e-commerce_wto special study

8/14/2019 E-Commerce_WTO Special Study

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MarcBacchetta,PatrickLow,AadityaMattoo,LudgerSchuknecht,HannuWagerandMadelonWehrens*

ELECTRONIC

COMMERCE

AND THE ROLE

OF THE WTO*TheauthorsaremembersoftheWTOSecretariat.Theopinionsexpressedinthisstudyarethoseoftheauthors.TheauthorswouldliketothankJean-GuyCarrier,DavidDunkley,K.MichaelFinger,DavidHartridge,MarkusJelitto,MasamichiKono,VesileKulacoglu,PierreLatrille,PatrickLydon,DenbyMisurelli,HeinzOpelz,MaikaOshikawa,AdrianOttenandLeeTuthillforhelpfulcomments.TheywouldalsoliketothankLidiaCarlos,AnneHughesandAishahColauttiforsecretarialsupport.


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This report is also available in French and Spanish - Price: Sfr 30.-.

To order, please contact:

WTO Publications154 rue de LausanneCH-1211 GenevaTel: (41 22) 739 52 08 or 53 08Fax: (41 22) 739 57 92

ISBN 92-870-1198-2Printed in SwitzerlandIII-1998-3,200 World Trade Organization 1998


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I. Summary and Introduction 1

II. The Main Instruments of Electronic Commerce 5

III. The Economics of Electronic Commerce and the Internet 15

A. Conditions for the development of electronic commerce: infrastructure and access 15

B. The economic effects of electronic commerce on user industries 19

IV. The Growing Importance of Electronic Commerce 23

A. Electronic commerce in numbers 23

B. Electronic commerce and the telecommunication and information technology sectors 27

C. Electronic commerce and its impact on user industries 29

D. International trade and electronic commerce 32

V. Policy Challenges in Electronic Commerce 35

A. Access to the infrastructure 35

B. The legal and regulatory framework for Internet transactions 37

C. Security and privacy of transactions 38

D. Issues in taxation 40

E. Electronic money 41

F. Enhanced opportunity in developing and industrialized countries 42

VI. Electronic Commerce and the WTO 45

A. Access to the Internet 46

B. Market access issues 50

C. Trade liberalization under GATS 52

D. Trade facilitation 57E. Electronic commerce and public procurement 58

F. Intellectual property rights and the TRIPS Agreement 59

G. Regulatory issues in the WTO 64

VII. Conclusion 69

Bibliography 71

i

Table of Contents


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iii

List of Tables

Table 1: Electronic Commerce: Features of Main Instruments 6

Table 2: Access to the Telecommunication Infrastructure, Selected Countries, 1996 7

Table 3: Growing Networks for Electronic Commerce 8Table 4: The Need for Bandwidth 8

Table 5: Automatic Teller Machines, Selected Countries 9

Table 6: Speed and Costs of Different Ways of Document Transmission 13

Table 7: Pricing of Conventional Telephony Compared to Internet Telephony, 1996 13

Table 8: United States Internet Commerce Revenue, by Sector, Projection for 2002 25

Table 9: Internet-Generated Revenues in the United States, by Sector, 1996 and

Projection for 2000 28

Table 10: Costs of Shipping within the United States and from the United States to Europe 33

Table 11: GATS Commitments on Mode 1 and 2 Trade for Various Service Sectors 53

List of Charts

Chart 1: The Prevalence of Microprocessor Cards and Smartcards,

1995 and Projection for 2001 9

Chart 2: Purposes for Maintaining a Website, 1993-1996 12

Chart 3: Cost of Buying Software over the Internet Compared to Traditional Channels 14

Chart 4: Peak Rate Internet Access Charges, August 1996 14

Chart 5: The Relative Importance of Commercial Channels for Companies Already

Trading on the Internet, 1997 and Projection for 2000 24

Chart 6: Value of Web-Generated Sales Worldwide, by Selected Research Companies,

1996 and Projection for 2001 24

Chart 7: Growth of Internet Hosts, by Region, 1993-1996 26Chart 8: Internet User Population, by Region, 1997 and Projection for 2000 26

Chart 9: Average Per Capita Spending on Entertainment Services in the United States,

by Sector, 1996 31

Chart 10: Internet Charges and Host Density, With and Without Infrastructure

Competition, 1995 36

Chart 11: ITA Tariffs, 1996 Applied Rates, Selected Countries 48


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Recent advances in three areas computer tech-nology, telecommunications technology, and softwareand information technology are changing lives inways scarcely imagined less than two decades ago. New

means of exchanging information and transacting busi-ness are transforming many aspects of social and eco-nomic organization. These modern technologies are be-ing combined, especially through the Internet, to link mil-lions of people in every corner of the world. Com-munications are increasingly unburdened from the con-straints of geography and time. Information spreadsmore widely and more rapidly than ever before.Deals arestruck, transactions completed, and decisions taken in atime-frame that would have seemed simply inconceiv-able a few years ago. This technological revolution willincreasingly touch every area of activity where the digi-

tal transmission of information serves a purpose,whether it be in the office, in business, or in the worldsof shopping, leisure and entertainment.

There were only some 4.5 million Internet users in1991, and estimates suggest that there will be as manyas 300 million or more by the turn of the century. Thetechnology upon which the Internet is based offers muchgreater versatility as a medium for conveying informationthan do letters, telephones and faxes. The spread of thistechnology will be accelerated significantly through costreductions occasioned by continuing technical advance,

which, combined with increased efficiency driven bycompetition, will bring significant benefits to consumersthrough lower prices and greater choice. Modern com-munication technology offers prodigious scope for neweducational and training opportunities, for spreading un-derstanding and knowledge, for transacting business,and for enjoying a broad range of leisure activities. Thevalue of electronic commerce has catapulted from virtu-ally zero to a predicted US$300 billion in the ten yearsup to the turn of the century.

Because the Internet is an open communications sys-

tem, facing little technological constraint on its expan-sion, it creates a borderless environment for commu-nications.Wherever the necessary communications hard-ware and software are in place, information can flowfrom one location to another along a seamless web,without regard for distance and jurisdiction. For societyat large, this means unprecedented opportunities, andthese opportunities will grow in ways that few of us haveyet imagined. But challenges and responsibilities comewith opportunity.

As to the division of responsibility between the private

and public sector in creating the appropriate environ-ment for the new information media, many would arguethat governments have a key responsibility to support

the spread of benefits from modern communicationstechnology as widely as possible within society, mainlythrough creating the underlying conditions in which thetechnology will flourish. The appropriate division of re-

sponsibility between government and the private sectorin the regulatory field may differ in regard to the formu-lation and implementation of policies. Second, an im-portant challenge is to define the appropriate scope ofintervention in pursuit of legitimate public policy objec-tives, so as to secure such objectives without compro-mising the promise of these modern technologies. Third,the global reach of the Internet and similar technologiesthat might emerge in the future implies a need for in-ternational responses to some of the policy challenges,and thus for active cooperation among governments.Finally, special attention may be needed to ensure that

developing countries benefit from these new technolo-gies.

The focus of this study is upon electronic commercein particular, and not the broader domain of modern in-formation technology in all its guises and uses.Electroniccommerce may be simply defined as the production, ad-vertising, sale and distribution of products via telecom-munication networks. Most of the discussion is limited tothe Internet - the medium with which electronic com-merce is primarily associated.The study points out,how-ever, that earlier technological innovations such as the

telephone and fax have been used in similar, albeit morelimited, ways to conduct business electronically, and fu-ture directions in which technology may lead remain un-certain. The study distinguishes among three stages inelectronic transactions - the searching stage, the order-ing and payment stage, and the delivery stage. Theseinteractions may be between interested parties on anarms-length basis, or may involve transactions withinfirms.

The searching stage is where suppliers and consumersinteract in the first instance. This stage may or may not

lead to an actual transaction. The second stage entailsordering and payment for the good or service, typicallythrough the electronic transmittal of credit card or bankaccount information. The third stage is delivery. Onlythose transactions that can be concluded through elec-tronic delivery of digitalized information may be carriedthrough entirely on the Internet. Electronic commerce viathe Internet must end at the second stage for purchas-es which cannot be delivered electronically, includingphysical goods like flowers or bicycles, and services thatcan only be supplied if the supplier and consumer are inphysical proximity, like haircuts, tourism and construc-

tion. It is the expanded scope for the third stage of elec-tronic commerce transactions that of taking elec-tronic delivery of the purchase which is perhaps the

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I. Summary and Introduction


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most notable contribution of Internet technology and themost challenging aspect from a policy perspective.

