of current technologies can be slowed by the

adaptation process. Analysts note that new information services must often conform, at least initially, to

existing constraints in data storage and transmission capacity and user interface characteristics. (Kinney,

1994) Industry representatives refer to a “wild-west phenomenon” when describing the on-line, inbroadcast interactions expected to be important in tomorrow’s home viewing experience. This captures the

sense of riskiness and uncertainty felt by the management of the entertainment industry today.

The potential for underinvestment due to systems integration and systems competition issues are

ever-present in discussions with industry technology executives. At one level, the industry and the

consumers it serves are confronting the choice between computer-based and television-based systems.

__________________________________

were averaged for each item so that the lowest average represents the highest priority.
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Conflicts between the computer industry and television broadcasters over regulations and standards for

digital television reflect this system competition. The inability of the marketplace to readily coordinate

layers of technology systems is indicated by cable industry representative's contention that computer

manufacturers don’t understand the broadcasting industry’s needs.

Similarly, the entertainment industry faced system-configuration choices regarding DVD

technology and responded through a collective strategy to standardize and share revenues from technology

development investments through cross-licensing arrangements. The DVD consortium, discussed above, is

described by industry representatives as an anticipatory response on the part of the entertainment content

segment of the industry to multiple hardware and software designs. They suggest that without agreement on

widely adaptable standards, potential consumers would fear being “stranded” by the incorrect system

choice. This “stranding” psychology is commonly associated with network externality problems.

Many industry representatives focused on the investment constraints imposed by lack of faster

progress in the area of digital compression technology. Content providers believe that whole new markets

await advances in digital compression. They argue that with improved compression technologies, home

video movies could contain both digital and analog formats for only 125% of the current cost of analog

alone. Underinvestments are arguably substantial. With a target market of 30-35 million copies per release,

and a price of $30 per copy, revenues linked to such technological improvements would be in the billions of

dollars. Similarly, terrestrial broadcasters foresee advances in data compression leading to the provision of

additional programming through the more efficient use of existing satellite transponder capacity.

Internet service providers couple the need for advances in compression technology with Internet

protocol improvements. They estimate that in the event of these improvements, demand for Internet content

would expand and industry investments would expand 30% per year accordingly.

Some cable operators argue that improvements in video server technology would enable the

provision of Video-on-demand services. The investments to accommodate the expansion of such services

could increase 2-3 fold according to industry representatives. The increase in VOD services faces

numerous barriers, including new transaction-billing schemes and intellectual property protection. Cable

industry representatives estimate that if VOD were in place today, they could invest an additional $2 billion

per year over a 5-year period.
106

Finally, at the most basic level of the supply of entertainment content, industry representatives

describe the need to create “tools” that enable creative people to better express themselves in a new digital

medium. This is regarded as a chief long-term concern. The industry is puzzling over the uncertain

institutional base for developing such talent. While there are numerous film production schools, they say,

there are fewer institutionalized sources of “story telling” talent equipped with the knowledge of what is

required to appeal to the public’s sense of exploration in a digital age. From the standpoint of barriers to

investment, this reflects a potential high-order systems integration problem, similar in some respects to

what economists describe as “complementary market coordination” problems associated with market

failures in an underdevelopment context. If the pace of technological and industrial development were not

so rapid in the convergent world of the home entertainment industry, this issue might be regarded as

sufficiently long-term to presume that market forces would arise to provide an appropriate response. As

well, since the institutional source of such talent might be educational institutions, there may be additional

reasons to question whether an adequate level of investment could be expected to materialize. After all, the

externalities that characterize such “public goods” as education are the chief economic rationale for the

heavy subsidies that educational institutions receive.

Both economic logic and empirical estimates from entertainment industry representatives suggest

substantial underinvestments due to specific barriers to IT development and implementation. The potential

for underinvestments estimated by entertainment industry representatives ranged from 30% to 300%. While

the evidence is anecdotal, our case study suggests that specific barriers to IT development and

implementation are discernible, and that rough order of magnitude estimates of the scope of the

underinvestments can be ascertained.

First, the general uncertainty that plagues convergent industries is readily apparent in the

entertainment sector. At a high level of abstraction this uncertainty can be seen in the presence of two or

three viable technology paradigms to which industry representatives must address there planning efforts.

Over and above this general uncertainty, firms face serious potential vertical systems integration challenges

as debates and disagreements surrounding the implementation of digital television strongly testify. As is

also the case in the banking sector, the consumers’ preferences are increasingly important and unknown.90

 

90 When we say that consumer preferences are increasingly important we mean that the increase in the availability of

alternative entertainment/information modalities makes the consumer a more effective voice in market outcomes. Another
107

Also, progress on advanced digital compression technologies and DVD technology are thought to be very

important and key standards related initiatives were highlighted. This focus on the role of standards

activities is clear evidence of high transactions costs and suggestive of the presence of network externalities

that can lead to market failure and underinvestment.

In Chapter 8, the nature and scale of barriers to IT investment in the home entertainment industry

will be considered within the context of the barriers confronting the banking and healthcare industries.

Considering these barriers together, as representative of the high-tech segment of the service sector,

provides the greatest insight for policy purposes.

__________________________________

way of expressing this is to say that the balance of market power is shifting to consumers. This is also a clear theme in the

banking industry.
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7. CASE STUDY: BARRIERS IN TECHNOLOGY DEVELOPMENT AND

IMPLEMENTATION IN THE HEALTH CARE INDUSTRY

7.1 INTRODUCTION

The health care industry, like the retail banking and home entertainment industries, is in the midst

of dramatic technological change, and the companies competing in these sectors must face all of the various

forms of risk. The chapter will describe the nature and key competitive features of the health care industry,

especially as it relates to technological change, and document the barriers in technology that the risks have

created.

7.2 THE SIZE AND SIGNIFICANCE OF THE HEALTH CARE SECTOR

The private health care sector grew by 42 percent in the decade ending in 1993, absorbing about 13

percent of the private service sector's employment and about 10 percent of the entire service sector's

employment (including government services in the total for employment in services) with somewhat more

than 8 million employees in the private health care sector. The Office of Technology Assessment (OTA)

provided some statistics about the health care industry, according to which some 10 million Americans

were working in health care—about a quarter of those were doing administrative work—and that the health

care workforce was growing at an annual rate of 3.9 percent. Up from 5.9 percent of gross domestic

product in 1965 to 13.9 percent by 1993, the total expenditures for health care in 1993 were $884.2 billion,

with roughly 43 percent paid for by government sources. The federal government paid almost 32 percent of

the $884 billion. (U.S. Congress, OTA, 1995)

Like the banking industry, the health care has many suppliers and has been experiencing a trend

toward integration. Health care is even more fragmented; instead of suppliers being numbered in the

thousands, their number exceeds 1.2 million. “There are more than 1.2 million health care providers—

ranging from solo practitioners to 1,000 bed hospitals—and they are often isolated in disparate corporate

entities from the more than 3,000 private insurance payers that distribute payments for health care

services.” (OTA, 1995, p. 6)

Like the banking and entertainment industries, concentration is increasing; further, much of the

concentration in health care will rely on information technology to create systems. “Some . . . fragmentation

may be reduced with the current trend toward vertical and horizontal integration of providers and payers into

systems that offer the full ‘continuum of care’ to covered populations.” (OTA, 1995, p. 6)
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The health care industry is a key part of the economy, and IT is believed to be a way to reconcile

the competing goals of cost containment and quality health care. As a recent Council of Competitiveness

report (CoC) observes:

The quality of health care that has been available in the United States and the advances we

have made in medical research have been the envy of the world. But U.S. health care costs

as a percentage of gross domestic product (GDP) are the highest internationally and rising.

Rising costs compete for valuable resources from the economy and curtail our ability to

compete successfully in world markets. ...

At the same time, demands on the health care system for additional and higher quality services are

rising. Many still do not have access to appropriate care or cannot afford it. And as the population ages, its

need for medical care is increasing. (Council on Competitiveness, March 1996, Executive Summary)

IT appears to hold considerable potential to help improve service and reduce cost. The OTA's

recent comprehensive report explains the potential and importance for IT as a way to achieve the national

goal of ensuring both containment of costs and the quality of health care:

. . . two key themes are introduced that echo throughout the chapters. These are cost

containment and standards development [italics in original], and they reflect congressional

concerns about containing health care costs and enabling administrative simplification.

(OTA, 1995, p. 11)

OTA estimates the administrative costs of providing health care at between $108 billion and

$135.1 billion per year in 1991, or between 12 and 15 percent of the health care bill. Annual savings that

could be realized through increased use of information technology in administrative functions are estimated

to range from $5 billion to $36 billion. (OTA, 1995, p. 11)

Of course, the foregoing estimates of the potential use of IT to reduce administrative costs of

delivering health care, do not address the potential for using IT in the actual content of health services — a

1994 National Research Council (NRC) report and the OTA report emphasize the numerous ways that IT

has improved the treatment of the medical problems themselves — and thereby improving quality and

perhaps reducing costs of achieving specified objectives. As the NRC report explains, “IT is today an

integral part of diagnosis and therapy.” (Quinn, et al., 1994, p. 78)

However, estimates of cost savings that assume rapid adoption of electronic data interchange and

high rates of market penetration may be optimistic; health care providers do not appear to be adopting these
110

technologies as rapidly as forecast. The development and adoption of effective standards is regarded as

critical:

Until standards are in place and compliance is widespread, costly activities—such as

maintaining multiple formats for health care information, dealing with exceptions, and

developing new interface software as new proprietary approaches to managing health

information become fashionable—will continue to offset some potential savings of

processing health care records and transactions electronically. (OTA, 1995, p. 13)

The new IT will reduce large transactions costs that are incurred as the industry works to cope

with exchanging information. As with the banking industry, there are barriers in technology development

and implementation that must be reduced if the potential for IT is to be realized.

7.3 THE NATURE OF THE HEALTH CARE INDUSTRY TODAY

The health care industry in the United States is undergoing a dramatic restructuring, brought on

primarily by the pressures to contain costs and by technological change that holds out the hope that the

containment of costs can be realized while still providing quality health care. According to the OTA:

Information technologies are transforming the way health care is delivered. Innovations

such as computer-based patient records, hospital information systems, computer-based

decision support tools, community health information networks, telemedicine, and new

ways of distributing health information to consumers are beginning to affect the cost,

quality, and accessibility of health care. Changes in the health care delivery system,

including the emergence of managed health care and integrated delivery systems, are

breaking down the organizational barriers that have stood between care providers,

insurers, medical researchers and public health professionals. Old distinctions between

clinical health information and administrative health information are gradually eroding as

new health care delivery patterns emerge that are supported by, and in some cases reliant

on, the widespread use of networked computers and telecommunications. (OTA, 1995, p.

iii)

Today, then, we see a U.S. health care industry at a crossroads; synergies between organizational

modes and information technologies are dramatically changing the relations among the customers, the

health care providers, and the third-party payers, both private and government, who pay for most or all of

the health care received by individuals. (Quinn, et al., 1994, p. 76) Indeed, the organizational modes have

shifted dramatically over the past two decades, and the shift has occurred in a way that reflects and

reinforces the development and implementation of IT to contain costs and yet deliver a high quality service.
111

The growth of managed health care has been one of the major influences in the health care

industry. These organizations use a number of techniques to control access to providers, contain costs, and

manage utilization of resources. The number of people enrolled in managed care plans has increased

dramatically in the past 20 years, rising to over half of all employees covered by employer group health

insurance by 1992. (OTA, 1995, p. 6)

The health care industry has turned to information technology in order to manage the vast amounts

of information that must be exchanged between the providers, insurers, medical researchers, and public

health professionals. Quinn, et al. (National Research Council), 1994, Table 2.7, pp. 76-77) report that the

health care industry's annual investment, in constant dollars, in IT hardware increased fourfold over the two

decades of the 1970s and the 1980s. The annual investment in 1982 dollars increased from $0.9 billion in

1969 to $3.6 billion in 1989. Over the same period, the National Research Council further estimates that

the health care sector's investment in IT capital stock increased from $3.3 billion to $15.7 billion in 1982

dollars. By 1992, in the 2-digit SIC industry Health Services, IT spending was $3,348 million and IT net

capital stock was $17,768 million.91 (Unpublished National Income & Wealth Statistics, BEA, 1994)

The National Research Council emphasized what we believe to be an important and significant

difference in the success of IT: in many applications to actual medical problems IT has been enormously

successful, whereas use of IT in the business side of the health care industry has been less so. Successful

medical applications of IT are numerous: for example, the use of computer controlled beams of radiation to

treat cancer, the use of high-speed computing to do computerized scanning and magnetic resonance

imaging, and the use of IT to monitor the vital signs of patients.

However, on the whole the application of IT to business operations (“back office”) and recordkeeping activities (“front office”) has been slow. The business operations and record-keeping activities in

health care today include several activities:

 

91 These figures are not deflated for comparability to the National Research Council's figures, because an appropriate deflator

needs to account for the unusually rapid decline in the prices of computing equipment and the dramatic increases in the

quality of the new equipment. Certainly the use of a general price index for economy-wide activity would underestimate

the gain in the quality of the IT capital stock over the amount of IT available in earlier years. In the foregoing figures, IT is

defined as purchases in the following equipment categories: office computing and accounting equipment, communications

equipment, scientific and engineering instruments, and photocopying and related equipment. Thus, software is not

included.
112

By far the most common use of information systems in health care is for billing,

accounting, and administrative tasks, which typically include the admission, transfer, and

discharge of hospital patients; materials management; and scheduling and management of

human and physical resources. (Quinn, et al., 1994, p. 78)

We believe that the observed slowness in those areas reflects the barriers in technology

development and implementation that occur when the technology and market specific risks are especially

likely to be important. The discrete, relatively narrow medical science applications that can be developed as

stand-alone proprietary equipment to be used by a hospital's physicians and staff are far less likely to

founder on technological barriers than the integrated systems of technology to be used widely in networks.