This study is a factual exploration of the benefits andchallenges associated with the development of elec-tronic commerce and the Internet. It does not prescribespecific policy actions, but rather attempts to identify the

main policy challenges, focusing in particular upon howthese relate to international trade and the WTO.

Organization of the study

The early sections of the study (Sections II and III) pro-vide a broad introduction to the subject of electroniccommerce,drawing on various sources,especially the ITUand OECD. Section II describes the salient characteristicsand uses of electronic commerce. Section III discussesthe economics of electronic commerce and the Internet,including ways in which the nature of the instrument it-

self is changing the structure and efficiency levels ofsome markets, the costs of various inputs into the pro-duction process, and ways of doing business.The role ofcompetition is identified as a key factor in enhancing andspreading the benefits of new communication technolo-gies.

Section IV focuses on the growth of electronic com-merce, noting the rapid expansion that has occurred ina few short years, and reporting on forecasts for contin-uing rapid growth. Some estimates suggest that withinfive years, Internet-based electronic commerce could ac-count for 2 per cent of all commercial transactions. Such

estimates are hazardous because of the very limited ex-perience upon which they are based, but few doubt thatgrowth in electronic commerce will be vigorous and sus-tained. While the bulk of electronic trade takes place inthe United States, greater geographical dispersion is ex-pected over the next few years. Expansion in the use ofthe Internet for commercial transactions is likely to occurin many sectors, including financial services, telecommu-nications, advertising, travel and entertainment services,and professional services. Business-to-business com-merce and retailing in some sectors will be transformed,and strong demand is anticipated in all sectors linked to

the provision of infrastructure for electronic commerce.

Section V switches to a policy discussion, focusing onwhat appear to be the most important challenges forpolicy-makers arising from electronic commerce. Thestudy suggests that even though governments may bedetermined to ensure that the potential benefits of elec-tronic commerce will be fully realized, and believe that acombination of the market and self-regulation by busi-ness can do much to safeguard this objective, there stillremain certain areas where governments will have a roleto play. The precise degree of direct government inter-

vention required to achieve particular objectives cannotnecessarily be pre-defined, and the study is careful toavoid prescription in this regard. Some of the areas of

likely concern, however, include: i) standards for theemerging global telecommunications infrastructure; ii)adequate investment in the infrastructure; iii) user-friend-ly and broad-based access; iv) a predictable legal andregulatory environment which enforces contracts andproperty rights; v) the security and privacy of information;vi) rules for dealing with what constitutes unacceptable

or conditionally acceptable content; vii) a predictableframework of taxation and financial regulation; and viii)equality of opportunity through better access and edu-cation for those least well-placed to adapt to the newenvironment.

None of these issues are new, but the speed ofchange in communications technology makes it impor-tant to ensure that regulation neither falls behind norunnecessarily interferes with the development of elec-tronic commerce. While some of the policy issues identi-fied above are concerned essentially with creating ap-

propriate underlying conditions for the conduct of busi-ness, others impinge directly upon actual transactionscarried out over the Internet. Of particular relevance inthe latter context are content regulation and taxation,which are among the most delicate issues that will haveto be addressed. In all cases, however, the fact that elec-tronic commerce via the Internet so clearly has inter-ju-risdictional ramifications would seem to presage a needfor governments to consider the appropriate scope ofinternational cooperation.

Section VI focuses more specifically on policy issuesthat appear to be of direct relevance to the work of the

WTO.The first part of the discussion deals with trade pol-icy aspects of access to infrastructure, emphasizing theimportance of efficient and low-cost supply of the es-sential raw materials for the conduct of electroniccommerce. The study reports on progress already madein the WTO in opening up and promoting competition inmarkets for basic telecommunication services and infor-mation technology products. It goes on to examinebriefly the legal framework of the General Agreement ofTrade in Services (GATS) insofar as it has an impact onaccess to some of the basic infrastructure relevant toelectronic commerce. This part of section VI also consid-

ers the question of coverage of Internet access servicesin Members commitments in basic telecommunicationservices.

Section VI then takes up market access issues. It notesrecent initiatives by the United States, and jointly by theEU and the United States, to promote a customs duty-free environment for electronic transactions. It is em-phasized that these initiatives refer only to customs du-ties, and not to other taxes. This is followed by a discus-sion of how electronic commerce might be characterizedin WTO terms, and what the implications of different ap-

proaches would be for the policy regime. Among the is-sues here is whether services transactions over theInternet could be considered trade in goods, trade in ser-

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vices,or a different kind of trade.The study suggests thatthe content of some digitalized information flows wouldseem at first sight to resemble trade in goods, while arange of services transactions are already covered underthe structure and trade liberalization commitments of theGATS. Significant differences in the rules of GATT andGATS would need to be taken into account in any dis-

cussion of the approach to this issue. If neither a goodsnor a services characterization is deemed suitable, dif-ferent rule-making challenges emerge. In line with theapproach taken in this study, no conclusions are drawnas to what might be the best approach to securing asuitable legal and institutional framework for electronictrade. A general point is made, however, about the de-sirability of ensuring policy neutrality so as not to distorteconomic incentives and decisions.

The third part of Section VI focuses on trade liberal-ization under the GATS, bearing in mind that existing

and possible future market access commitments in GATShave a direct impact on the conduct of electronic com-merce. The fourth sub-section examines briefly the rela-tionship between electronic commerce and trade facili-tation, noting in particular how the open Internet-basedsystem underlying electronic commerce can contributeto reducing the costs of trade and streamlining customsadministration.

The fifth and sixth parts of Section VI respectively ex-amine the implications of electronic commerce for pub-lic procurement and intellectual property rights.Governments are making increasing use of electronicmeans for procurement, giving rise to the question ofhow far international rules may need to be developed tofacilitate electronic procurement. A large share of elec-tronic commerce based on the Internet involves prod-ucts protected by intellectual property rights, and intel-lectual property rights also play an important role in thedevelopment of infrastructure and access-related equip-ment. Electronic commerce and the Internet will affectthe way intellectual property rights are administered, and

may raise certain issues relating to copyright and trade-marks in particular.

The final part of the study focuses on regulation, iden-tifying some of the jurisdictional, monitoring and en-forcement issues raised in electronic commerce. It dis-tinguishes three categories of regulatory intervention.

The first involves universally shared regulatory objectivesaimed at prohibiting particular kinds of content, such aschild pornography or bomb-making instructions.The sec-ond category also entails prohibition or direct control ofcontent, but involves objectives that are not shared byall jurisdictions, on account of national differences instandards and values. The third category comprises ac-tivities where there is no interest in preventing or dis-couraging commerce, but where the authorities seek toprotect consumers either through the establishment ofpreconditions for market entry, such as licensing or qual-ification requirements, or through the dissemination of

information that permits consumers to make more in-formed choices.

The study notes that approaches to regulation maydiffer, depending on the objective. A key question is thedegree to which governments see a need to establish co-operative arrangements internationally for the purposesof defining regulatory approaches and/or the enforce-ment of regulations. A second question is how far directregulation by government is necessary, as opposed toself-regulation by business. A third issue is the feasibili-ty of attempting regulation at the border. It is already

the case, for example, that much regulation in the sphereof both goods and services takes place at the point ofproduction or supply, and not at the frontier. Finally, boththe GATT and the GATS have established precedents fordealing with the trade policy aspects of regulation - em-phasizing the objective of applying the least-trade-re-strictive measures available in a transparent and non-discriminatory manner to achieve a given public policyobjective.


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Six main instruments of electronic commerce can bedistinguished: the telephone, the fax, television, elec-tronic payment and money transfer systems, ElectronicData Interchange and the Internet. This is a broad defi-

nition of the term electronic commerce; in many dis-cussions, electronic commerce only refers to the Internetand other network-based commerce. Nevertheless,instruments such as the telephone, fax and television arealready used for commercial transactions, especially inindustrialized countries. It is not uncommon, for exam-ple, to make orders over the phone and pay for them bycredit card. The emergence of new instruments such asthe Internet did not, therefore, invent electronic com-merce. But the Internet does open up many new possi-bilities: with the Internet all elements of a commercial

transaction can be conducted on an interactive basiswith one or many people, unconstrained by time andspace, in a multimedia environment with sound, imageand text transmission, and at relatively low (and still de-clining) costs. This makes the Internet much more versa-tile than other instruments of electronic commerce. Thelatter typically need to be combined with each other orwith more traditional instruments such as mail or phys-ical shopping, to conclude a transaction. The Internetwill, therefore, reduce barriers to communication andtrade to a greater degree than established electronic andtraditional means of commerce, and following the intro-

ductory discussion in this section, most of this study fo-cuses on the Internet. A summary of the main featuresof various electronic commerce instruments can be foundin Table 1.