7.4 MAJOR COMPETITIVE ISSUES

The health care industry is highly fragmented and this fragmentation, compounding other barriers

in technology development and implementation, is making the task of developing and implementing IT a

daunting and slow-moving task. As observed earlier, the providers number more than a million, and there

are the over 3000 private insurance payers and various third-party payers as well that must interact with

customers and providers of health care. Further, a fully effective IT system must integrate providers and

insurers with the medical research community, government health care agencies, and public health

organizations. The OTA describes a part of the challenge clearly:

A network of private-sector intermediaries has formed to facilitate the complicated

relationships between the various organizations. It is unlikely that any of these entities will

be willing to collect or organize data that save money or effort for some other organization,

but deliver the intermediary no immediate benefit; systemic savings may be irrelevant in a

vertically fractured industry. (OTA, 1995, p. 6)

As we observed earlier, there is a current trend toward vertical and horizontal integration of the

various parts of the health care industries. Acquisitions and mergers, joint ventures, and contracts can be

used to forge an “integrated delivery system . . . that brings together hospitals, primary care providers,

nursing homes, home health care providers, pharmacies, and other services into a single system.” (OTA,

1995, p. 6) The use of such combinations of organizations is often a way to attempt to surmount barriers in

technology that cause market failures and underinvestment in technology. (Teece, 1980) The heart of the

challenge for the health care industry is the need to develop the substance of the health care product and the

organizational modes of its delivery simultaneously with, and in the context of, the development of the new

IT. It appears that electronic data interchange is not achieving rapid adoption, in large part because
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organizational and technological impediments make it likely that widespread digitization will happen only

in synergy with the progressive adoption of managed health care practices and development of integrated

service delivery systems. (OTA, 1995)

This challenge of systems integration in a historically fragmented industry, facing strong public

pressure for cost containment, would exist even if IT did not fundamentally alter the way that health care

services are delivered. Yet in the midst of the integration challenges being faced by traditional hospitals and

managed health organizations, on-line health care delivery is also emerging. (Hafner, May 27, 1996, pp.

77-78) While still facing impediments arising from authentication and confidentiality issues, the use of the

Internet for the delivery of health care is underway as Ferguson (1996) makes clear.

This change has many dimensions. One observer notes the likely impact on-line communications

among patients will have on the practice of medicine:

The whole structure of medicine has been based on the assumption that physicians have

the current information and patients don't. The bottom line is, the consumers will have

virtually all the information the professionals have. . . . Once people start getting in good

communication, you won't be able to play the game in the same way. (Bulkeley, 1995)

The increase in the use of a drug called gabapentin or Neurontin to treat amyotrophic lateral sclerosis

provides an example of how on-line communications can affect medical practice. Patients used the internet

to share their observations about the success of the drug, and physicians were then asked to prescribe the

drug. (Bulkeley, 1996; Gilbert, 1996)92

The report of the Council of Competitiveness about the restructuring of the health care industry in

the information age summarizes the challenges facing the health care industry as it develops its own Health

Information Infrastructure (HII):

This restructuring to improve quality and service while reducing costs will not succeed

without access to more and better information. Health care providers such as physicians,

nurses, and other practitioners, along with health care delivery organizations such as

hospitals and managed care systems, need access to more complete and better-integrated

patient data. Along with payers, they want more consistent data regarding the outcomes of

 

92 Other sources of information about the use of the Internet to deliver health care include: Hedrick (1996), Levy and Snider

(1996), NPR (1996), and Walker (1996).
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diagnoses and therapies. Payers want more details regarding the performance of different

health plans, and citizens need access to information to assist them in staying healthier

longer or in more capably managing their illnesses or those of loved ones....

Advanced computing and communications capabilities will permit distant health care providers to

“see” patients, whether they are in their homes, in another city, in another state, or perhaps in another

country. Practitioners will be able to access patient information wherever it may be located. Researchers

will be able to share appropriate data in order to more effectively assess outcomes and ultimately develop

more beneficial treatments to keep the population healthy. (Council on Competitiveness, March 1996)

7.5 THE R&D FUNCTION IN HEALTH CARE SERVICES

Health care organizations have been important users of IT, with the uses in diagnosis and treatment

as well as with the processing of administrative work and information more generally. Our interviews with

the CTOs (Chief Technology Officers) or CIOs (Chief Information Officers) of such organizations reveal

that health care firms actively participate in the development of technology. For example, based on our

interviews in the health care industry, a RDT&E group at a large health care company would typically do

strategic planning, research on emerging technologies, pilot and implementation projects, research on

emerging vendors, have a technical laboratory where testing and evaluation are done, and also have some

R&D projects. Based on our interviews, such an archetypal RDT&E group has between 15 and 25 people

and reports to the company's CIO, and, again based on our interviews with CIOs, about 80% to 100% of

the group's efforts are devoted to IT. Typical projects include applied R&D such as developing software

for clinical systems or various testing activities such as evaluating alternative hand-held equipment. In

addition, health care companies with large hospitals will have longer term R&D projects in medical

informatics. These longer term projects concern issues such as imaging research, not things that will be

solved in the next 5 years. Shorter-term projects, like tele-radiology, are more typically assigned to the

applied RDT&E group which reports to the CIO.

Interviews with technology development managers indicate that, they continue to play an important

instigating role as co-developers of technology.93 One way that health care organizations

 

93 For the health care industry, interviews were conducted with the technology managers of UniHealth America, Wisconsin

Health Information Network, a collection of holding companies including Lahey-Hitchcock Clinic and Dartmouth Hitchcock
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help to “get the ball rolling” is to participate in collaborative ventures to develop software for the health

care industry. Thus, the health care companies that we studied reported participation in product design and

development . The health care organizations acted as beta test sites and used the experimental products in

pilot programs with their own physicians. Health care industry representatives have also collaborated with

the manufacturers of IT hardware—for example, a specialized telephone switch used in the health care

organization and provided by a foreign firm wanting to break into the U.S. health care market with its

product. With both the software and the hardware development, the collaboration is between health care

companies and technology firms that want to understand more about health care. They want to get into the

market, and they have a concept. The health care organizations help them to develop the product, adopting

the technology, serving as a beta site, and providing feedback.

While there are important exceptions, health care companies, like other service sector firms, tend to

follow, rather than lead, in the development of technology of all kinds. This problem of being outside the

main locus of IT development activity causes some of the uncertainty health care organizations face in

formulating their technology strategies. Clearly medical researchers work closely with computer scientists

and other IT experts to develop the IT used in diagnosis and therapy. These IT experts are developing

technologies that have been used in other scientific applications. However, the bulk of the R&D that is

embodied in the technologies applied in services, is done outside of the service industry and embodied in

purchased products. If we categorize all IT-related activities as either development or implementation, the

bulk of IT-related activities in health care are implementation related.

Our interviews with health care executives suggest that for large health care organizations, between

10% to 20% of IT expenses are for purchased hardware, 10% to 20% are for purchased software, and 10%

are for purchased, external, implementation services. Internal development and implementation costs take

the remaining 50% to 70% of the budget, and those expenses are weighted toward implementation and

T&E activities. For our interview respondents, an average of 40% of all IT expenses in health care go to

“back office” functions, with the remaining 60% are going for service content and delivery.

__________________________________

Medical Center, Columbia/HCA, and Humana, Inc.
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Again, based on our interviews, health care organizations also do T&E work in collaboration with

other organizations, using their experience and ongoing business to assist especially in software product

design and development and to provide a beta test site for new products.

Health care companies also do considerable collaborative technology development work, and

additionally, there are many collaborative efforts pursuing standards-related activities. Respondents

identified many important standardization actions in progress:

ASTM is working on laboratory standards. HL7 is working on inter-organization

communications and inter-system communications within health care. ANSI is working on

message structure, claim and payee related information at the payee level, and has adopted

HL7 as an ANSI standard. Additional work is ongoing with CPRI (Computer Patient

Records Institute), CORBA medical standards, X12 EDI standards, and more generally

work on technological standards for open systems and the Internet.

Standards issues can be closely related to the fundamental nature of the industry. For example, one

health care technology manager explained that the most important standards problem for health care is with

application data standards. Different people call the same thing different names—disease states for

example will have many different names, and the lack of standardized language complicates the successful

use of IT.

7.6 THE TECHNOLOGY LANDSCAPE

The Office of Technology Assessment (1995) has provided a detailed documentation and

assessment of the technological landscape in the health care industry, carefully explaining the role of

information technologies in health care and listing and discussing the key information technologies for

health care. Our discussion here focuses on technologies regarded as critical to the future of the health care

industry and on the barriers that are preventing greater progress.

The technologies currently important to health care organizations, and those technologies expected

to be critical in the next five to ten years, show a strong emphasis on efforts to contain costs. There are

immense data acquisition, communication, and storage problems to be addressed with IT. According to one

health care technology manager, “Our financial services have been automated for decades, so that part of

our IT is quite mature. But our clinical systems are still very much paper based. I say we have a

‘sneakernet’ for moving paper. We move 4000 patient [paper] charts a day in one hospital, and that is

growing by 26 linear feet a week. Archival policy is ‘forever,’ so there is a big problem here.”
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The key problems within the health care organization are interoperating across large numbers of

organizations—both within a parent organization and across independent organizations (such as the

providers and the insurers)—and containing costs by figuring out a way to reduce all of the paperwork—

that includes patients charts that are passed around in hospitals and it includes writing prescriptions and

signing them. Exotic imaging tools and the like are in the works, but our sense is that inter-and-intraorganization-interoperation and paperwork reduction are the critical near-term objectives for the

productivity of IT in health care.

Key technology areas identified in interviews with technology officers of large health care

companies are itemized in Table 7-1.

Table 7-1. Key Health Care Technologies

• Broadband networking

• Communications infrastructure (ATM)

• Electronic data interchange

• Interoperability technology (integration technologies)

• Messaging middleware

• Networking

• Security technology

• Telemedicine

• Web technology

• Hand-held technology

• Imaging

• Applications development tools (for speedy delivery of information products)

• Modularity of software

• Object oriented programming

• Large distributed database technology

• Knowledge-based systems

• Records redundancy

In addition to the identification of key technologies, industry representatives indicated which of

several areas of information technology were critical to the health care industry’s future. In Table 7-2,

these technologies are ranked according to the cumulative number of responses by industry representatives.

While the number of people surveyed was small, they represent some of the largest firms involved in the

health care industry; their responses provide a strong cross section of industry technological concerns.

Consistent with the technology policy framework developed in Chapter 3 (regarding the appropriate policy
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response to the various technology barriers), it is possible to interpret the ranking of technology areas in

terms of requirements for generic and infratechnology support.94

 

94 The list of technology areas ranked by industry technology managers contained technology areas in which NIST technical

specialists felt there was an appropriate role for NIST and in which NIST was engaged in technical activities. The list also

contained technology areas that were considered more appropriate to private sector activity and where private sector

activities were ongoing. Only technology areas that were considered critical to more than one company are included in the

table presented here.
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Table 7-2. Health Care Industry IT Priorities by Technology Area and Type95

Technology Type Technology Area Rank

Techniques for manipulating unstructured textual information 1

Visualization methods for access, manipulation, & exchange

of complex visual information

1

Systems management 1

Image recognition & processing methods 2

Generic Technology Scaleable parallel systems both tightly coupled & clustered 2

Design for speech recognition hardware and software 2

Systems integration 2

Data management 2

Electronic commerce applications 2

Software testing and analysis tools 3

Open distributed processing 3

Firewalls and Internet-based tools 1

WWW and IPv6 security 1

Internet security policy development and guidance 1

Network scaling 1

Advanced authentication technology 2

Quality of service for multimedia & real-time applications 2

Data compression 2

Infratechnology Wireless communication 2

Cryptographic standards 3

Conformance tests for cryptographic standards 3

Vulnerability analysis and testing 3

Multimedia collaborative computing 3

Common windowing protocols 3

Multimedia protocols 3

Next generation internet protocols 3

Compression algorithms 3

 

95 Respondents were asked to indicate which of 49 technology activity areas (identified in Perine, 1996) were of critical

importance to their industry’s future. We emphasize that the interviews were informal and covered a broad range of topics

within a very limited interview period. Technology areas are ranked according to the cumulative number of times they

were indicated as critical.
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It is noteworthy that health care respondents expressed interest in some technology areas that

neither banking nor entertainment industry firms indicated. These include:

• Internet security policy development

• Techniques for manipulating textual information

• Image recognition and processing

• Scaleable parallel systems

• Vulnerability analysis

• Multimedia collaborative computing

• Common windowing protocols

• Multimedia protocols.

This uniqueness may be indicative of specialized technological requirements. It may also be that while they

share technological requirements with other industries, one industry is simply ahead of another with respect

to the development and implementation of the technology area in question. Without comparable technology

roadmaps it is difficult to make such generalizations.

However, there are also many areas of apparent common interest across the case study industries.

These include: electronic commerce applications, cryptographic standards, firewalls and Internet-based

tools, network scaling, and wireless communication. Health care technology managers also appear to share

a subset of interests with the banking industry, on the one hand, and the entertainment industry on the other.

Mutual interests with banking include: design for speech recognition, data management, conformance tests

for cryptographic standards, and advanced authentication technology. Mutual interests with the home

entertainment industry include: WWW and IPv6 security, systems management, systems integration, next

generation Internet protocols and quality of service for multimedia & real-time applications. Health care

industry representatives expressed little interest in software conformance and performance testing; in

modeling, simulations, and mathematical algorithms; or, not surprisingly, the technologies related to “inhome” equipment such as set-top boxes.

Finally, as in other case study industries, it often proved extremely difficult for industry

respondents in health care to uncouple and prioritize IT performance characteristics (usability,
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interoperability, reliability, security, and salability). Nevertheless, it was possible to ascertain a ranking on

the basis of several interviews. Table 7-3 presents this prioritization.

Table 7-3. Health Care Industry Ranking of IT Performance Attributes96

Characteristic Rank

Usability 1

Reliability 1

Scalability 2

Interoperability 3

Security 4

7.7 BARRIERS IN TECHNOLOGY DEVELOPMENT AND IMPLEMENTATION

Without exception, health care managers cite traditional barriers in technology development and

implementation as principal causes of underinvestment in IT. However, the human relationship between

doctor and patient, perhaps unique to health care, further magnifies these barriers and contributes to slow

acceptance of IT improvements.

7.7.1 Types of Barriers and Their Impacts

Industry representatives identified several major implementation problems. According to one

technology manager, “Our biggest problem is getting our variety of business units to standardize.” Other

problems identified included the difficulties of installation and the costs of installation. The chief

opportunity cost of addressing these implementation problems is that operating units have to commit

resources to set standards and to provide training. The opportunity cost is that it takes time away from

providing health care services. For another respondent, “The biggest problem is that implementation is a

multi-year process. This is hard for users to accept and understand. We need to pour the right foundation,

but users expect everything to happen at once. We need infrastructure and that takes time to build. We have

weak parent companies and strong operating units, so there are interoperability problems that exist because

 

96 Respondents were asked to rank these IT performance qualities as 1= most important and 5 = the least important.

Rankings were averaged for each item so that the lowest average represents the highest priority.
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of the management structure. Our financial services have been automated for decades; this part of things is

quite mature. But clinical systems are still very much paper based.”

A big problem is getting medical staff to accept the new technologies—”We've got a lot of doctors

who want to use a pencil.” Not surprisingly, the RDT&E people reporting to the CIO are doing work on

hand-held IT devices. As Slack (1993, p. 358) observes: “If a computer . . . is seldom used, it probably

offers no advantage over traditional methods of processing and presenting . . . information. Attention

should then be directed to the computer rather than the clinician.” Apparently, the RDT&E units

experimenting with new hand-held devices are providing just such attention.

The implementation problems identified by industry representatives contain a large managerial

element but also user issues that are somewhat unique to the health care industry. The CIO just quoted

continues, emphasizing, we believe, the importance of technology that is successfully adapted to the users'

circumstances. Usability, then becomes paramount. The CIO observes that the implementation problems

have to do with the reluctance of users to adapt to change. “It is a matter of users' desires, we need to

change the people to be able to use the applications currently available. Health care is more of a cottage

industry than say the retail banking industry. There is an independence issue here, just as with academic

freedom. You wouldn't want someone telling you how to teach Economics 1; well, the doctors don't want

someone telling them how to interact with their patients. There is a special relation between the physician

and the patient. They don't want this turned over to machines.”

The project team discussed major economic and technical barriers to progress with industry

representatives. Regarding economic barriers, a common theme was that market pressures on health care

seriously constrain investments in IT development. As one CTO reported, “Even though the price of IT is

falling, the pressures exerted by “managed care” cause financial constraints that limit investment.”

Regarding the technical barriers, technology officers cited the difficulties of adapting new

technologies to legacy systems. Many systems in use are nearly obsolete, yet the health care organizations

are trying to patch them together. Technology officers report that it is difficult to communicate because of

the problems in adapting to the legacy systems. Such legacy problems are indicative of the systems nature

of the technology in question. Legacy problems emphasize the time dimension of coordinating system

technologies. And, according to some, the problem is compounded by the rapid rate of technological change

and planned obsolescence on the part of vendors.
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As we have discussed earlier, when describing the technology landscape, human interface problems

are critical. The technology must be sufficiently usable to allow the special relationship between physician

and patient to survive in the new IT environment. From the perspective of another technology officer who

did emphasize the financial constraints, the technical solutions are essentially available, but the problem is

social acceptance of sharing of confidential information across authorized users. “Sharing confidential

health care records is something physicians and patients haven't accepted. I can solve their problems; the

physicians won't accept the solutions.” Again, we believe that the general set of problems identified here

suggest the importance of “usability” of technology. The importance of having technology that physicians

and other clinicians find useful and usable is stressed by Slack (1993).

Our respondents pointed to another barrier—the legislative barrier—that has delayed the

development of usable technology, although to an extent the barrier reflects the lack of acceptance of

usable, reliable, and secure and authenticated IT. As one respondent explained, “There are 50 different

state legislatures, all in different stages of saying that exchange of electronic information is illegal or legal. .

. . Probably less than 10 states in the union accept electronic signatures. A physician's password is in effect

his signature. But if he shares the password with someone else, is it still his signature? How many offices

still have a rubber stamp for the physician’s signature? So the problem is not new, it has just appeared

anew in an electronic context.”

7.7.2 Investment Impacts of Barrier Removal

Health care technology officers were unanimous in their belief that the industry would be investing

more barriers in technology were removed. Estimates of the increase in investment varied. One respondent

observed, “Just removing the technical barriers would result in a 50% or more increase in investment. If as

well there were not the ‘economic’ barriers making spending difficult, investment would double.” Another

observed, “Technology is evolving rapidly, but physicians are paying as little as possible for IT because of

the financial constraints. . . . So yes, without financial constraints, there would be an acceleration, with

more funds going to vendors.” Another CIO argues that not having the funds to invest is a significant

economic barrier. “IT is more and more a key element to what we do. Everyone needs to realize that ...we

need to spend more.”

Relaxing the social acceptance barrier would also result in more investment according to several

respondents. For example, a government mandate for payment for services in telemedicine would greatly

stimulate these types of services. As a result that would be “a great boon to investment”. Regarding the
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extent to which investment would increase if barriers were removed, “I can't answer except qualitatively,

anything more would just be an uninformative stab in the dark. But, if the economic incentive for

information management tools is increased, there would be “a very positive effect on investment.” Another

CIO observed, “Yes, if people would accept the technology, more would be used. IT will never in my

opinion be more than five to six percent of sales in the health care industry. We're at about 1.5% now, so

double or triple that would be the change.”

For the industry as a whole, technology officers believe that overcoming barriers in technology

development and implementation would result in revenue growth and productivity enhancement.

Respondents observed that health care is an industry that depends on intercommunication. The impact

would be especially great for hospitals. Their revenues would be greatly increased because the hospitals

would be able to reach their physicians more readily and that is where the revenues are. Respondents

observed that not only would revenues increase, additionally there would be a reduction in costs—patients

and physicians wouldn't travel as much. Respondents believed that initial set up costs would be outweighed

quickly by the cost reductions. There are large economies of scale; including the gains from a wider

application of standards of practice. As one respondent observed, “The trend in the last 15 years is toward

far few hospitals; . . . That trend will continue. . . . In health care, there will be maybe 500 organizations

across the U.S. that would each have two to ten billion dollars in sales. So the effect would be a high

market share in our local area and increased productivity.”

Our respondents' views of the technology barriers in health care are consistent with the recent

comprehensive assessments by OTA (1995) and the Council on Competitiveness. (March 1996). The

Council on Competitiveness (CoC) has identified barriers in technology in health care by focusing its study

on four key sectors of the health care market: remote care (the use of telemedicine to deliver health care

services to patients), personal health information and management (the insistence that patients take more

responsibility for their own health care and the encouragement of such initiative with wellness programs

and health information), integration of health information systems, and health care research and education.

(Council on Competitiveness, March 1996) The CoC list of barriers is extensive; the barriers identified can

be traced to the many uncertainties concerning IT applications in health care, and often these uncertainties

can be tied to health care specific problems in achieving the IT performance goals articulated by NIST, that

IT be usable, reliable, interoperable, secure, and scaleable.
125

Regarding the use of telemedicine for remote care, the CoC “identifies several barriers preventing

widespread commercial adoption: lack of reimbursement, cumbersome licensing and credentialing

requirements, malpractice issues, funding uncertainties, institutional inertia, telecommunications costs, and

human resistance to change.” Regarding personal health management, the Council finds: “Key barriers to

wider dissemination of health-related information revolve around the authenticity and appropriate use of

information amid the changing dynamics among patients, practitioners, and health care delivery

organizations.” (Council on Competitiveness, March 1996, Executive Summary)

Regarding the systems integration for health information, the Council finds that:

many barriers are contributing to slow market development: high start-up costs,

fragmented provider structures, rapidly changing affiliations among health care

stakeholders, the slow development of standards for formatting and transmitting

information, the proliferation of proprietary solutions, and concern regarding how to

ensure privacy and confidentiality. Market growth will depend on the ability of the health

care and information systems industries to solve the “many to many “ problem: integrating

many pieces and types of information, in many formats, on many platforms, from many

stakeholder environments, for use in many geographic locations. (Executive Summary)

Clearly, there are usability problems that make IT applications in health care especially difficult:

The health care delivery system has several unique characteristics that discourage the

spread of information technologies. Health professionals perform a wide variety of tasks

including rapidly changing combinations of “hands-on” care, inductive and diagnostic

thinking, detailed record-keeping, patient education, and communication with colleagues.

Most of the hardware and software approaches that address one of these aspects of

medical practice intrude unacceptably on some other aspect: computers are not yet as

useful, ubiquitous, and handy as the stethoscope and other common medical technologies.

In addition, medical practice is extraordinarily complex and it changes rapidly.

Systematizing even the process of performing medical procedures, much less rationalizing

the language and scientific knowledge underlying those procedures, is an almost intractable

problem. Despite the ongoing efforts of standards-setting bodies, no unified conceptual

model exists that is powerful enough to construct the mapping between the information

that must be stored in computer databases and medicine as it is practiced. In a sense, there

is not yet a consensus about what information should be kept in computer-based patient

records or how it should be described, organized, and indexed. (U.S. Congress, OTA,

1995, pp. 2-3)

Barriers in technology, notwithstanding, the promise of IT as a way to reduce costs while

maintaining quality health care is great. Early and successful use of an integrated hospital-wide system of

computing was reported at Boston's Beth Israel Hospital and Brigham and Women's Hospital. (Safran, et
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al., 1989; Bleich, et al., 1989; and Safran, et al., 1990) This system combined both the financial and the

clinical sides of health care. Integrated computing systems help the clinicians provide patients with better

care, and additionally the more accurate data has substantially increased the recovery of revenues from

delivering health care. Usability, reliability, and the integration of the financial and clinical information in

an accessible, interoperable system are key components of this early success of hospital-wide IT. Rapidly

evolving IT and the need for ever-widening networks of providers, insurers, policy-makers, and consumers,

have perhaps caused the technological frontiers to advance faster than the health care industry has been

able to move forward to embrace helpful new technologies.

7.8 SUMMARY

In summary, health care is a widely dispersed industry undergoing rapid structural and

technological change. In many respects, this change is very similar to the challenges affecting the other two

industries we examined. Like the other industries, it has potential applications to transform both the

business practices of health care and the basic way the “industry” delivers its services.

Health care also faces many unique challenges due to the dispersed nature of the industry, the

extreme pressure for cost containment, and the difficulty of developing “systems” approaches. All of these

challenges result in market failure, many of which could be addressed by NIST. In Chapter 8, the nature

and scale of the barriers that lead health care providers to underinvest in IT are considered along with

similar barriers confronting the banking and home entertainment industries.
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8. CASE STUDIES: OVERVIEW AND POLICY CONTEXT

8.1 INTRODUCTION

In this chapter, we present the essential themes that emerged from case studies of three important

service industries — retail banking, home entertainment, and health care. All three are in the midst of

dramatic technological change, and the companies competing in these industries face many of the

uncertainties and risks that lead to underinvestment. A summary of findings from all three case study

industries is presented in each of the following broad areas of concern:

• Size and significance of the industries

• The competitive impact of IT

• The technology landscape

• The R&D function in the service sector

• Barriers to technology development and implementation

• Barriers to technology in a policy context

• Case study methodology insights.

8.2 SIZE AND SIGNIFICANCE OF CASE STUDY INDUSTRIES

Both individually and as a whole, the industries we studied are economically significant. Together

they account for over 20 percent of private service sector employment. Each of these industries has an

important indirect economic significance as well. By mobilizing savings and allocating credit across time

and space, banking plays an important role in helping households cope with economic uncertainties.

Technological improvements in banking can have a significant impact on the cost of economic transactions

throughout the economy. Health care has become a major focus of public concern. In addition to its impact

on the quality of life, technological change in health care is regarded as an important means of controlling

health care costs. The home entertainment and information industries have extraordinary cultural and

political significance. They provide an important conduit between the U.S. household and the outside world

— politically and culturally.
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8.3 THE COMPETITIVE IMPACT OF IT TODAY

All industries we examined in this report are prodigious consumers of information technology.