A pervasive instrument of electronic commerce is thetelephone; almost one billion lines and cellularsubscribers are reported worldwide

The oldest and so far most important instrument ofelectronic commerce, or of conducting business viatelecommunication networks, is the telephone. A num-ber of characteristics have helped the telephone toachieve and maintain a leading role in commercial trans-actions. One reason is its widespread availability: thereis one telephone for every two inhabitants in OECDcountries, and many developing countries report onetelephone for every ten of their inhabitants (Table 2).Thenumber of telephone lines and cellular phone subscriberscombined reached 900 million in 1996. By the year2001, 1 billion phone lines are expected to exist, with afurther 400 million people connected to the telecom-

munication networks via cellular phone (Table 3). This isequivalent to almost one quarter of the total worldpopulation projected for that year.

It is possible to advertise, negotiate, purchase andpay for goods and services by telephone, and thetelephone is increasingly inexpensive and easy to

useThe telephone is a very versatile instrument: it allows

for goods and services to be advertised, purchased andpaid for (in conjunction with a credit card). Selected ser-vices are even distributed over the phone and then paidfor through the phone bill. Such services can include, forexample, telephone banking, a telephone directory in-quiry, the sandman calling to announce bedtime for chil-dren,or certain types of adult entertainment.A non-stan-dard transaction which may require some negotiationscan be conducted much more easily by interactive com-munication over the telephone than by mail. Other ad-

vantages of the telephone are the low cost of equipmentand the user-friendliness of the instrument. The tele-phone also requires very little bandwidth - that is, capa-city for data transmission.

In many instances, however, the phone only preparestransactions which are then concluded on paper andlead to physical delivery of a product. Until recently, thetelephones communication potential was limited tovoice (spoken) communication between just two people,but telephone conferences and even video conferenceshave now become possible. High-quality video confer-

ences, however, require considerable up-front investmentin equipment and bandwidth.The latter is not availableon a standard phone line, or even on a more powerful,digital ISDN circuit (Table 4).The use of video phones andvideo-conferences is therefore still very limited.

In many countries, the use of telephones is relativelycheap, and fees for local calls are sometimes even in-cluded in the basic connection charge. Charges for long-distance and international calls, however, vary dramati-cally across countries.This limits the use of the telephonefor long-distance purposes, especially in poor countries.However, declining costs and competition among tele-phone service providers have brought down ratesmarkedly in many countries. Rates for international callsmade in the United States, for example, have declined bya factor of 300 since 1930. If current costs for long dis-tance or international calls in low-cost countries such asthe United States are any measure of the savings po-tential in other countries, we are likely to witness furthersignificant falls in telephone charges in the near future.

Faxes offer speedy business communication anddocument transmission

The main advantage of the fax lies in replacing tradi-tional mail services with more speedy document trans-

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II. The Main Instruments of Electronic Commerce


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Table 2: Access to the Telecommunication Infrastructure, Selected Countries, 19961

Country Telephones Fax Cable TV Personal Internetper 100 per 100 per 100 computers hostsinhabitants inhabitants households per 100 per 100

inhabitants inhabitants

Industrialized countries:

Australia 49.6 2.5 .... 31.2 2.81

Canada 57.5 2.4 .... 19.0 2.01

Finland 55.1 2.4 27.0 18.1 5.52

France 54.7 2.7 3.0 15.1 0.42

Germany 48.3 1.8 31.0 18.2 0.87

Italy 42.9 2.2 .... 9.2 0.26

Japan 47.8 6.8 .... 12.8 0.59

Netherlands 50.9 2.9 84.1 23.2 1.74

Sweden 68.3 3.4 43.0 21.3 2.61United Kingdom 48.9 2.4 2.0 18.0 1.00

United States 59.5 7.3 59.0 36.4 3.80

Developing and transition countries:

Argentina 14.1 0.1 .... 2.4 0.04

Brazil 7.4 .... .... 1.8 0.05

Chile 11.0 .... .... 3.7 0.10

China 2.3 0.0 .... 0.3 0.00

Hong Kong, China 54.0 4.3 .... 15.1 0.78

India 1.1 0.0 .... 0.2 0.00

Indonesia 1.3 0.0 .... 0.5 0.01

Korea (Rep. of) 39.6 0.8 .... 13.2 0.15

Mexico 9.2 .... .... 2.9 0.03

Poland 13.1 0.1 .... 3.6 0.14

Russia 16.2 0.0 .... 2.4 0.05

Singapore 45.5 .... .... 21.7 0.95

South Africa 9.1 0.2 .... 3.9 0.24

Turkey 20.1 .... 1.4 0.02

Selected country groups:

EU 47.6 2.2 20.5 15.1 0.79

OECD 44.6 3.5 .... 18.1 1.43

Non-OECD .... .... .... 0.8 0.02

WORLD 11.5 0.7 .... 4.3 0.28

1 Or closest year available.

Sources:ITU, "Challenges for the Network", 1997a; OECD, "Information Infrastructures: Their Impact and Regulatory Requirements", 1997a; UNDP, "UNHuman Development Report", 1997.


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mission. The fax is also frequently used as a substitute

for the telex which, in the past, provided a paper trail forcommercial transactions.1 Although in principle a num-ber of commercial functions such as advertising, pur-chasing or the initiation of payments can be carried outby fax, this instrument lacks the potential for the trans-mission of voice communication and sophisticated im-ages (the quality of faxed photographs, for example, istypically very low). Interactive communication is not pos-sible, and any complication in a transaction requires anadditional fax or phone call for clarification. Fax charges,network access, bandwidth requirements, and user-friendliness are similar to the telephone, although fax

machines are typically more expensive. These character-istics have made the fax important in communicationand commerce between businesses, but much less soamong individual consumers. There is less than one faxper ten telephone lines in OECD countries, and less thanone fax machine per 100 inhabitants in the world as awhole (see previous Table 2).

One billion televisions worldwide broadcastadvertising and invite home shopping, buttelevision is a one-way street of communication

The television enjoys an even more widespread dis-tribution than the telephone.There are over 1 billion tele-visions in the world, with every second inhabitant in in-dustrialized countries and every seventh inhabitant indeveloping countries owning a television set.One in fivehouseholds in the European Union and more than everysecond household in the United States are now con-nected to Cable TV. At first thought, few people wouldconsider television as a means of electronic commerce,but a large share of shopping from home is shaped

through advertising and shopping programmes on tele-vision. Television advertising, for example, absorbs onequarter of all advertising expenditure in the UnitedStates. Cable TV has extended the commercial potentialof television by providing many additional channels andintroducing new facilities such as interactive TV or pay-per-view TV.

One limitation of television as an instrument of elec-tronic commerce is the need to conduct transactions inmultiple steps.After watching an advertisement, the con-vinced viewer has to pick up the telephone, make pay-ment, and then await delivery of the desired product. Inother words, television is a one-way street of commu-nication where viewers cannot actively seek offers or ne-gotiate the terms of a transaction.2 In addition, the pro-duction costs of a TV spot are rather high, and involveconsiderable outlays on studios and equipment.However, the relatively low costs of a TV set and sub-

scription charges for the viewer, as well as the user-friendliness of TV, have contributed to its success as ameans of entertainment and commerce.Furthermore, ac-cess to cable TV could become very important to futureelectronic commerce applications with large capacity re-quirements, since cable TV lines have much more band-width than telephone lines.

Electronic payment systems are boosting electroniccommerce, with much potential for the use ofsmartcards

Electronic payment and money transfer systems likeautomatic teller machines (ATM), credit cards, debitcards or smartcards are also part of electronic com-merce.3 Although these instruments typically only serve

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1As the telex is similar in its functions to the fax, they are discussed jointly.2An exception is interactive TV which, so far, has not been very successful with users.3Computer-banking uses telecommunication networks in a similar manner as electronic data interchange or the Internet, and therefore can be seen as an early electronicmeans of financial service provision.

Table 3: Growing Networks for ElectronicCommerce

(Million units)

Category 1991 1996 2001(Proj.)

Telephone main lines 545.0 741.1 1000

Cellular subscribers 16.3 135.0 400

Personal computers 123.0 245.0 450

Internet host computers 0.7 16.1 110

Personal computerswith Internet access(Internet users) 4.5 60.0 300

Source: ITU, "Challenges to the Network", (1997a).

Table 4: The Need for Bandwidth

Bandwidth Telephone linerequirement equivalent

"Standard" telephone 19 K bit/s1 1

Common web connection 29 K bit/s 1.5

ISDN circuit and Internettelephony 64 K bit/s 3.3

High quality video conference 2 M bit/s2 104

Standard television 10 M bit/s 521

Full motion color TV 90 M bit/s 4700

1K bit/s = 1000 bits per second2M bit/s = million bits per second

Source: OECD, "Information Technology Outlook", 1997i.


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to make or receive payments, they have become very im-portant complements to other means of electronic com-merce and conventional commerce.ATM machines arenow the standard means for balance inquiries and cashwithdrawals in industrialized countries (Table 5). Manymillions of credit and debit cards are used routinely formaking payments.

Microprocessor-based cards with much more infor-mation storage potential, including so-called smart-

cards with credit, debit, and money storage abilitieshave emerged in recent years. Microprocessor-basedcards of various kinds are quite well established inEurope (the best known being telephone cards), whilstthe older and simpler magnetic strip cards still dominatein the United States. Very powerful smartcard systemsare presently being introduced, which can prove theidentity of the buyer in an electronic transaction, and en-crypt (code) the card number, the credit limit and the ex-piration date of the card for maximum security of elec-tronic transactions. By contrast, all magnetic-strip-basedcredit or debit card information needs to be verifiedthrough an extra phone call or a machine next to busi-

nesses cash registers. Consequently, the use of micro-processor-based cards and smartcards is projected to riserapidly in the near future (Chart 1).

Electronic Data Interchange facilitates business-to-business transactions and trade; an extension to theInternet is promising

Another important instrument of electronic commerceis so-called Electronic Data Interchange or EDI. EDI typi-cally entails the exchange of documents and informationbetween the computers of two businesses without hu-

man intervention. Its purpose is to lower costs and speedup bidding, order taking, invoicing, and so on (Jimenez,1997). Bidding for contracts via EDI, for example, has re-

Table 5: Automatic Teller Machines,Selected Countries

(Machines per million inhabitants)

1978 1986 1994

Canada 11 127 578

France 19 172 355

Germany ... 66 361

Italy1 ... 76 378

Japan 111 494 978

United Kingdom 39 182 334

United States 44 286 418

Average 49 200 487

11987 and 1995 for Italy.Source: OECD, "Financial Market Trends", No. 67, June 1997e.


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sulted in cost savings of 5-20 per cent, and time savings

of 50 per cent for firms. EDI has also been applied suc-cessfully in automating customs administration and,thereby, facilitating international trade. To give an ex-ample, one could imagine that EDI results in the follow-ing transactions without any human intervention: a carproducers stock of tyres falls below a certain threshold.Automatically, its computer sends out an order request-ing delivery of tyres from the tyre factory. The computerat the receiving end confirms this request, processes theorder for delivery and sends back a confirmation and abill. On receipt of the tyres, the computer of the car man-ufacturer automatically initiates payment of the bill.

In the past, EDI was normally used between bigmanufacturers and their suppliers in a so-called hub-and-spoke system. Members of the EDI system becamepart of an established network with its own telecom-munication infrastructure and standardized forms.Equipment and connection costs rendered participationin the EDI system quite expensive, limiting its prolifera-tion. In 1996, only about 200,000 of the United States6 million firms (but 95 per cent of the biggest 1000firms) participated in EDI. Participation worldwide

reached 500,000 firms in the same year (ITU, 1997a). In

the past, superior security (e.g., compared to theInternet) favoured such hub-and-spoke systems.However, with technological solutions to security con-cerns in sight, the future will probably lie in extendingEDI access through Internet gateways.4 This will allowmuch cheaper access for small and medium-sized firms.As a consequence, 30-40 per cent of U.S. businesses areexpected to use EDI by the year 2000.

300 million Internet users are expected by 2000,extending the scope of what and how we trade

The main focus of recent interest in electronic com-merce has undoubtedly been on the Internet. For almostthree decades, the Internets reach virtually doubledevery year (see Box 1).By 1991, the number of users hadreached about 4.5 million; by 1996, 60 million Internetusers were reported, and this number is likely to grow toabout 300 million or 5 per cent of the worlds popula-tion by 2001. Commercial transactions on the Internet in1996 accounted for only a fraction of one per cent of alltransactions in the United States, but this share is likely

Box 1: The History of t he Internet

The origins of the Internet go back to the 1960s when new ways of communicating between researchers were sought. In1969, the ARPANET (Advanced Research Projects Agency Network) was established between four U.S. Universities with sup-port from the Department of Defense. The ARPANET allowed communication between users through the Network ControlProtocol which converted messages into streams of packets at the source, and then reassembled them back into messagesat the destination. During the first decade, the ARPANET was mainly used to facilitate e-mail (the first one was sent in 1972),support online discussion groups, allow access to distant databases, and support the transfer of files between government

agencies, companies and universities. The Pentagon became briefly interested in the ARPANET as a wartime communicationtool, but this idea was quickly abandoned. During the early 1980s, the TCP/IP protocol was introduced, which set standardsfor the flow of information across networks and allowed the identification of users through Internet addresses or domainnames. This gave rise to communication between various interconnected networks and, thus, the Internet was born.

In 1990, the World Wide Web (WWW) was created, allowing the online transmission of webpages, which integrated textand graphics for the first time. In order to facilitate information exchange over the web, various programs and applicationswere introduced, which made the once research-oriented system more accessible for commercial and private use.Commercial activities on the Internet, such as virtual shopping and online banking, started in 1994. Meanwhile, public sup-port for the Internet in the United States (mainly from the Defense Department and the National Science Foundation) hadbeen largely phased-out.

Since its beginning in 1969, the Internet has experienced rapid growth.The number of hosts grew from 32 in 1972 to 10,000in 1978, 100,000 in 1989, and to 1,000,000 in 1992. By July 1997, almost 20 million hosts were reported, and projec-tions are for a further rapid increase to as much as 300 million users by 2001. The first international online links were

established in 1973, with connections between the United States, the United Kingdom and Norway. In 1997, more than110 countries were connected to the Internet, and universal coverage is foreseen in the near future.

In the 1980s, a number of European countries had already introduced network-based communication systems using pre-Internet technology, of which the French Minitel system is probably the most well-known. The Minitel is a purely text-basedmedium which uses standard telephone lines and which offers numerous services from shopping to stock quotes. By 1994,6.5 million terminals were registered, resulting in total sales of FF 6.6 billion (about 1.1 billion US$). The prominence ofMinitel, however, initially delayed the use of the Internet by French businesses and consumers, so that in 1997, the devel-opment of an Internet-compatible Minitel was started, which will allow the Minitel to become an integrated part of theInternet (OECD, 1997f).

Sources: Hobbes Zakon, R. Hobbes Internet Timeline, 1997; Hafner and Lyon, 1996; OECD, 1997f;Wendell, K. Internet History, 1997.

4One way to illustrate the difference between EDI and the Internet is in terms of the degree of openness of the networks they use. Where EDI is operated through closednetworks, only registered users have access. With gateways to the Internet, EDI will operate increasingly through open networks. This will blur the distinction betweenclosed-network-based EDI versus open-network-based Internet commerce. The distinction between the two, as presented in Table 1, will therefore become somewhat ar-tificial in the future.


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to grow to 2-3 per cent by 2001, and to about 14 percent of all consumer purchases by 2007.

The Internet is an extremely versatile means of com-merce. In respect of some products, all elements of theproduction and distribution chain can be completed on-line and across borders: for example, after reading an on-

line advertisement, a customer in Switzerland can senda data request to the American owner of a databankstored in Canada.The computer of the United States com-pany forwards the data request to the databank for au-tomatic retrieval. The retrieved data is then sent fromCanada to the United States.The computer in the UnitedStates requests, receives and verifies the credit card pay-ment or possibly the electronic money transfer from theSwiss client, and sends the requested data to Switzerland.In other words, advertising, production, purchase, pay-ment and delivery of the service can be conducted elec-tronically through just one instrument: the Internet.5 This

degree of automation is still the exception rather than therule, and frequently customers still pay by phone andcredit card after ordering on the Internet. However, thisexample shows the enormous potential of the Internet forelectronic commerce in certain sectors.