Their role as lead buyers of embodied technology may provide them with a more significant role in the

direction of technological development than the level of their formal R&D expenditures — or the size of

their RDT&E staffs — would suggest. IT is one of the most important factors in the ongoing

transformations of all three industries.

In all three industries, IT is being implemented in the context of rapid technological and industrial

change. The convergence of technologies and industries is characterized by senior technology managers as

“a tidal wave” and uniformly creates “a fog” in their technology planning and implementation processes.

This industrial and technological convergence is occurring in historically highly fragmented industries. As a

result, significant “cultural lags” are perceived to be slowing the convergence process.

The “high-tech stew” that is created by technological and industrial convergence creates both

uncertainty and profound systems integration problems. Interoperability and legacy system integration

problems are particularly pronounced.

Industry representatives uniformly cite standards-related activities as primary business policy

issues. As buyers of technology, primarily, service sector firms are chiefly concerned with standards

development efforts that produce compelling, widely adaptable standards, rapidly. It appears that many

(perhaps too many) ad hoc collective industry efforts are oriented towards such standards-related activities

and that traditional industry-wide “official” standard-setting organizations are perceived as lacking a focus

that is consistent with the service providers’ priorities. Traditional standard-setting organizations are also

perceived as being too slow and reactive to support the fast-paced tempo of IT developments.

The “tidal wave” of information technology appears to be shifting the balance of market power

from suppliers to consumers, across the industries that we have analyzed. The proliferation of “channels”

of communication, and information available through those channels, reduces information costs and

switching costs for consumers. For service suppliers, competitive pressures to improve service content and

to deliver services more effectively (utilizing IT) are key. The shifting balance of market power causes

great uncertainty for service sector firms. What consumers will want; how fast they will adopt new

technologies; and how they will utilize new services appears to be highly uncertain in the minds of industry

planners.
129

Throughout these industries, strategic positioning appears to be an overriding concern of corporate

strategy. Firms are positioning themselves horizontally (i.e., taking advantage of multiple service delivery

modalities — wireless, cable, Internet) as well as vertically (i.e., attempting to better control service content

production and delivery).

8.4 THE TECHNOLOGY LANDSCAPE

Corporate technology managers typically describe the technology landscape that they face as

extremely chaotic. None were aware of anything resembling “technology roadmaps” that could be used to

guide our analysis of industry-wide technology issues.97 The pace of change is perceived by some to be too

rapid for such efforts to be effective. In the words of one industry representative, “we are forced to navigate

rather than plan.” Despite this perception, most technology managers contend that such “roadmaps” exist

for internal purposes, though they are more likely to be implicit than formal.

The absence of shared understandings of the technology landscape makes public investment

planning that is technology-specific most difficult. Some explicit systematic discussion of the technological

division of labor (for example, between tiers of the industry, or among large and small firms within a

horizontal industry segment), of the nature of the underlying technologies (for example appropriability

signatures), and the timing and level of technology investment by various key players are rudimentary

components of such planning. Without a shared technological framework, at a minimum, such planning

will be highly imperfect.

We were able to characterize technology frameworks for the purposes of exposition but these lack

the specificity necessary for the systematic and balanced survey of service sector technological

requirements. In banking for example, we perceive three broad categories of technology application with

which to understand the main dynamics of technological development and implementation: channel access

technologies, by which banks gain access to their customer base; customer targeting technologies, by which

banks assess data for the purposes of defining financial services and targeting customer segments; and

 

97 By “technology roadmap” we mean a document that includes some or all of the following: a taxonomic characterization of

the important components of a system of technologies; a description of the state and direction of the various system

components; identification of barriers to achieving the desired technological goals; identification of key players for each

system component; an assessment of what organizations are “responsible” for advancing (or likely to advance) the

technological objectives; a timeline describing when intermediate or end states are likely to be achieved; the resources level
130

back-office technologies, aimed at improving the efficiency of banking operations. In entertainment, we can

distinguish between technologies that emphasize entertainment from technologies that emphasize

information, but the distinctions between these paradigms are fuzzy. In health care too, broad categories of

IT applications can be discerned: “back-office” applications, including the maintenance and communication

of medical services performed and billing; “front-office” applications, including the maintenance and

communication of patient health and treatment records; health service content, including the applications of

IT to diagnosis and therapy; and health service delivery, especially the burgeoning of on-line health

services.

There is some evidence to suggest that such roadmaps are emerging as an outcome of the chaotic

environments in which service sector firms are currently operating. In banking, for example, industry-wide

efforts are just underway to make sense out of what industry observers call the “vegetable soup” of

collaborative efforts all aiming at apparently similar technology development and standardization issues.

Key Infrastructure Technologies: Each industry, indeed each firm, has a somewhat unique set of

technologies, or technology implementation concerns, that are paramount. But some concerns appear to be

common to all industries, even industries that are otherwise very different. Among the technology areas

common to all three case study industries are the following:98

• Electronic commerce applications

• Cryptographic standards

• Firewalls & Internet-based tools

• Network scaling

• Wireless communication

• Data compression.

__________________________________

required to effect the desired intermediary or end states; and the likely source of those funds.

98 A list of technologies was developed from material provided by NIST IT experts. (Perine, et. al., 1996) This list served two

purposes in our interaction with industry. First, it provided a very useful focal point for discussions with corporate

technology managers. In addition, the technology list kept the focus of our case study interviews relevant to NIST

capabilities.
131

It is obvious too that some technology concerns cross industry lines because of similar service

delivery strategies. For example, retail banking and home entertainment seem to share some similar service

delivery strategies. Gaining ready access to the home is a priority for both of these industries, but is much

less important for the health care industry at this stage in its technology evolution. In addition to the

technology areas shared by all three industries, the following are common to banking and home

entertainment:

• Monitoring & control for large networks

• Set top boxes for interactive TV

• Distributed databases.

As dissimilar as banking and health care appear with respect to service delivery strategies, they

may have similarities — such as security and record-keeping requirements — that cause common concerns

not shared as strongly with home entertainment. Among the technology areas of common concern to the

banking and the health care industries are the following:

• Design for speech recognition hardware and software

• Data management

• Conformance tests for cryptographic standards

• Advanced authentication technology.

Similarly the home entertainment and health care industries express common critical concerns for

the following technology areas:

• WWW and IPv6 security

• Systems management

• Systems integration

• Next generation Internet protocols

• Quality of service for multimedia & real-time applications

• Compression algorithms.
132

In an attempt to understand service sector IT needs from a functional standpoint, we asked industry

technology managers to rank 5 IT performance attributes. It was anticipated that by combining ranked IT

technology areas with ranked performance attributes, NIST IT specialists would gain a more specific

understanding of each of the industries’ needs. Respondents’ rankings of IT performance attributes are

presented in Table 8-1. While respondents typically had a very difficult time uncoupling and ranking these

attributes for their industries, some differences between the industries are discernible.99 The importance of

usability and reliability across the sectors reflects the profound difficulty service providers are having

convincing their own intermediary users and consumers to accept new IT-based modes of operation and

service delivery.

Table 8-1. Ranking of IT Performance Attributes by Industry

Retail Banking* Home Entertainment Health Care

Usability Interoperability Usability

Security Usability Reliability

Reliability Reliability Scalability

Interoperability Scalability Interoperability

Scalability Security Security

* The ranking for retail banking is based on the authors’ judgments.

8.5 THE R&D FUNCTION IN SERVICE SECTOR FIRMS

Aggregate R&D statistics, discussed in Chapter 1, indicate that the service sector accounts for an

increasing share of the U.S. economy’s total R&D activity. Interviews with service industry technology

managers focused, in part, on the scope and nature of the R&D activities undertaken in their companies.

For the three industries studied, we conclude that it is more appropriate to speak of the RDT&E (research,

development, test, and evaluation) function of service sector firms than to speak of simply their R&D

function; that the emphasis is on test and evaluation activities; and that the primary focus of this activity is

information technology. In the three service industries discussed here, the emphasis is on information

gathering, research on emerging vendors, pre-acquisition test and evaluation efforts, designing and

 

99 It was anticipated that IT managers would view these criteria as discrete and rank them accordingly. Typically, however,

they were viewed as integral and difficult to rank or weight.
133

monitoring pilot projects, assessing and monitoring software service agreements, and evaluating the

applicability of IT protocols developed by standards development organizations.

What genuine R&D is performed in service sector firms often involves engagement with hardware

and software suppliers. While independent R&D efforts by service sector firms have been unusual, industry

technology managers report that they exert significant influence instigating and determining the direction of

technology development by vendors. Often they engage in co-development efforts wherein service sector

firms provide code and/or performance specification while hardware/software manufacturers are

responsible for managing the productization process. In some cases, such joint efforts were then utilized to

support standard-setting efforts.

There is a suggestion, at least, that service firms are engaging in more co-development efforts than

in the recent past, and that the RDT&E function is becoming increasingly important. These changes are

almost solely due to the impact of IT, in particular to the increased emphasis on the application of IT to

service delivery and content, rather than to “back office” operations. As these technologies become an

integral part of the basic service that firms deliver, internal control is perceived as more important.

RDT&E staffs are small but growing. Corporate technology managers sense that such staff growth

is a response to secular changes in the nature of their industries, such as the integration requirements that

are the result of industry convergence and the movement toward integrating IT into service content and

delivery. For large firms, an RDT&E group of 15-25 people is typical. Often, this staff coordinates the

efforts of additional engineering and RDT&E staffs at the divisional level. The technical focus of 80-100%

of the typical RDT&E staff is on information technology.

8.6 BARRIERS TO TECHNOLOGY DEVELOPMENT AND IMPLEMENTATION

INVESTMENTS

Throughout the industry trade press, and over and over in interviews with technology managers,

three general barriers to greater IT investment are emphasized. First, industrial and technological

convergence creates an intense strategic planning “fog.” Second, industrial and technological convergence

compound, and are compounded by, interoperability and legacy system integration problems. The

description of the banking industry’s problems in this regard is representative of other service industries we

examined:
134

The realm of current technology offers an abundance of problems and issues that have yet

to be solved. Current technology is so complex, and already offers so many choices, that

banks have their hands full with it. Only a portion of any bank’s systems infrastructure can

be state of the art at any given time, so the issue of simply catching up (where it makes

sense to do so) can be a full time job. Banks would have a full plate if there were not going

to be any more technological advances. (Steiner and Teixeira, 1990)

The third and final prevalent theme is that of shifting the balance of market power toward the

consumer who, in turn, is regarded as hesitant and uncertain about how to use IT as a services access

device. All case study industries are increasingly sensitive to the uncertainties of what the consumer will

choose. The stakes of the wrong choice are high. If investments are made in one direction and the consumer

moves in a different direction, the previous investment — and time — is lost and the switching costs can be

enormous. In our view, these conditions lead to a high background level of uncertainty that surely dampens

investment enthusiasm. In interviews with health care technology executives, it was estimated that greater

acceptance of IT on the part of users (both final and intermediate users) could lead to a doubling or a

tripling of IT investments.

Industry respondents uniformly argue that significant underinvestment results from readily

identifiable barriers in technology development and implementation. For the home entertainment industry

alone, estimates of the level of underinvestment in technology range from 30% - 300% across a variety of

potential investment projects. For many of the key technologies identified by technology managers, specific

barriers were identified and estimates of the underinvestments were made.

In the health care and retail banking industries, financial constraints were specifically identified.

These financial constraints, caused by persistent cost reduction concerns, force hurdle rates up and

investments down. Banks and hospitals alike identify short planning horizons (high hurdle rates) as a

barrier to higher levels of much-needed investment. Bank executives describe planning horizons of no

longer than 18 months, and health care technology managers describe the need for longer-term planning

horizons to solve serious legacy system problems. They describe the gap between what is technically and

physically required to provide IT-based operations, services, and service delivery, and what financial

constraints impose. Estimates from health care technology managers suggest IT underinvestments of

greater than 20%. These problems are compounded, in some cases, by overinvestments that were the result

of “wildly inaccurate” projections of past waves of innovation. In banking, for example, the memory of

overly enthusiastic investments in automatic teller machine (ATM) technology have cultivated a “careful

attitude” toward such novel phenomenon as Internet banking.
135

Both health care and banking suffer from pervasive legacy system integration problems. Health

care executives estimate that these problems cause IT underinvestments of 50% or more. Others, while

unwilling to hazard a quantitative estimate, suggest that solving the legacy systems integration problem

would be “a great boon” to investment. The legacy systems problem is only one manifestation of a much

larger system coordination problem that affects service firms and their customers as well. Technology

managers across all industries express acute uneasiness in the face of rapid technological change and

rapidly-evolving IT system choices. For example, bank executives express grave concerns about being

“stranded” by investments in the wrong network.

Home entertainment representatives provided estimates tied to specific technology issues. For cable

service providers, the realization of improvements in video server technology could lead to a 2-3 fold

increase in investment. And the mitigation of barriers to the implementation of video-on-demand

technologies could lead to additional billions of dollars of investment a year by cable network operators.