Another strength of the Internet is its multimedia po-tential with simultaneous voice, image and text trans-mission. Downloading of documents (text), conductingtelephone calls over the Internet (voice)6 and games andpictures (image) are already available online. But manyobservers see potential in the interactive and simultane-

ous transmission of all three types of data in a digital for-mat, for example, for online video conferences and multi-media services.7

The Internet will also extend the scope of what istradeable. In the past, many services were considerednon tradeable, but through the Internet, many medical,legal, architectural, travel, accounting, education andnumerous other services could become tradeable overlong distances within and across countries (Primo Braga,1997). Assume, for example, the following, rather exot-ic example: in the past, an X-ray of a crash victim had tobe analyzed on the spot by a local doctor. It would havebeen much too time-consuming to send the imagesomewhere else for diagnosis. Now, it is possible for suchimages to be sent instantaneously to a specialist some-where else, possibly in another country, who then e-mailsback a diagnosis. This extension of the frontier of trade-ables is due to the fact that, in principle, all of the goodsand services which can be digitalized can be transportedover the Internet - such as extracts from databanks, mu-

sic, films, documents, medical diagnostics and imagery,lectures and classes, stocks and bonds and much more.

However, there are two uncertainties arising from thisextended boundary of what is tradeable. First, it maysometimes be difficult to determine where a transactionhas actually taken place: assume the X-ray is sent from

country A to an Internet address in country B which thencontacts a specialist in country C. The hospital in coun-try A may think this is a service from country B while itis, in fact, outsourced to country C.To further compli-cate matters, the owner of the Internet address in B mayactually be located in yet another country D.These loca-tional complexities pose a potential nightmare forlawyers, regulators and tax collectors (OECD Observer,1997k).8 Second, the border between what constitutesa good and what constitutes a service can becomeblurred. Indeed, some might even argue that electronictransmissions of digitalized information are neither

goods nor services. These are important issues for inter-national trade and trade regulation, which will be dis-cussed in more detail in Section VI.

In summary, the Internet can be used for a multitudeof exchanges and transactions, including e-mail, leisure-ly reading and searching for information (browsing orsurfing),advertising and promoting personal or businesscauses, linking people in private or professional circles,and publishing, selling, purchasing or providing services(OECD, 1996a). When asked why they are present onthe Internet, companies respond that their website is

mainly a means for advertising, communication and pub-lic relations, customer information, online sales and cus-tomer support (Chart 2). Given this multitude of func-tions of Internet-based electronic commerce, which al-lows purchases through companies websites without aphysical shop, people often speak of virtual (or cyber-space) shopping.

The Internet may also allow so-called telecom-muting, whereby people do all or part of their workfrom a computer terminal at home. Some firms have suc-cessfully experimented with telecommuting, which hashelped them save particularly on office space. The officein these firms is becoming mainly a means of meetingand communicating. Telecommuting also allows em-ployees to live far away from the office, which couldalleviate urban congestion and may save employerssome wage costs. However, only certain types of workwith a high electronic data processing content and eas-ily monitorable output are suitable for telecommuting.Lack of security and technical support at home, isolation

5Note, however, that payment by credit card in this example strictly speaking implies two instruments.6Internet telephony has emerged in recent years, whereby calls are routed through the Internet (see below for further details).7Data transmission in a digital format means that all data is transformed into strings of zeros and ones. Sound, text and images can be digitalized and then sent si-

multaneously through the net. Digital transmission is at the basis of the Internet. However, digital information can be transformed into analogue signals with the help ofa modem. A second modem at the receiving end transforms the analogue signals back into digital ones.That is why Internet users can communicate through standardanalogue telephone lines. A modem is not needed when sender and recipient have a so-called ISDN connection which allows digital data transmission.8The fiscal and trade policy implications of such situations are discussed in later sections of the study.


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of home workers and less time for managers to becomebetter acquainted with their staff are additional disad-

vantages of telecommuting.

In some areas, the costs of Internet-based commerceare only a fraction of those of other instruments

The Internet is not only more versatile than other in-struments of electronic and conventional commerce, italso compares favourably regarding delivery time anduser costs.9 The operating costs of the Internet are typi-cally very low. Time online can cost as little as a localtelephone call of the same duration.Therefore, the costsof document transmission, telephone calls, and retail

transactions over the Internet often compare veryfavourably with conventional commerce and other elec-tronic instruments.Table 6 shows that the Internet-basede-mail transmission of a 42 page document from theUnited States, both abroad and within the United States,is much faster and cheaper than air mail, courier or fax.These ratios may not be quite as favourable for theInternet in countries where phone charges are higher,and where the delivery of e-mail can sometimes be de-layed. However, the Internet seems already to be erod-ing regular mail and fax business. The price of Internet

telephony versus conventional telephony confirms thispicture (Table 7). Chart 3 illustrates that transaction costs

for an Internet purchase of, for example, software (whichis then delivered through the Internet) are less than onetenth of a purchase made by telephone and one fiftiethof a purchase at a traditional retailer (OECD Observer,1997k).Arguably, the savings are much lower as regardsto the purchase of a book delivered by physical means,for example, where shipping and handling costs have al-so to be included, along with customs and tax adminis-tration costs, but the Internet will be competitive for asignificant number of transactions.

Another important cost factor for sellers is the ex-

penditure involved in setting up shop. Start-up costscan be significant. A reasonably sophisticated Internetwebsite for a bank, for example, can usually be estab-lished for about US$ 50,000. Annual site maintenancecosts (for changing and developing the site) are of a sim-ilar magnitude if no major technical complicationsarise.10 The reach of a site is potentially unlimited. Thecost of setting up and maintaining a physical bankbranch, on the other hand, is typically much higher andthe potential reach is much more limited (Booz, Allenand Hamilton, 1997a).

9The next section will provide a more thorough discussion of this issue.10Some banks have found the experience of integrating electronic banking with the existing data processing system to be very costly. This led a large German bank, forexample, to take over another bank with a well-developed electronic banking system rather that develop its own (Die Zeit, November 21, 1997).


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Access and costs warrant improvement, and sometechnical and regulatory issues need to be addressed

Given the significant cost advantage of network-based data transmission in many areas, the spread ofdata exchange, e-mail, Internet telephony and electron-ic purchase of many goods and services is likely to con-tinue. Companies, in particular, will find that withoutthese cost savings they lose competitiveness. Business-to-business commerce is, therefore, likely to be the maingrowth area of the Internet in the near future.At the lev-el of the individual consumer, however, the costs of apersonal computer and a modem to gain access to theInternet are still considerable, and, once this equipmentis purchased, it becomes obsolete very fast. Furthermore,Internet service charges, typically paid on a monthly ba-sis to a service provider, plus the charges for using a tele-phone line can be quite significant. In 1996, monthly ac-cess charges for 20 hours online averaged US$ 60 inOECD countries and exceeded US$ 40 in all but four ofthem (Chart 4). Access charges are coming down, buteven US$ 20 per month is a sizable amount for con-sumers in industrialized countries and even more so inthe developing world. Cable TV-based Internet usage

could significantly reduce equipment costs, as first expe-riences with Web TV in the United States show.

Another frequent problem of the Internet is band-width limitations which at times cause congestion. It canbe very frustrating to wait several minutes to access asimple website or download a short document. Thisproblem is exacerbated by information overload andthe poor quality of much of the information on theInternet. Furthermore, the Internet is not yet very user-

friendly; it takes moderate computer skills and quitesome practice to move around the Internet with easeand to conduct purchases successfully. In addition, un-certainty about technical standards, the jurisdiction oftransactions, the validity of contracts, possibilities of re-dress, the security and privacy of information, and the fu-ture role of government in regulating and taxing Internet

activities (including international trade) could hold backthe development of electronic commerce issues wewill come back to later in this study.

We do not know exactly in which direction electroniccommerce will develop, but it is likely to changestrongly the way we communicate and do businesswith each other

Given the advantages and shortcomings of the vari-ous instruments of electronic commerce, many peoplepresently use the telephone, the fax, the Internet, and

regular mail in a complementary manner.While we havepointed out some of the innovations and advantages ofthe Internet, it is uncertain which instrument or combi-nation of instruments will dominate electronic commercein the future. Other electronic and conventional meansof transactions will react to the Internet challenge, for ex-ample, by lowering price or improving the scope andquality of services.On the other hand, technical progressmay result in the convergence of various instruments ofelectronic commerce in comprehensive multimedia sys-tems (European Commission, 1997a). Despite this un-certainty, there seems to be consensus that electronic

commerce, especially via the Internet, will strongly influ-ence the way we communicate and conduct business inthe future. The next two sections of this study will pro-vide arguments and empirical evidence in support of thisclaim.

Table 6: Speed and Costs of Different Ways ofDocument Transmission1

Costs (US$) Time

New York to Tokyo

Air Mail 7.40 5 daysCourier 26.25 24 hoursFax 28.83 31 minutesInternet e-mail 0.10 2 minutes

New York to Los Angeles

Air Mail 3.00 2-3 daysCourier 15.50 24 hoursFax 9.86 31 minutesInternet e-mail 0.10 2 minutes

1Example of sending a 42 page document.