Similarly, entertainment industry executives estimate that more rapid progress on next generation digital

compression standards could unlock investments to support billions of dollars in the home video market

revenues. Advances in data compression standards are expected to lead to investment by television

broadcasters as well, as these technologies will enable additional programming while utilizing existing

satellite transponder capacity. Finally, entertainment industry technology managers' project that

improvements in Internet protocols would result in a 30% increase in related IT investments.

Table 8-2 summarizes the anecdotal evidence of market failure derived from the three case

studies.100 This evidence is categorized by industry, by type of technology barrier, and by the most

appropriate policy instrument available to NIST. Point estimates of the scale of underinvestment are

indicated where available. The evidence presented in Table 8-2 could provide a starting point for NIST

interactions within individual industries. We are confident that the problems identified reflect the major

technology barriers being experienced by the respective industries. Also, the following cross-cutting issues

 

100 The “evidence” presented in Table 8-2 is varied. It includes direct evidence of barriers, such as estimated underinvestment

caused by barriers; indirect or circumstantial evidence, such as the existence of institutions organized to address barriers;

and perceptual evidence, such as an expressed “need” for more rapid progress.
136

are clearly discernible: uncertainty about customer preferences; “legacy” interoperability problems;

“distance” from the locus of technology development; and computer security issues.101

In summary, these barriers, and the associated underinvestment, are linked to economic conditions

that are not conducive to proper functioning of the market mechanism. It is these market failures that

constitute the primary justification for government participation in service sector technology development

and implementation activities. There is ample anecdotal evidence of barriers to technology development and

implementation that lead to the types of market failure that NIST is equipped to address. Coupled with the

general statistical evidence of the service sector’s substantial underinvestment in IT, the case studies

suggest a potentially important role for NIST in support of the service sector. The nature of that role is the

subject to which we now turn.

Table 8-2. Evidence of Barriers by Market Failure Type and Service Industry

Appropriate

Policy

Instrument

Type of

Technology

Barrier

Retail

Banking

Home Entertainment Health

Care

Recognition • Individual co-development

efforts with communications

hardware suppliers

• Formal horizontal

collaborations (e.g., FSTC)

• Historical inexperience with

cooperative strategies

• Unimagined IT applications

• Locus of technology

development outside service

sector

•Collaborative ventures (e.g.,

CableLab, DVD

Consortium)

•Locus of technology

development outside service

sector (services poorly

represented in many

standards development

activities, e.g., DAVIC)

•Unimagined IT applications

•Wireless technology (PCS)

potential for “paradigm

shift”

• Collaborative ventures with

software developers (e.g.,

numerous ATP awards)

• Locus of technology

development outside service

sector

Support for

Generic

Technology

Long Time

To Market

• “Widely inaccurate”

economic projections of past

innovations (ATMs)

• Customer preferences

unclear

•Customer preferences

unclear

•Improvements in video

server technology to enable

VOD service

(underinvestment: 300%)

• Intermediate customer

preferences unclear &

resistant to IT

(underinvestment: 200-

300%)

• Long time to

 

101 The evidence presented here was the result of open-ended questions regarding technological barriers and the resulting

underinvestment. In Section 8.7.1 the results of a ranking of a standard list of 47 IT areas provides information needed to

prioritize critical technology areas according to their pervasiveness.
137

commercialization (e.g.,

imaging research)

Excess

Competition

Among

Developers

•Two or three home interface

paradigms (TC, computer,

teleputer)

Excess

Competition

Among

Implementer

s

• Technology investments

seen as critical to bank

survival

• Highly fragmented industry

• Pressures of “managed care”

limit IT investment

(underinvestment: 200%)

• Highly fragmented industry

Spillovers • Roadmaps emerging to

make sense of a “vegetable

soup” of collaborative/

standardization issues

•Digital copyright concerns

associated with

Internet/video-on- demand

Interoperability of

Systems

• “Legacy” interoperability

problems (associated with

larger IT system

coordination problem)

• Physical networks

• Software agreements

monitoring

•Two or three home interface

paradigms (TC, computer,

teleputer)

•Wireless technology (PCS)

potential for “paradigm

shift”

• “Legacy” interoperability

problems (associated with

larger IT system coordination

problem)

• “Legacy” interoperability

problems (associated with

larger intra- and inter-IT

system coordination

problems) (underinvestment: +50%)

Support for

Infratechnolo

gy

Development

High

Transaction

Costs

(Info/Asset

Sharing

Difficulties)

• Formal horizontal

collaborations (e.g., FSTC)

• Historical inexperience with

cooperative strategies

• Roadmaps emerging to

make sense of a “vegetable

soup” of collaborative/

standardization issues

•Collaborative ventures (e.g.,

Cable Lab, DVD

Consortium)

• Collaborative ventures with

software developers (e.g.,

numerous ATP awards)

Infratechnologies

• Progress on digital

compression standards is

too slow

• Certification & acceptance

marks

• Emphasis on customer

access technology

• Computer security

standards & protocols

(major issue: protecting

confidential information)

• Network test & evaluation

tools/ data compression

standards

•More rapid progress on

digital compression

standards — “going beyond

MMPEG-2” (investments to

support $billions in video

market revenues)

•Improved Internet protocols

(under- investment: 30%)

•Computer security standards

& protocols

•Network test & evaluation

•Compression algorithms

• More rapid progress on

digital compression

standards

• Progress on EDI standards

essential to HC cost

reduction

• Computer security standards

& protocols (major issue:

sharing confidential

information)

• Network test & evaluation

• Compression algorithms
138

8.7 BARRIERS TO TECHNOLOGY: THE POLICY CONTEXT

In this section the proceeding summary of technology barriers and related underinvestments is

placed in a context that can support policy discussion and choices by NIST. In section 8.7.1 the discussions

of the key technologies (section 8.5) and barriers to technology development and implementation (section

8.6) are interpreted through the lens of appropriate policy instruments discussed in Chapter 3. In section

8.7.2, the private service sector’s major institutional responses to technology barriers are summarized as a

prelude to the discussion of policy implementation in the final chapter.

8.7.1 Matching Policy Instruments and Barriers to Technology

As discussed in Chapter 3, barriers to technology development and implementation can result in

market failures and underinvestment. The appropriate public policy response to these technology barriers

depends on their specific nature. Briefly, general riskiness associated with technology development and

implementation can be addressed through broadly applicable policies such as tax incentives. While our case

studies clearly show high levels of general risk, the types of problems identified in this report are not

appropriate for such solutions. Rather, the sources of market failure are identified and described at a level

of detail that allows some discussion of appropriate policy instruments. This is the level of analysis

required for NIST to begin to develop specific institutional responses to service sector market failures.

As observed by Tassey (1997), ferreting out the nature of the barriers to further development or

implementation requires sophisticated policy analysis and significant input from industry. The case studies

in this report go some distance in fulfilling this requirement. And while it is often not easy to isolate the

exact nature of specific barriers, an attempt is made here to categorize cross-cutting barriers for the

purpose of indicating a potential course of action for NIST. However, in any specific case a finer grain

analysis, and more detailed industry input, is likely to be required prior to any institutional response.102

 

102 Ideally, a thorough review of the technologies at issue would precede the interview, so that specific economic dimensions of

the topic could be explored. For the most part, technology reviews for the case studies presented here were conducted

simultaneously with the industry interviews. In addition, interviews for these case studies covered a wide variety of topics,

partly to discover specific barriers to technology and partly to ascertain the economic significance of these barriers. Ideally,

each barrier could have been pursued in detail and then, once a cross-cutting view was established, additional questions

could be raised and addressed. Due to the initial sweep of the inquiry for each of the case study industries, this kind of

focused analysis was not possible. These case studies were understood to be anticipatory of detailed discussion between

NIST technology experts and their industry counterparts. The appropriate level of detail could be ascertained in such

meetings, or in anticipation of them.
139

General risk. While assessing general risk is not the focus of our investigation, it invariably was

present as the “background noise” to understanding and exploring more specific types of barriers. For

example, financial constraints were often mentioned, as were planning horizons (short planning horizons =

high hurdle rates) of no more than 18 months. A health care -related estimate suggests that with reasonably

less stringent financial constraints IT investments would double.

In all cases, industry observers expressed a great deal of uncertainty. The roots of this uncertainty

are many: the pace of technological change; the complexity of dealing with that change operationally in

such information systems-dominated businesses; the dramatic consolidations taking place in these

industries; and especially in banking and home entertainment, the industrial convergence phenomenon. This

sense of uncertainty is no better expressed by the banker’s profound strategic planning question, “What is a

bank?”

Specific risk. Case study analysis provides a window onto specific types of risk that arise from a

market’s or a technology’s stage of maturity, its degree of publicness, or its potential to reduce market

transaction costs. (Tassey, 1997) Table 8-3 organizes service sector infrastructure technologies according

to the scope of their application and type of policy instrument appropriate to their development. Consider

the technology areas common to all three case study industries (column 1) discussed in section 8.6

(electronic commerce applications, cryptographic standards, firewalls & Internet-based tools network

scaling, data compression, wireless communication). Of these, the private sector appears to have a

dominant role in developing and implementing electronic commerce applications, but the fact that all three

industries ranked this technology area as critical to their future, suggests, at a minimum, some public policy

concern to identify and address any cross-cutting barriers (such as interoperability and security issues).

Perhaps there are underlying generic technologies involved in electronic commerce applications that would

be appropriate targets of collaborative research of the type supported by NIST’s Advanced Technology

Program.103 In the other five technology areas, NIST information technology experts identify important

issues appropriate to public sector involvement. In fact, NIST is currently engaged in the development and

implementation of infratechnologies that support these technology areas, though, to our knowledge, these

have not been focused or organized to support any special needs of the service sector. (Perine, et al. 1996)

 

103 Such collaborative efforts would want to ensure representation of vertically related partners, including service sector
140

While the high-priority technology areas common to retail banking and home entertainment —

monitoring and control for large networks, set-top boxes, and distributed data bases — are the focus of

much private investment, their priority ranking by representatives of two very different industries suggests

that generic technologies and infratechnologies may underlie the effective service delivery strategies that

these technologies support (column 2). Further evidence of the potential for a public sector role in

providing infrastructural support for at least one of these technology areas (set-top box technologies) is

suggested by intensive standards-related activities that have surrounded the regulation of interactive TV

services. These activities pertain to the existence of complex systems of interfaces that can retard

interoperability and timely adoption of technologies. Interactive TV technologies, such as set top boxes, are

critically important to the service delivery strategies of service industries and firms.

The critical technology areas common to other service industry pairs (health care and banking,

health care and home entertainment) more clearly involve technologies in which NIST does provide

infrastructural support (conformance testing for cryptographic standards, authentication technology, next

generation internet protocols, multimedia quality of service tools, and compression algorithms). Even where

the proprietary role in technology development would appear to dominate (e.g., design for speech

recognition hardware and software), the cross-industry nature of the priority accorded this and other

technology areas (data management, systems management, systems integration) increases the probability

that elements of generic technology are important to their fullest development and implementation.104

Listed in column 3 of Table 8-3 are technology areas considered critical to members of single

industries. These would be the lowest priority for technology policy initiative unless additional information

allowed the selection of individual service sector industries as recipients of technology policy support.

__________________________________

companies.

104 NIST’s ATP has funded the development of both pen-based and spoken language interface projects in the past. ATP has

also organized “focused programs” to advance the development and implementation of generic health care technologies.
141

Table 8-3. Cross-Cutting Infrastructure Technologies and Appropriate Policy Instruments

Appropriate

Policy

Instrument

Cross-Cutting Technologies Inter-Industry Technologies Intra-Industry

Technologies

Support for

Generic

Research

• Electronic Commerce

Applications

• Monitoring & Control for

Large Networks

• Set-top Boxes

• Distributed Data Bases

• Design for Speech

Recognition

Hardware/Software

• Data Management

• Systems Management

• Systems Integration

• Operating Systems &

Utilities (Banking)

• Video Servers

(Entertainment)

• Hierarchical Mass Storage

Systems (Entertainment)

• Virtual Reality

(Entertainment)

• Techniques for Manipulating

Unstructured Text (Health

Care)

• Vizualization Methods for

Complex Visual Information

(Health Care)

• Image Recognition &

Processing (Health Care)

• Scaleable Parallel Systems

(Health Care)

• Software Testing & Analysis

Tools (Health Care)

• Open Distributed Processing

(Health Care)

Support for

Infratechnology

Development

• Crytographic Standards

• Firewalls and Internet-based

Tools

• Network Scaling

• Data Compression

• Wireless Communication

• WWW & IPv6 Security

• Conformance Testing for

Cryptographic Standards

• Authentication Technology

• Next-generation Internet

Protocols

• Multi-media Quality of

Service Tools

• Compression Algorithms

• User Interfaces &

Information Access

(Entertainment)

• Multimedia Protocols

(Entertainment)

• Internet Security Policy

Development (Health Care)

• Vulnerability Analysis &

Testing (Health Care)

• Multimedia Collaborative

Computing (Health Care)

• Common Windowing

Protocols (Health Care)

It is very clear that across the service industries examined, the broadly defined technology areas of

computer security (cryptographic standards, firewalls & internet-based tools, conformance tests for

crytographic standards, advanced authentication technology) and networking (network scaling, data
142

compression, wireless communication) are the dominant concerns of the service sectors. In both of these

areas, NIST is involved in providing technology infrastructure support.

Whether it makes sense to orient NIST’s ongoing efforts in these technology areas toward the

service sector’s special needs, indeed if infratechnologies can be construed as sector specific, requires

deeper interaction between technical specialists in NIST and industry.

Given the scale of the underinvestments that are occurring in the service industries we examined

(ranging from 20% to 300% in specific areas), and the common need for a broad range of technology

infrastructure elements (especially those related to computer security and networking), it is clear that

targeted technology programs are appropriate and that they can foster greater technology investment and

economic growth in the service sector. To understand the specific roles that NIST can effectively play in

any particular technology area requires further detailed discussions and negotiations between technical

experts representing NIST and service sector firms respectively. In discussions with corporate technology

managers, all expressed a willingness to engage in such a dialog.

8.7.2 The Private Sector Response to Technology Barriers

In each of the case study industries, firms are responding to barriers in at least 4 ways. First, they

are investing considerable funds into coping with IT development and implementation barriers. As we

indicate in Chapter 2, the cost of IT implementation can be four to five the times the investment in

hardware and software. Second, firms are increasingly investing in technology development, typically in the

form of co-development projects with suppliers in the manufacturing sector. Third, they are engaging in

collective R&D efforts with other members of their industry (though these, too, often involve

manufacturing sector participants). Finally, they are engaging in standards-related activities.

There appears to be considerable overlap in these activities. All but the second are considered

initial evidence of (potentially incomplete) responses to market failures. Even co-development efforts can be

related to market failure problems, to the extent that they are related to standards-making activities. It is not

uncommon for co-development efforts between service sector firms and their hardware or software

suppliers to result in products that are put forward in standards-related efforts. Standards efforts, in turn,

are evidence of (perhaps incomplete) collective responses to technology system complexities that often lead

to underinvestment in technology and market failures. We contend that collective industry responses are

located in the “neighborhood of market failures” and are, therefore, likely to offer a window onto an
143

appropriate supporting role for NIST. In other words, we interpret collective action as the first line of

circumstantial evidence that something is amiss with the functioning of the market mechanism; something

that demands more than singular action on the part of competitive firms.

For example, the Financial Services Technology Consortium (FSTC) and the Bankers

Roundtable’s newly formed Banking Industry Technology Secretariat (BITS) represent two responses by

the retail banking industry to technology development and implementation barriers. They also provide an

insight into how NIST might appropriately support service sector responses to market failure. The FSTC,

in what participants describe as its “adolescent phase,” has already involved public organizations — in the

form of Technology Reinvestment Project funds and National Lab participation. The BITS is in its

“infancy” but defines goals (such as the creation of a “certification process” and “acceptance marks") that,

ceteris paribus, are clearly within the scope of NIST’s concern and core competency. These two

organizations are representative of emerging economic forces affecting the development and implementation

of banking technology.105

FSTC is a collaborative R&D effort aimed at providing open solutions to problems confronting the

banking industry as it moves into the world of internet banking in the not too distant future. Incorporated in

1993, FSTC has involved representatives of banks, other financial service providers, IT hardware and

software companies, national laboratories, government agencies, and universities.106 FSTC currently has

about 90 member organizations and sponsors project-oriented collaborative research & development on

interbank technical projects affecting the entire financial services industry. Particular emphasis is placed on

active projects involving development of the internet and supporting a smooth transition toward an

integrated global electronic commerce.

Currently, FSTC projects include: the Interbank Check Imaging Project, aimed at exchanging

digitized computer images of paper checks using new open systems of computer platforms and

 

105 While there are undoubtedly other collaborative organizations whose examination would throw light on our subject,

industry representatives believe that collaborative banking organizations with an explicitly R&D focus were few and far

between.

106 The government agencies have included: the U.S. Department of the Treasury, the U.S. Postal Service, the National

Security Agency, and the Export-Import Bank. National laboratory participants have included: Oak Ridge, Lawrence

Livermore, and Sandia. Our impression from interviews with FSTC bank participants is that the role anticipated for the

national laboratories in the early stages of FSTC never materialized.
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technologies; the Electronic Check Project, to validate the business and technological risks and

opportunities for an all-electronic financial instrument; the Electronic Payments Project, to develop a broad

architecture that enables electronic commerce process over public networks; and the Fraud Prevention and

Control Project, to investigate how to improve fraud detection and prevention for interbank information

sharing. Successful implementation could mean the reduction of check processing costs by as much as 33

percent, the secure integration of existing proprietary bank infrastructure with rapidly growing public

networks, and the demonstration of effective fraud detection technologies and methodologies.

FSTC is one of a handful of bank-related organizations that are pursuing similar collective

solutions to what for a long time have been proprietary solutions to IT systems issues. Other organizations

pursuing a similar or complementary course include: CommerceNet, the Joint Electronics Payments

Initiative (JEPI), the XIWT, the IISP, the National Association of ClearingHouses, and the World Wide

Web Consortium (WWWC). All these organization are dedicated to some extent in developing and

promoting the infrastructure for Internet banking. The existence of so many initiatives with apparently

overlapping objectives has recently given rise to the Bankers Roundtable’s Banking Industry Technology

Secretariat (BITS). BITS was formed, in large part, to organize and focus what one observer calls “the

primordial soup swirling around internet banking.” BITS has identified over 40 organizations with

complementary or overlapping missions and has proposed an number of initiatives aimed at cooperatively

facilitating “the evolution of a seamless electronic financial services delivery and payments environment

that will have the capability of linking customers — at their choice — with the marketplace through

banks.” (Bankers Roundtable, 1996)

BITS key initiatives are: to accelerate the establishment of new electronic payment and product

delivery systems through the development of interoperable specifications and standards; to create, through

a certification process for providers of banking products, an infrastructure for the safe and secure

electronic environment that will embrace bank brands and respect consumer privacy; and to enhance

consumer confidence, via an “Acceptance Mark,” and evaluate the feasibility of industry-driven payment

certificate authentication and real-time settlement.

In the health care industry too, we find similar collective responses to technology barriers. Health

care industry representatives identified and emphasized the standardization efforts underway throughout the

industry. There are many important standardization actions in progress. HL7, ASTM, COBRA Medical

Standards, X12 EDI Standards, and more generally work on technological standards for open systems and
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the Internet.107 Respondents emphasized the pressing need for such work on standards, especially electronic

data interchange standards. A recent OTA analysis of the role of technology in the health care industry

stressed the importance of such efforts to achieving the cost reduction that the public is demanding:

Until standards are in place and compliance is widespread, costly activities—such as

maintaining multiple formats for health care information, dealing with exceptions, and

developing new interface software as new proprietary approaches to managing health

information become fashionable—will continue to offset some potential savings of

processing health care records and transactions electronically. . .

The development of technical standards is primarily a private-sector activity. However, it

could be accelerated through federal participation in developing standards that would

encourage information exchange and protect the privacy of participants in the health care

system, and through expeditious implementation of such standards in all federal health care

matters as a catalyst for their adoption by the private sector. (OTA, 1995)

A recent survey of service sector R&D collaborations sheds additional light on how the various

collective responses to market failure overlap in practice. (Leech and Link, 1997) The survey found: i.) that

the primary objective of many formal service sector R&D collaborations is to gain access to

complementary research or technical skills that are unavailable to individual service sector firms; ii.) that

the collaborative R&D undertaken by service sector firms was less oriented to basic research than nonservice sector collaborations; and iii.) that formal collaborative R&D projects often have standards- and

protocol-related objectives (i.e., are more infratechnology focused), more so in fact than collaborative R&D

projects undertaken in non-service industries. On the basis of this analysis and the findings of our case

study investigations, we conclude that collective industry activities of all kinds are typically attempts to

 

107 The Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA) governs continuation of health care coverage

requirements between two employing organizations, placing the burden of compliance solely upon the employer. Prior to

COBRA, when an individual was no longer employed by a sponsoring organization, he or she and any dependents would

either be discontinued from insurance coverage or would have the option to continue coverage under a modified plan.

While many of these plans complied with conversion options and respective state laws, the provisions were not uniform.

Health Level Seven (HL7) is an application protocol for electronic data exchange in Health care environments. The term

"Level 7" refers to the highest level of the Open System Interconnection (OSI) model of the International Standards

Organization. In the OSI model the functions of both communications software and hardware are separated into seven

layers or levels. The seventh level refers to the application level. The application level defines the physical format of a

message, or the location of the actual fields of each electronic message. In June 1994, HL7 became an ANSI Accredited

Standards Organization.

The ASC X12 (a designation assigned by ANSI) was chartered to develop the structure, format, and content of electronic

business transactions conducted through Electronic Data Interchange (EDI). The result of the ASC X12 committee's efforts

are the ANSI X12 Standards.
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address both technology-specific types of market failures (e.g., high risks due to technical complexity,

requiring technical expertise not available to the firm) and market-related types of market failure (e.g. high

transactions costs associated with systemic nature of IT that standards-related activities attempt to

address). Moreover, it appears that NIST’s mission and expertise are highly complimentary to the

objectives of these efforts.

8.8 CASE STUDY METHODOLOGY INSIGHTS

Case studies involve a process of discovery. They often raise as many questions as they answer.

These case studies answered numerous questions that could not be addressed successfully by other means.

We identified specific technological concerns considered critical to three important service sector industries.

We identified perceived barriers to the fuller development and implementation of these critical technologies,

and we obtained some sense of the magnitude of the underinvestments associated with these barriers.

Applying the logic of market failures we are able to understand, generally, the market conditions that

appear to lead to underinvestments in technology.

The case study investigations also led us to conclude that the body of economic literature through

which we understand the logic of market failure has two shortcomings. The first is that it provides very

little discussion about the kinds of evidence of market failure that would be most useful to applied case

studies. As an important tool of technology policy, improvements in the applicability of market failure

concepts is much needed. “Tools” with which to identify and assess the presence and degree of market

failures, in the absence of complete information, are necessary, especially in support of prospective policy

analysis.

The second shortcoming of the market failure literature, as it applies to the service sector, is that it

is focused almost exclusively on the supply of technology at the expense of attention to demand. While the

logic of market failures clearly applies to both the conditions of demand and supply, the bulk of the

discussion to date is rooted in a production-oriented paradigm. Service sector firms are primarily

consumers of technology. Their underinvestment is in large part caused by their economic conditions as

buyers. Service sector firms are also forced to understand, and to respond to final consumers. It appears

that some barriers to the service sector’s greater investment in technology are rooted in economic conditions

faced by final consumers. These market failure modes have received far less attention by economists and

policy makers. While we do not claim to have solved, or even adequately formulated these issues here, we
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believe they are worthy of consideration as further analyses of the service sector market failures is

undertaken.
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9. DIRECTIONS IN TECHNOLOGY POLICY FOR THE SERVICE SECTOR

9.1 WHAT WE HAVE LEARNED

According to the national statistics reviewed in Chapter 2, the development and implementation of

technology is increasingly important to the service sector of the economy. Because of the importance of the

service sector to national economic growth, and because technological innovation is the single most

important source of growth, technology policy in support of the service sector is an important area of

policy concern.

Except for the communications services industry and the computer services industry, the service

sector is for the most part a consumer and lead user, rather than a developer, of technology. Nevertheless

considerable resources are expended by service sector firms in support of co-development efforts and, more

importantly, in the testing, evaluation, and implementation of technology. NIST’s special capabilities in test

and evaluation practices, and its historical role in standards development activities (both of which are

important to service industries) should provide a good foundation for interaction with industries across the

service sector.

IT is the single most important focus of all technology development and implementation in the

service sector. Between 80 percent and 100 percent of RDT&E staff time in the large service sector firms

studied is dedicated to IT and IT-related issues. ITL’s new institutional focus on IT is another reason to

expect successful interaction with a broad mix of service industries.108

Increasingly, we believe, IT in service sector firms is moving from “back office” applications

forward, to become an integral part of service content and delivery, and as this “phase change” occurs

service sector RDT&E staffs will grow and the share of internally developed technology, relative to the

total cost of technology, will grow. More importantly, this phenomenon sheds new light on the role of

technology in the service sector and, potentially, on NIST’s role in supporting the service sector.

 

108 On December 9, 1996, NIST announced the formation of its new Information Technology Laboratory, a consolidation of the

former Computer Systems Laboratory and the Computing and Applied Mathematics Laboratory.
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As stressed throughout this report, the existence of market failures— breakdowns in the incentive

structure that drives private investment — provides the chief economic rationale for government

involvement in technology development and implementation. We have argued that a cogent approach to

government technology planning requires an analytic framework that can effectively differentiate types of

market failure according to the various policy instruments best suited to their mitigation (Chapter 3); we

have demonstrated in the case study chapters that such a framework can be applied effectively to discover

and discern the most serious areas of market failure; and (in Chapter 8) that it is possible to apprehend

cross-cutting specific technology areas that are critical to service sector growth . What is required beyond

all this is a concept of institutional engagement — the modus operandi by which NIST delivers generic and

infratechnologies to the service sector.

In the following sections we first posit a refinement to the conventional understanding of the role of

the technology infrastructure in the service sector. The succeeding section will suggest an approach to

NIST engagement with the service sector.

9.2 A SERVICE SECTOR-SPECIFIC TECHNOLOGY GROWTH MODEL

In Chapter 1, the technology growth model developed by Tassey (1995) was explained. This model

recognizes an important “division of labor” among the various “estates” in a nation’s system of innovation

— universities, the private sector, government — and describes how these technology estates interact to

effect economic growth.