Source: ITU, "Challenges to the Network", 1997a.

Table 7: Pricing of Conventional TelephonyCompared to Internet Telephony, 1996

Telephone Conventional Internetconnection telephony1 telephony2

US$/minute US$/minute

USA-Germany 0.78 - 1.36 0.10 - 0.45USA-Nigeria 1.28 - 1.86 0.10 - 0.45

USA-Saudi Arabia 1.27 - 1.87 0.10 - 0.45

USA-Singapore 0.90 - 1.56 0.10 - 0.45

1Range of rates charged by AT&T.2The range of rates for Internet telephony shows the estimated level fromthe United States to foreign countries.

Source: ITU, "Challenges to the Network", 1997a.


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In the previous section it was argued that electroniccommerce will provide many new opportunities.Transactions via the Internet, EDI and more sophisticat-

ed applications of the telephone and television haveemerged through quite radical improvements in com-munication and information technologya processwhich started with the discovery of electricity and the in-vention of the telephone and telegraph. The rapidprogress in electronic commerce raises interesting andimportant new questions: how does the development ofelectronic commerce and the Internet affect economicactors, and what are the likely effects on economicgrowth and welfare?

The development of electronic commerce and the re-

alization of its potential benefits have been discussed inthe economic literature from two perspectives: (i) thenecessary conditions for the provision and developmentof electronic commerce and Internet services; and (ii) theeffects of electronic commerce and the Internet on sec-tors which apply these new means of exchange.The firstquestion focuses mainly on infrastructure and accessrequirements, and the contribution of technologicalprogress to cost-efficiency in the supply of electroniccommerce and Internet services. The second question isconcerned mainly with how electronic commerce and theInternet will affect supply and demand of goods and ser-

vices in various markets, and with the impact of thismedium on market structure and competition in variousindustries. In a nutshell, the proliferation of electroniccommerce is predicted to lower transaction costs andproduction costs, facilitate entry and increase competi-tion. This, in turn, will lower prices, increase quality, andcreate new and more diverse products, thereby increas-ing economic growth and welfare.

A. Conditions for the development ofelectronic commerce: infrastructure andaccess

Progress in information technology andinfrastructure provision have permitted thedevelopment of electronic commerce, culminating inthe emergence of the Internet

The growth of electronic commerce has been linkedclosely with the development and diffusion of new in-formation technologies and of telecommunications infra-structure. New information technologies, which include

the fax, the digital telephone, and the Internet, havebeen discussed earlier. Telecommunications infrastruc-ture has developed considerably over the past few

decades, and now involves either fixed-line or radio-based networks which can both be used for electroniccommerce. Fixed-line networks encompass telephonenetworks supplied through cable or wire links, cable TVnetworks, wire-based networks established by trans-portation utilities,and in some instances electricity distri-bution networks. Radio-based networks include cellulartelephony, fixed-point radio-based networks, and satel-lite communication systems. In terms of infrastructure ca-pacity requirements, the telephone and the Internet, sofar, rely on relatively low capacity (narrowband) net-

works, whereas television utilises broadband cable net-works.Closed communication networks of varying capa-city have also been adopted by some companies to ex-change data electronically, e.g., through EDI.

The Internet is particularly important in establishinglinks between existing forms of electronic commerce.Thisis the reason why most studies on the development ofelectronic commerce focus on the growth of the Internetor on what is sometimes called the GII, the GlobalInformation Infrastructure. This section will, therefore,focus largely on electronic commerce conducted via the

Internet, although many of its findings apply to otherinstruments of electronic commerce.

Data transmission via the Internet utilizestelecommunications infrastructure very efficiently

The Internet is a network of networks (not surpris-ingly called the web) with broadly the following struc-ture.At the bottom, i.e., closest to users, are local areanetworks. These networks are connected to a mid-lev-el or regional network, which, in turn, connects to oneor more backbones11. Most backbone and regional

network traffic moves over leased phone lines. However,these lines are not used in the same way for Internet andfor normal phone services. In the case of phone services,an end-to-end circuit is set up each time a call is placed.This circuit is not accessible to other users until the callhas ended, no matter how much data it actually trans-ports. Such a system, called circuit switching, hasproven very practical for real-time applications such asvoice conversations, since data transmission is instanta-neous. The system also allows for easy and detailed ac-counting of network usage.

III. The Economics of Electronic Commerce and the

Internet

11This is how the U.S or the European portions of the Internet can best be pictured. But the Internet is rapidly becoming more and more complex, and it is increasinglydifficult to obtain a complete overview of the network in a particular country. Individual service providers generally furnish maps of their own backbones which provideonly a partial representation.


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The Internet employs a different technology calledpacket-switching. Data sets (meant in a genericway, i.e., an e-mail message is a data set as well) arebroken up into packets, which are then sent indepen-dently over the network to their destination. No end-to-end circuit is reserved. Packets are simply passed fromthe source computer to router computers (these pass da-

ta along, based on information in the packets header)until they finally reach the destination computer.The lat-ter then reassembles the packets according to a specificprotocol. Because routes are constantly optimized, dif-ferent packets belonging to the same data set may takevarying routes. The main advantage of packet-switchinglies in so-called statistical sharing of communicationlines, whereby packets from different sources can sharethe same line.Consequently, packet-switching can use agiven capacity more efficiently than circuit-switching,where data are only transported between the connectedparties, typically leaving much unused capacity.

The costs of Internet service provision include mainlyline charges and routers

The conditions of supply of Internet services dependon the costs and pricing of such services. Turning first toinfrastructure costs, the latter depend mainly on thecharges for communications lines (which are mostlydetermined by telecom operators), on the price of routersand other computing facilities, and to a lesser degree onthe wages and salaries of operators. When, in about1970, routers became cheaper than lines, it became

more efficient to use a technology which economizes ontransmission capacity (McKie-Mason and Varian, 1995).This explains the preference for packet-switching overcircuit-switching in the case of the Internet.

As line charges and routers are fixed costs, the mar-ginal cost for sending an additional data package for agiven capacity is essentially zero. One important excep-tion to this is network congestion, which can result insignificant costs in terms of transmission delays, longeraccess times, and possibly loss of information. Thesecosts, however, are borne by users of the network and

not directly by the Internet service providers. However,congestion costs have also been partly internalized byservice providers through provision of extra capacity toaccommodate peaks in demand.12

Flat-fee pricing schemes predominate, reflecting verylow marginal costs, but these pricing schemescurrently contribute to congestion

Given rapidly rising demand for Internet services andthe need for new capacity and congestion management,

the pricing of Internet services is of key importance inproviding the right incentives for the efficient use ofexisting infrastructure and sufficient provision of addi-tional capacity. In this context, it is useful to look at thepricing decisions to be made at different levels in thehierarchy of networks: first, backbone providers have tosettle charges for data transport across each others net-

works. Second, backbone providers charge mid-level net-works for access to the backbone on permanent, leasedlines (so-called dedicated lines). Third, mid-level net-works charge local area networks for access. Finally,Internet service providers charge users who do not needa dedicated line for so-called dial-up connections tothe network which permit intermittent access at some-what lower speeds. Dial-up connections are the typi-cal Internet connection used by normal households,whereas large companies and organizations often havededicated lines to local-area or mid-level networks.

The most frequently used pricing scheme for Internetservices is flat-rate pricing (ITU, 1997a; McKie-Masonand Varian, 1997). This consists of an annual fee for afixed-bandwidth connection, allowing for unlimitedusage within the limits of the purchased bandwidth. Flatrates are typically applied down the network hierarchyfrom backbone to mid-level and from mid-level to local-area networks.

Until recently, and for historical reasons, pricingarrangements between Internet service providers werebased on the principle the sender keeps all and did notinclude a settlement for the transportation of data over

other providers backbones. Consider the case of a datastream sent by user 1 who is connected by backbone Ato user 2 who, in turn, is connected to backbone B.Under the sender keeps all system, neither 1 nor Awould have to pay for the transportation of the data onbackbone B. Today,however, some large providers do tryto charge small providers for the unbalanced use oftheir networks. This charge is not based on the trans-ported data volume, but rather on a specified level ofcapacity at which the small provider can feed data intothe network of the large provider.