In the case study analyses presented is this report, we find evidence to support the view that there

are important extensions to the original Tassey model:

[The original model] more accurately represents a manufacturing firm or industry than one

in the service sector. Thus, limiting the conceptual framework to this representation would

contribute to a somewhat out of date focus of R&D policy in which most technical

infrastructure is still oriented toward the manufacturing sector, with only a slow shift

toward support of information technology and services more generally. (Tassey, 1997)

It has been observed that even within the manufacturing sector there are variations in the role of

technology, and that for one of those variations — supplier dominated industries — investments in new

machinery and equipment, acquisition of hardware and computers, and manpower training are often more

meaningful indicators of technological change than the firm’s own R&D efforts, despite the fact that some
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internal R&D is performed. (Brouwer, 1995)109 Thus far, the supplier-dominated model is completely

consistent with the findings presented throughout this report. But this model goes on to suggest that, the

similarity of supplier dominated industries (manufacturers or service providers) is based in large part on the

“process orientation” of the technology implementation. These supplier-dominated industries are thought to

“concentrate on process rather than product development.”

In our view, this model misses an important dynamic: the “phase shift” in the application of IT

from the “back office” forward to content development and delivery discussed in other models of service

sector innovation. Our findings are more consistent with a dynamic model of innovation; with the

proposition of an innovation life cycle — or “reverse product cycle” — that propels the evolution of IT

implementation from the “back office” forward to “new product” development.

In describing the conditions for a phase shift in the application of IT toward product innovation,

Barras clearly anticipates the main outline of our findings. His model foresees the phase shift toward the

use of IT in the development of service content and in service delivery. Two important aspect of that shift

are the change in the point of consumption (which we see very clearly in all three case study industries),

and a change in the balance of market power toward the consumer (which appears very clear in the case of

home entertainment and retail banking with the proliferation of “access channels”). (Barras, 1989) In 1986,

Barras could see that progress toward this “third stage” had hardly begun and that it required the

“progressive digitization to a broadband network capable of transmitting text, data, voice, and live

pictures.” Today those capabilities are either near, or fast approaching, the “state of the shelf.”

Similarly, Mitchell’s (1989) model of innovation in the service sector stressed the following: the

service provider’s imperative to control or influence hardware or software design (which case studies reveal

in terms of co-development efforts); the necessity of the services to integrate technology into complex

systems or organizations (which case studies reveal in terms of the imperatives of interoperability,

especially the interoperability of current, past and present IT elements); the technical demands of operating

these complex systems or organizations on a daily basis (which case studies reveal in terms of the extensive

test and evaluation processes to assure error-free IT introductions and adaptations); maintaining that

 

109 Brouwer employs a taxonomy developed by Pavitt (1984) to interpret the findings of a European service sector innovation

survey.
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complex system to deliver services reliably (which case studies reveal in terms of the high rank according to

reliability as an IT performance parameter); and the prominent role of the end users as the direct customer

(which case studies reveal in terms of emphasis on access to customers “wherever they are,” and the

uncertainty about consumer preferences that burdens many a service sector IT investment project). In our

view, the “phase shift,” that appears to be occurring across the service sector, in the application of IT

forward to content and delivery (over and above its use to dramatically increase efficiency in ‘back office”

and “front office” functions) accentuates all these facets of the services market. What this means for

Tassey’s original technology-based economic growth model is characterized in Figures 9-1, 9-2, and 9-3.110

Figure 9-1. The Two Faces of Service Sector Technology Infrastructure

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are two fundamental interfaces in the service provider’s use of IT: one between multiple hardware and

software vendors and the service sector firm; and one between the service sector firm and the consumer.

 

110 The depiction of the technology infrastructure shown in Figures 9-1 through 9-3 are consistent with the model of service

sector technology infrastructure developed by Tassey (1997).
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The service sector RDT&E function has emphasized test and evaluation activities vis-à-vis hardware and

software vendors but, as noted throughout this report, there have also been co-development relationships

with these vendors. We believe that, increasingly, service sector RDT&E functions are also engaged with a

very different kind of R&D regarding their interactions with consumers. Our case study interviews found

examples of service sector attention to both the hardware/software facets of this provider-customer

interface (e.g., bank research efforts geared to biometrics to ensure greater security) as well as the content

aspects of the interface (e.g., entertainment company research on “how to appeal to the consumer’s sense of

exploration”). The literature too suggests that, increasingly, service sector firms must be concerned with

R&D in the areas of human factors, psychology, and applications design that address the providercustomer interface. (Mitchell 1989)

Within this framework, the provision of NIST’s technology infrastructure occurs at both

interfaces, for example, supporting increased interoperability through support for vertically organized

generic co-development efforts, or the development of techniques and tools for assessing complex systemsubsystem-component compatibility. At the service provider-customer interface, organizational processes

(like the National ISDN Users), or infratechnologies to advance or characterize the security, reliability, and

usability of service delivery technologies, are likely to be appropriate and desirable.

Figure 9-2 addresses another layer of complexity. Here we capture the basic elements of the service

sector supply chain: service content (movie production, news reporting, financial instruments) and service

transport and delivery. To some extent the interoperation of content providers and service deliverers is

accomplished by means of vertical integration with manufacturers. Nevertheless the need for technology

infrastructure within the service sector should not be overlooked. As service delivery modalities (cable,

telephone/Internet, broadcast, and wireless) continue to converge, the technology infrastructure must be

there to support it. This adds another dimension to NIST’s technology infrastructure role.

Finally, Figure 9-3 attempts to capture the full complexity of the service sector’s requirement for

technology infrastructure. In addition to the manufacturer and customer interfaces depicted in Figure 9-1,

and the intra-sectoral content-delivery interface addressed in Figure 9-2, here we also capture the intraindustry interface that is so important to the physical networks that characterize much of the service sector.

In health care, retail banking, and home entertainment, the physical interconnection among service

providers can involve barriers (in the form of security concerns) to greater utilization if IT.
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Figure 9-2. Intra-Sectoral Technology Infrastructure

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The service sector is structurally complex. The role of the technology infrastructure in the service

sector is extensive, supporting the interaction of markets at many levels and at many stages of the value

chain that runs from manufacturing to the final consumer. Both generic and infratechnologies can mitigate

the barriers that lead to market failure in several aspects of the service sector’s complex structure.

Given this complexity, even with knowledge of the nature and general structural location of market

failures, how do policy makers determine a mode of engagement through which to exercise market- and

technology-specific policy instruments in support of the service sector? Historically, NIST has “engaged”

the manufacturing sector, in part, through its participation in the voluntary standards development process.

As described in the following section, this presents a challenge in the case of the service sector.

9.3 THE LOCUS OF SERVICE SECTOR TECHNOLOGY POLICY ENGAGEMENT

This section presents a general approach to NIST’s interaction with the service sector. This

approach synthesizes our understanding of the evolution of the IT standardization process (a poorly

understood aspect of industrial activity generally, according to Hawkins (1995)) with our
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Figure 9-3. Role of Technology Infrastructure in the Service Sector

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understanding of service sector needs in the face of barriers to technology and market failures. We

emphasize greater involvement by NIST in strategically selected, ad hoc service sector efforts to address

standards-related issues in other than (perhaps in addition to) traditional voluntary standards fora. Our

understanding is that traditional standards organizations are perceived as remote from, and not focused on,

the pressing technology issues facing service industries. If NIST is to successfully engage the service

sector, it must do so where key problems are being identified and addressed.

One of the primary ways NIST has supported the manufacturing sector of the economy is through

participation in, and support of, voluntary standards organizations.111 In a technology-based economy,

 

111 In recent years, NIST — through its Advanced Technology Program — has also emphasized other forms of infrastructural

support The following discussion is focused on NIST’s role in supporting standards-related activities, support that Tassey

categorizes as the provision of “infratechnology.” In practice the development and implementation of infratechnologies and

generic technologies often occurs together, especially so in the service sector. Where appropriate our discussion of

standards-related support should be construed to include support for generic technology as well.
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standards are taking on increased importance due to the complexity of new products, the speed at which

new models come into being, and the fact that these products are frequently embedded in systems whose

effectiveness is, in turn, dependent on the interfaces between the components. (Tassey, 1995b) One of

NIST’s traditional roles in this regard has been to develop methodologies for assessing and assuring system

“fit.” This is a prime example of NIST’s role as a developer and disseminator of “infratechnology.”

The standards development process — especially for IT standards — is under severe strain. Speed

in standardization is essential for the future of IT, and most standards bodies are simply not geared to

operate as quickly as needed. (OECD, 1991) Yet despite this “growing and widespread dissatisfaction,” no

new coherent approach has emerged. (Alexander, 1995) The change in the pace and complexity of IT and

its myriad application, along with greater recognition of the importance of the quasi-public goods nature of

certain technology elements, has caused several new types of standards-related organizations to emerge.

For example, Cooperative Research and Development Agreements (CRADAs) between government

technology organizations and industry often have the early development of infratechnologies as their

objective. (Tassey, 1995)

Other types of organizations, such as RJVs and private consortia, have emerged as well, some

expressly formed to bypass the formal international standardization process by delivering sponsored de

facto standards ratification by the market. (David, 1995) That said, standardization still ranks among the

least understood industrial phenomena, and the debate about the role of the government regarding ITrelated standards-making processes is in a state of turmoil according to knowledgeable observers.112

(Hawkins, 1995; David, 1995) For our purposes, we assume that because of the large public spillovers

NIST has generated by supporting the standards development and implementation process (See Tassey

1995a), their support of service sector infratechnology will also be beneficial. Still, it is unclear what the

optimum forms of participation might be.

According to analysts of the standards-making process, many difficulties must be resolved if IT

standards are to remain effective:

 

112 Paul David describes the economic logic of public policy concerning technical standard-setting in general as in an unsettled

and confusing state. He observes that the “present turmoil” is especially noticeable in regard to standards affecting the

information, computer, and telecommunications industries. (David, 1995).
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The thrust of standardization efforts in IT has changed and as a result of a number of

developments, such as the ever-increasing range of cross-fertilization between information

technology and communications, the major importance of individual PCs, and the resulting

need to link them with networks, the growing diversity of satellite equipment and of

software, the rising demand of users for compatibility and interoperability, etc. Largely as

a result of these developments, some of the traditional approaches which long prevailed in

many areas ... are no longer viewed as realistic or economically desirable.

At the same time, the acceleration of technological advances in the IT area has put the

standardization system under pressures which may often be contradictory: the production

of standards becomes more urgent, but consensus between the interest groups may be more

difficult to achieve because of uncertainties and the magnitude of vested interests.

Furthermore caution is required to formulate standards which will evolve in line with

further development. (OECD, 1991)

This dynamic has given rise to functional standards (e.g., Open System Interconnection - OSI)

which define performance to be achieved at different layers of technological systems but retain some

freedom in deciding how the standard will be met; and anticipatory standards, which are developed before

the expression of the actual standard and before the onset of competition and its irreversible consequences.

This dynamic is seen as formative to the effective development and promulgation of IT standards:

The relevance of these anticipatory standards will depend on the ability of [their]

developers to assess the potential outcome of on-going research in the areas under

consideration. For this reason, links between R&D and standardization activities are

required, calling for a new generation of committees and organizations at the interface of

R&D and standardization. However the anticipatory standards will also contribute to

removing user representatives from the standardization process since, by its very nature,

an anticipatory standard will anticipate the needs, the demand, and even the very existence

of users who do not yet exist.

The ways in which this contradiction between the required participation of users and their

de facto absence will be solved will no doubt be decisive for the future of standardization

in the IT area. It underlines in any case the magnitude of the new role which may be

assigned to governments, as potential clients for new technologies and a representative of

the public good and the interests of future clients. (OECD, 1991)

This phenomenon is shown in the upper left of Figure 9-4, as a drift in the locus of traditional

voluntary standards development activity (and, presumably, NIST’s role in that activity) away from

(“upstream” from) the manufacturer-service provider nexus. This interpretation of events is consistent with

case study observations that traditional standards organizations lack the focus and the flexibility to meet the
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needs of service sector firms, and with the emergence of ad hoc collective industry organizations in

response to various IT barriers. 113

Figure 9-4. Emerging Role for User-Oriented Anticipatory Standards Activity

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The collective responses, such as those observed in the banking and health care industries, are

interpreted as attempts to fill a void for technologically sophisticated, infrastructural requirements. Some

have argued that the “ownership” of standards-making processes by users was inevitable as multi-IT

vendor procurement increasingly becomes the norm. In this situation the responsibility for compatibility

has, de facto, been delegated to the user. (O’ Connor, 1988) In any event, we hypothesize that these “user-

 

113 Interestingly, the standards literature makes exceptions to the general observation about a lack of “user” involvement in IT

standards processes when it comes to well-organized user industries, such as banking. In discussing the organization of the

Banking Industry Technology Secretariat (BITS) in Chapter 8, we asked why these activities were not being undertaken by

X9 (the ANSI organization concerned with banking standards). The response: that X9 was too reactive, too slow, and too

broadly focused to address the very real needs of the core banking organizations.
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focused” collective industry organizations are the institutional solutions to the dilemma posed by the

contradictory needs for greater user participation and more R&D-focused, anticipatory IT standards.

There is another potential role for NIST, depicted in the lower portion of Figure 9-4. The

integration of the user into the standards process is widely perceived as an important trend. According to

some, the ability to accomplish this is required to maintain the legitimacy of the IT standards in the face of

rapid change. (Lundvall, 1995) But what is meant by “ the users?” Clearly, users include intermediary

users, such as service sector providers. Clearly too, these intermediaries are, to a large extent, responsible

for determining and attempting to serve end user needs and requirements. But just as clearly, the service

sector itself is having difficulty understanding its users’ expectations and this translates into barriers of

uncertainty and, consequently, underinvestment in IT. So it is at least arguable that NIST should act as a

catalyst for efficient standards development — including both content and timing — by facilitating

consensus building among the disparate and changing stakeholders.114 In summary, it appears that NIST

has a potentially important role to play in supporting the needs for technology infrastructure in the service

sector and that a convenient “entry point” is provided by the various types of informal collective industry

organizations that have emerged to facilitate the needs of intermediate IT users.

However, there appears to be growing and widespread dissatisfaction with the institutional

framework for standardization. The integration of NIST core capabilities with emerging IT-focused,

service sector organizations may provide some support to the evolution of an important process, in a

manner that maintains the relevance of the traditional standards organizations (through NIST liaison),

while also augmenting their capacity for addressing the service sector infrastructural needs.

From our industry case studies and survey of RJVs reported in Chapters 5-8, we conclude that

collective, technology-focused service sector organizations are a good entry point for dialog with industry

representatives. These organizations are demonstrably prone to collective action; they are easily

 

114 The National ISDN User’s Forum (NIUF), initiated by NIST in the mid-1980s, may contain elements of a model for

integrating the perspectives of technology suppliers and users. Whether the definition of “user” in the NIUF context

included end-use consumers is unknown. In its early history, the NIUF conducted “user” surveys of service providers

attempting to prioritize the ISDN standards most in need of the implementation agreements that the NIUF was established

to develop. A different model of “user involvement” is proposed by Alexander (1995) and Naemura (1995).
159

identifiable; they are responsive; they are articulate spokespersons for pressing technological issues, and

they are often involved in activities that are in need of NIST’s core technical capabilities.

Across the service sector firms and industries we have studied, collaborative R&D mechanisms are

being utilized to acquire the expertise needed to conduct their IT-related research, develop specialized IT

capabilities, and to advance IT standards. In the banking industry, traditional industry associations are

organizing special technology-focused efforts to rationalize diverse, overlapping, and potentially redundant

technical development and standards-related activities. In many cases industry has expressed interest in

exploring the potential that appear to require the kinds of expertise that NIST has developed. While NIST

could have some role to play in providing specialized infratechnology expertise to these collaborative

efforts, it may also be that the other elements of risk (capital intensity, technical risk, long time to market,

and appropriability) are not being addressed through these specific collaborative organizations and that

NIST could play an additional role in helping industry address such barriers.

Finally, if our assessment of trends in the organization and development of IT standards-related

activities is accurate, these collective service sector activities are an important link in the overall

development of the technology infrastructure that is increasingly important to the service sector. NIST can

engage with these service sector organizations in ways that promote communications between IT users and

the traditional IT standards organizations, while at the same time providing much-needed expertise in the

analysis and anticipation of IT trends, in the evaluation of competing standards proposals, and in

supporting the solution of other important cross-cutting technological issues that are stifling IT

development and implementation in the service sector.

Such an orientation is consistent with the recently articulated strategic plan of NIST’s new

Information Technology Laboratory (ITL). ITL’s strategy focuses on the development of measurement

tools for impartially measuring IT products so that developers and users can evaluate how products

perform and assess their quality. The strategy emphasizes involvement in early phases of standards

development and specification development in advance of the formal standards process; support of informal

standards groups (including industry consortia and professional societies) in defining and managing

standards in a more precise and robust manner; and selected involvement with formal standards

organizations where NIST’s contribution can be significant.
160

9.4 POTENTIAL NIST RESPONSES: CROSS-CUTTING TECHNOLOGICAL

ISSUES

We have described a broad need for technology infrastructure and what we perceive as a trend

toward greater service sector responsibility for instituting that infrastructure. We believe that NIST clearly

has a role in supporting that process. This section discusses the cross-cutting issues that affect the

development and implementation of technology in the service sector. In some cases familiarity with various

NIST programs suggests approaches to persistent, cross-cutting issues. In other cases, no programmatic

model suggests itself.

Before discussing issues, it appears that there is a “cultural” affinity between the needs of the

service sector and the general mission of NIST that bodes well for programs aimed at supporting the

service sector. Besides belonging to the (public) service sector itself, one of NIST’s primary missions is the

support of national and international standards. Due to their position in the value chain, and specifically

due to their general status as technology users, the service firms are natural allies in the development of

timely, widely adaptable standards. Generally speaking, service sector firms prefer multiple sources of

supply for the technology intensive assets they acquire. Effective standards are an important way to

increase the supplier base.

We perceive an additional affinity rooted in the nature of the typical service sector R&D function.

Service sector technology managers are predominately oriented to the test & evaluation facets of the larger

technology development process. To the extent that NIST’s core competence lies in the development of

definitive test and evaluation methods, the general needs of the technology-based service sector may closely

match this expertise.

Against the background of a perceived “cultural fit” with the service sector, there are three overarching technology issues that an effective program of technology support should address. They are:

• Industry and technology convergence

• Service sector-customer interface

• System interoperability and security.

These broad issues are considered in turn.
161

The issue of convergence has two aspects. The first deals with the uncertainty that affects service

sector industries. The second aspect of uncertainty is that experienced by consumers. In the three industries

analyzed in-depth for this report, technology “roadmaps” were unavailable. Not only would such road

maps (and the process that produces them) facilitate the objective policy analysis of industries and firms

(for example in the form of understanding and industry or a firms distance from a potential technology

“frontier”), but it appears that if properly developed, maintained, and diffused, these could reduce the level

of uncertainty that afflicts technology managers, and almost certainly positively affect the degree of

technology underinvestment. The externalities associated with such an undertaking alone suggest a “public”

role. To be useful, such road maps would have to be widely shared, so their benefits would far exceed those

appropriable by any individual company. Moreover, the nature of industrial and technological convergence

is such that, to be useful, “technology road maps” would need to cover numerous industries (horizontally

and vertically). In addition, without some “honest broker” involvement, such an undertaking would be

vulnerable to “capture” by narrow proprietary interests.115

Whether such road maps represent a response to technology-specific market failures or

infratechnology weaknesses will depend on the breadth and maturity of the technology covered. It appears

that the generic research efforts supported by NIST’s Advanced Technology Program often involve the

development of a road map specific to the group of firms involved. On the other hand, the perception that

security-related standards are critical to the future of all three case study industries suggests that the

coordination of the relevant technology components, trends, and responsibilities embodies infrastructural

requirements spanning many service sector industries and their technology suppliers. Such economics of

scope increase the ranking of the underlying infratechnologies in terms of economic importance, and

therefore imply a high priority for NIST’s ITL.

Another facet of the uncertainty that service sector firms face is rooted in the uncertainty about

customer preferences. While the analysis for this report did not include customer survey information,

 

115 This last point has important implications for the success of the proposed undertaking. Perhaps its success is related to the

extent to which the largest, most vested companies would participate in the process of developing a widely accepted

technology roadmap. Such “privileged groups” often account for the success of collective organizations. (See Olson, 1965)

While the involvement of large, diversified companies might, therefore, contribute to the success of the undertaking, sound

public policy would have to control any opportunistic behavior on their part. This is a role for which NIST is well-suited to

the extent that the same dynamic is present in the standards-formulation process.
162

introspection and observation suggests that “the fog” facing consumers is far thicker than that facing the

professional technology managers interviewed for the case studies presented.

The “road map” concept could form an element of the public education function that calls out to be

addressed (or at least analyzed). We are not suggesting here that “road maps” are central to the demand

side of the convergence problem. But we do believe an effective program to support the technology-based

service sector must address the demand side of the market failures problem through some effective public

information approach.

It does seem clear from the case studies that the supply side of the market is often “on -hold” in the

face of both high risks and profound uncertainties and, to a large extent, that these are rooted in an even

deeper uncertainty arising at least in part from consumer ignorance about preferences in the face of rapid

technological change. In the case of health care, at least, the (intermediate) “consumers” (the physicians

and related care providers) are by no means ill-equipped to understand the issues and the potential costs

and benefits of greater technology implementation. Yet even there, industry representatives perceive a

certain lag in the face of the inevitable adoption of greater and greater levels of technology. Perhaps this

case suggests that even where adequate information is accessible, sophisticated (intermediate) consumers

are reluctant to incorporate technology to an ever greater degree in the absence of methods to validate its

effectiveness or its compliance with other, systemic requirements of service provision. In either case,

effective support for technology-based service industries appear to require a focus on users as well as

providers of services.

To be most effective, a NIST program to support service sector technology must address a second

overarching issue. In each of the case studies the design, development, implementation, and interoperation

of technical customer interfaces was seen as paramount. That is, as IT is increasingly used by the service

sector to provide service content and delivery, the importance of making these interfaces far more “user

friendly” (appealing to the all types of users), reliable, standard, and secure is apparent. And while the

design and development of such interfaces may be largely a private sector responsibility, evaluation

methods and techniques for assessing the quality of customer interfaces has important “public” aspects and

could yield benefits across the service sector in terms of hastening customer acceptance.

The last overarching issue that needs to be incorporated into an effective program to support

service sector technology concerns the interoperability of forthcoming, current, and vintage IT software,
163

components, and systems. Often referred to as “the legacy problem,” it is so widespread and costly, that

any attempt to bolster the technology infrastructure of the service sector must address the issue. Clearly

there are common problems in this regard within the same industries and, more than likely, there are

common problems across industries. But to the extend that these common problems are being addresses

individually by firms, or by industries where inter-industry solutions are possible, extra transactions costs

are being incurred and less technology is therefore being acquired and implemented.

Familiarity with some NIST programs suggests the possibility of establishing a “test bed” that

could serve as an initial service sector support program. Such a program might entail a cooperative effort

on the part of IT manufacturers, software producers, and service sector providers. Some representative

“mix” of hardware and software systems would comprise the physical assets of such an undertaking, and

NIST’s IT test and evaluation capabilities might be brought to bear in support of critical technical

issues.116

9.5 POLICY ANALYSIS IMPROVEMENTS: LESSONS LEARNED

Based on the investigations undertaken for this report, our experience with economic tools and

databases, and our retrospective appreciation of issues not sufficiently covered, in this final section we

recommend important areas for additional research in support of NIST’s strategic planning in support of

the service sector.

First and foremost, additional case studies are in order. In depth case studies are the only route to

gaining the level of detailed understanding needed by NIST to support investment choices. Additional case

studies would undoubtedly lead to an improved conceptualization of the role of the technology

infrastructure in the service sector. For educational and public communications purposes an improved

conceptual model of NIST’s role in supporting the service sector could be very important.

The “granularity” and homogeneity needed for the comparative case study analysis of industries

would be improved by the cost-effective development of industry specific technology roadmaps. Useful

 

116 Interestingly, in the banking sector, IT consulting firms have established roughly similar organizations to promote the

potential for integrating all manner of new IT capabilities. See, for example Andersen Consulting’s Financial Ideas

Exchange, www.ac.com/topstories. What we propose is a test bed that addresses the fundamental problems caused by

continuous upgrading of IT.
164

approximations of technology roadmaps can be derived from patent data. To be most useful in support of

service sector-focused NIST planning efforts, patent-based analysis should proceed from the development

of 2 conventions: i) a consensus patent-based definition of information technology; and ii) a consensus

patent-based definition of “infratechnologies.”

Another important area of research in support of NIST’s service sector-focused planning should be

directed to the theory and application of the concept of market failure. In our judgment, discussion of

market failure is rarely undertaken from the perspective of the buyer. An improved understanding of the

concept or market failure from a buyer’s perspective would help clarify important issues and lead to better

applied analytical tools.

Such tools are another important concern. For case studies of the quality (in terms of focus and

depth) required by NIST, it would be very useful to develop “rule of thumb” metrics (not unlike the

Hirshmann-Herfindahl Index used as an applied microeconomic analysis device in support of antitrust

policy) that provide useful, though imperfect, insights under circumstances of relatively sparse industry

information. Relatedly the development of a standard, easy-to-use methodology for generating estimates of

IT underinvestment based on readily available accounting information would be very useful and could

support priority ranking of industries for infratechnology support. In the conduct of case study surveys, it

was often difficult to establish a baseline of information from which to derive underinvestment estimates.

Given that income & balance sheet information is generally available, properly developed it could prove

very useful in the conduct of important, but time-constrained, discussions with technology managers.

Finally, to the extent that improved statistical estimates of the degree of underinvestment in the

service sector are warranted, four areas of further research would add depth to the quantitative analysis

contained in this report. First, a methodology aimed at formulating frontier production functions could

prove more insightful and possibly allow a tighter integration between firm-level statistical analysis and

case study methodologies. Second, broader and deeper analysis of the role of RJVs in standards-related

activities across the service sector would provide additional insight to the work reported her which focused

on just one of the service sectors — communications services. Third, it would be useful to improve

statistical models of service sector productivity by the addition of components that address the competitive

impact of standards-related activities.
165

Fourth, the above models and hence public policy would benefit greatly from better

characterization and measurement of the several private and public elements making up service sector

technologies, as well as the interactions among these elements. It is the respective economic roles of these

private and public technology elements and their complex interactions that create market failure and

thereby lead to a need for a public policy response.
166

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