Flat rate pricing has a number of advantages forInternet service providers and users. It does not requireexpensive accounting of data flows, and the billing ofusers is relatively cheap. Flat rates are also close to themarginal costs for providers, as the costs of sending anextra packet are nearly zero most of the time. Flat ratesalso encourage the diffusion of the Internet amongstdial-up users, as the latter can use their existing phoneconnections and, therefore, do not incur additional costsfrom Internet usage. However, flat rates also have draw-backs. The main problem is that they do not provide an

12Providers typically have 50 per cent spare capacity on their networks during peak periods. Note that this spare capacity does not only serve to handle momentary burstsof traffic but also protects the provider from quick increases in demand, especially considering that it takes between 45 and 90 days to have a standard line installed(see Gareiss, 1997).


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incentive to economize on Internet usage and conse-quently contribute to congestion. This is similar to theclassic tragedy of the commons. Because incrementalusage of the network is free once the fixed fee has beenpaid, users tend to overuse the common resource com-pared to a situation in which the price reflects the rela-tive scarcity of the resource. In this context, Internet us-

age of little economic value has the same consequencesfor network congestion as attempts to transmit an ur-gent and valuable piece of information, as flat-rate pric-ing does not allow the transportation of information tobe prioritized on the basis of its value.13

Usage-based pricing could solve congestion-relatedproblems, but obstacles include high administrativecosts and user preferences

Various other pricing mechanisms have been pro-posed to prevent congestion and to promote a more ef-

ficient use of resources.14 Most of these involve pricingsystems where users are charged for actual or potentialusage. Usage-based schemes allow providers greaterflexibility in terms of pricing, and under some of them,the price would remain zero if the network is uncon-gested. Users can benefit by purchasing only those net-work services where the value exceeds the costs. If ap-propriately designed, such schemes may facilitate thesupply of differentiated services, improve the allocationof resources, and eliminate the problems associated withcongestion.

The very limited application of usage-based pricingindicates several disadvantages. Accounting and billingcosts in such schemes can be high relative to congestioncosts. Experiences from the telephone sector have shownthat overhead costs for usage-based billing can amountto 50 per cent of telephone bills. Settlement of linecharges on the basis of actual data transmission be-tween service providers can also be rather costly.Furthermore, experiences with usage-based pricing havenot been very encouraging. Service providers in severalcountries, for example, Italy and the United States, hadto abandon such schemes after customers flocked to ri-

vals implementing flat rates (ITU, 1997, p. 21; Bailey,1995). Usage-based pricing has been successfully intro-duced in New Zealand. However, this may be related tothe fact that New Zealand had only one (high-cost) linkto the Internet which induced customers to economiseon usage time as they could not seek out alternative(flat-rate) service providers.

In summary, the current flat-rate pricing mechanismin most countries does not always optimize the use ofInternet infrastructure, and more efficient pricing mech-

anisms which reduce congestion and information loss orwhich prioritize high-value information may be desirable.However, flat-rate pricing may reflect user preferencesand the high administrative costs of more sophisticatedpricing schemes. Furthermore, the resulting congestionmay be a transient problem before technical progressprovides new solutions regarding pricing and capacity.

Competition in infrastructure and access provisionencourages Internet development

Economists typically agree that competition does agreat deal to minimize costs, and thereby maximize ben-efits to consumers. The level and nature of competitionbetween network and access (Internet service) providers,however, differs considerably among countries. In theUnited States, for example, competition among bothtypes of providers is relatively fierce. There are, for ex-ample, at least thirty providers who now offer nation-

wide service over a backbone of high-speed circuits.Hence, charges closely match costs, with the caveat dis-cussed above (Gareiss, 1997). However, in many othercountries the number of backbone infrastructureproviders is limited.This permits them (be they private orpublic) to use their market power to charge monopoly oroligopoly prices. In such cases, measures to strengthencompetition and to bring prices closer to competitive lev-els would clearly be welfare-enhancing.

Lack of competition in infrastructure provision may bedue to historical factors. In the past, infrastructure

providers were assumed to be natural monopolies.Therefore, they were either in public hands or were strict-ly regulated. However, the situation is evolving rapidly,and competitive markets among infrastructure providersare a real possibility, at least in large markets, as witnes-sed in the United States. In the European Union, thederegulation of the telecom sector in January 1998 isexpected to promote developments similar to those inthe United States.

Empirical evidence also identifies deregulation andcompetition in the telecom sector as being key for futureInternet development. In OECD countries, for example,the average price for leased line access to the Internet incountries with telecoms monopolies in 1995 was 44 percent higher than in countries with competitive provisionof infrastructure (OECD, 1996a). Competition is also im-portant in the market for dial-up access. In fact, theconsiderable dispersion of Internet access charges (forboth infrastructure and Internet service providers), as re-ported previously in Chart 4, reflects in part the varyingdegree of competition in domestic markets. Countrieswhere competition is absent show, on average, more

13

The problem can be compounded by users with high-capacity access lines. Already a limited number of such users can cause congestion if they feed large quantitiesof data into the system.14However, there seems to be little consensus among economists on new pricing policies. McKie-Mason and Varian (1997) favour usage pricing, whereas Anania andSolomon (1997) support flat rates.


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than twice the costs and only one fifth of the Internet us-age of those with competition (OECD, 1996c).

Although competition in many areas of telecom-munication and information technology may be growing,there are also reports of ever more mergers and acquisi-tions within and across these sectors. Infrastructure

providers, for instance, have started providing Internet ac-cess.15 This development has been ascribed to the con-vergence of different types of infrastructure and informa-tion technologies towards more integrated systems,which, in turn, induced the integration of companies totake advantage of related economies of scale, react to un-certainty about future demand, acquire skills, and gainmarket power (European Commission, 1997a). Thesedevelopments may pose new challenges to competitionauthorities worldwide.

Demand is growing rapidly with more and moreusers benefitting from expanding networks, and newand more sophisticated applications

Internet development seems to be strongly supply dri-ven, as rapid technical progress has reduced costs con-siderably in the past (OECD, 1997g, p.10). Nevertheless,demand also plays an important role in the developmentof Internet services. Demand for Internet services is de-termined by the number of users who want to be con-nected to the network and the rate of network usage.The rate of usage, in turn, is determined by the type of

applications which are offered on the network and bythe extent to which each application is used. The explo-sion of demand for bandwidth in the last few years is aconsequence of both an increase in the number of usersand the capacity required for new and more sophistica-ted applications.

Another factor determining demand is the existenceof network externalities (Shy, 1995). Positive network ex-ternalities are the gains for existing network users fromthe entry of an additional user. The more users there are,the more interesting and useful a network becomes bothto existing users and new entrants alike. Such externali-ties explain, for example, why local networks have beeninterested in interconnecting with one another.

Internet congestion, if prevalent, is also likely to affectfuture Internet demand. Users would probably be willingto pay a premium for the transmission of high-value da-ta, if this would guarantee speed and reliability. If con-gestion is not dealt with, however, the Internet couldlose some of this traffic to other instruments of datatransmission.

Demand for Internet services depends on their priceand on the price of complementary andsubstitutable goods and services

Internet pricing is important for demand in general. Inthe early days of the Internet, services were de facto freefor most users, as they had free access to the Internet

through governmental and academic institutions. This ischanging rapidly with the increasing number of privateand commercial users who pay for Internet access. Forprivate dial-up users, the costs of local phone com-munications and the charges imposed by Internet serviceproviders affect demand. Lower charges for local callsand for access to the network through service providersshould, for example, induce an increase in the numberof users. Commercial users with dedicated lines wouldalso benefit from lower line leasing charges.

Liberalization of the telecommunications market maygo a long way towards lowering average telecommuni-cation charges and, thereby, stimulating demand forInternet access. However, it may not necessarily result inlower prices for local communication (to benefit dial-up users) in the short run. In Europe for instance, tele-com monopolies argue that they have been forced tosubsidize local calls by governments pursuing universalaccess policies, and that liberalization now forces themto rebalance their prices so that they reflect true costs.Also, liberalization of telecom services may increase com-petition in the market for long-distance and internation-al services, and line leasing, much more than in the mar-ket for local calls.16 In the long run, competition in themarket for local network connections is likely to be stim-ulated by the development of new technologies. CableTV lines, for example, are already able to carry Internetdata, and electricity lines will be tested for this purposein the course of 1998.

The total costs of Internet access and usage do notonly include the charges for connecting to a local serviceprovider and for using the local telephone line. Users al-so have to acquire complementary goods, i.e., hardwareand software, which determine demand for Internet ser-vices. Access to the Internet, for example, normally re-

quires a personal computer.This is still a costly purchase,which explains in part why the penetration rate of per-sonal computers is generally still limited. However, in-creased competition in information technology is likely tolead to further technical progress and price reductions.Furthermore, new technologies are being introducedwhich extend the capacity of the television and the tele-phone to supply Internet applications.

Demand for Internet services also depends on theprice of substitutable services. For a very long time, theInternet was used mainly for electronic mail. Electronic

15See European Commission (1997a) for more examples of vertical and horizontal integration.16In the United States, prices for local calls declined between 1992 and 1997 despite the fact that competition in local markets is still limited. But pressure to increasethe price of local calls is increasing. See Wall Street Journal, 3 December 1997.


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mail is a relatively close substitute for the telephone, thetelefax, and regular mail. Once connected, communica-tion through electronic mail is virtually free of charge,which is not true of its substitutes. Similarly, the successof Internet fax and Internet phone is due to the price dif-ference as compared to its conventional competitors.Other things being equal, a reduction in the prices of

traditional telephone, telefax or mail services would re-duce the incentive to use the Internet.

B. The economic effects of electroniccommerce on user industries

The expansion of electronic commerce on the Internetis not only related to progress in infrastructure and ac-cess opportunities. It also depends on the emergence ofprofitable business opportunities. For business purposes,the Internet opens possibilities which go much beyond

existing information/communication technologies.All theelements of the value chain of certain transactions fromproduction to distribution can in principle be conductedonline.The Internet offers integrated fax, mail, and (soon)phone services at relatively low cost. It allows interactiveor non-interactive transactions between just two ormany individuals. Finally, the Internet allows the transferof digitalized information from one computer to anotherat a low price (see also Tables 6 and 7, and Chart 3, pre-viously listed). This makes the Internet a very versatileand powerful instrument of electronic commerce, despitethe fact that the commercial use of the Internet only be-

gan a few years ago.

The Internet reduces transactions costs

Two effects of electronic commerce on user industriesare most frequently cited.The first involves the impact onintermediaries and changes in the supply chain betweenthe design of a product and its final sale to a customer.The second effect concerns market structure. It is oftenargued that the Internet is the great equalizer in thatit will allow small firms to compete with big firms on anequal footing, thereby resulting in increased competi-

tion. Both these effects are in fact the result of lowertransaction costs, arising from faster and cheaper infor-mation flows and communication.

The Internet allows firms to perform certain activitiesat lower cost. The efficiency gains here result from im-proved internal organisational and management effi-ciency of enterprises (through faster and cheaper com-munication), as well as from increased competition be-tween suppliers. The Internet also has the potential toimprove the quality of a service by allowing for morerapid adjustment of supply to changes in demand, faster

product development and market testing, and an in-creased ability to customize client needs. A number ofprominent examples of the benefits from electronic com-

merce on the Internet have been reported, as a numberof companies have successfully introduced an EDI- andInternet-based purchasing system, with considerablesavings in terms of turn-around time and supply costs(see also the previous section). Internet-based electron-ic commerce has also made some inroads into retailingof high tech products with an increasing number of com-

panies selling such products via the Internet (ITU,1997a).

Internet-based electronic commerce can change thestructure of firms and sectors

The Internet is also likely to affect the vertical di-mension of firms. Any product is a combination ofgoods and services. Consider, for instance, a book in ashop: it includes the authors ideas, the paper on whichit is printed, the services of a cover designer, marketingspecialists, a publisher, a transport firm and a retailer.

The providers of these goods and services can either bepart of a single firm which controls the whole chain be-tween writer and reader, or they can consist of severalspecialized firms.The extent to which goods and servicesare produced in house by a single firm is referred toas the vertical dimension of a firm.

The Internet may affect the vertical dimension offirms through its impact on the costs of communicatingand transmitting information. Firms integrate or splinterin order to become more efficient (or to gain marketpower).The availability of new information and commu-

nication technologies creates new conditions which in-duce adjustments in various sectors. Consider, for in-stance, the case of financial services. The Internet has fa-cilitated access to information on financial marketsthrough free access to online information services.Brokers who used to sell integrated services (i.e., thetrade and information for the client on what to trade)now find themselves competing with online brokers whosimply conduct trades and provide no advice or infor-mation. Online competition here has resulted in less dif-ferentiated services competing purely on price, ratherthan on the quality of the service (as reflected by the val-

ue of the background information). The result has beenvertical disintegration, i.e., the separation of informationservice provision from actual trading activity.

Similar changes have affected travel agents, thoughsometimes with an opposite effect in terms of vertical in-tegration. The Internet sale of airline tickets is much lessexpensive than conventional ticket sales through a trav-el agency. Airlines are, therefore, trying to circumventtravel agencies and sell directly to customers in order toavoid paying commission.Alternatively, airlines can try tosell through online agencies at a discounted commis-

sion. The expansion of online ticket sales, however, isconstrained by regulations which prohibit price reduc-tions. Consequently, Internet customers cannot benefit


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from lower ticket prices.This leaves airlines with a strongincentive to integrate sales activities into their ownoperations.

Profound changes can be expected in the retail sec-tor as a whole, as the Internet facilitates shopping fromhome.Already, a first wave of cybermallshas been fol-

lowed by more successful specialized retailers, and,morerecently, multi-product megastores have appeared(The Economist, 1 November 1997). However, much un-certainty remains as to the type of Internet shoppingwhich will ultimately prove successful. But this is hardlysurprising given the relative novelty of Internet shopping.Experience gained so far has shown that firms cannotsimply replicate existing formulas, and that they have todesign new methods if they wish to sell on the Internet.This applies not only to the retail sector, but also to manyother sectors which try to sell existing or new goods andservices online.

The spread of the Internet and continuing expansionof information available on the Internet is likely tochange fundamentally the market for information.This isbecause consumers may be willing to pay a premium forhigher quality information, and firms may specialize incollecting and processing information for consumers orfirms.A new information processing industry may, there-fore, emerge.

The Internet facilitates market entry, thereby

benefitting small and medium-sized enterprisesA number of economists have argued that the

Internet will affect market concentration and increasecompetition via the easy entry of new competitors.This, it is argued, benefits in particular small and medi-um-sized enterprises. First, the capital cost of entry, i.e.,the costs to set up shop on the Internet, is relativelylow compared to conventional outlets. Second, the costof establishing a reputation in the new environment isalso lower than for established markets, and somebodywith a bright idea can supposedly make an enormous

impact with only a limited upfront investment. Examplesof this may be found among a number of specializedInternet retailers. However, each success story is accom-panied by many more failures, and the actual cost of set-ting up a successful business on the Internet is probablyhigher than is generally believed.Also, market entry maybe more restricted than first thought. One reason couldbe lack of competition in upstream industries whichsupply Internet merchants. As regards the music indus-try, for example, it has been suggested that control of themarket by just a few companies has limited price cuts on

the Internet, which, in turn, has thus far limited thegrowth of online compact-disc stores (The Economist,May 10, 1997).

The demand for Internet-based commerce will beboosted by lower transaction costs, such as searchcosts, delivery time and charges, and travel costs

The demand for goods and services provided throughall (electronic and non-electronic) means will be affect-ed by the advent of the Internet. First, the Internet can

reduce search costs compared to other electronic or con-ventional means of commerce. Consumers typically donot have complete information about the price and qual-ity of goods they are considering to buy.The cost of ac-quiring more information can be fairly high if one has tomake a number of phone calls or browse through vari-ous papers. Powerful Internet search programs can nowhelp customers find the cheapest offer among a largerange of suppliers in a short period of time.

Furthermore, consumers can benefit from reductions

in other transaction costs.All products which can be dig-italized can, in principle, be distributed through theInternet. This enables consumers to buy from supplierslocated all over the world and have their purchases de-livered at near zero transportation costs. Moreover, thecost associated with the delay between order and deliv-ery is reduced. We mentioned above that ordering andpayment costs for Internet transactions are typically low-er than for most other means of commerce.A number ofservice industries are also likely to benefit from lowertransaction costs, as online supply does not necessitate

physical interaction between buyer and seller. A builder,for example, may not have to travel to see his architectif he can access required plans via the Internet. The pro-ducer of a product may not have to meet physically withthe designer of a product.

Some economists, however, have been more scepticalabout the possible savings in transaction costs. Searchcosts are not always as low as suggested. Finding theappropriate information requires skills which can becostly to acquire. Also, searching might take some time,particularly when the network is congested. Relying on

only one source of information, such as a single searchengine (search program) or online travel agent,may al-so provide biased information. In addition, transactioncosts may be affected by the fact that the rules and lawsgoverning commerce on the Internet are not yet in place,an issue we will return to at a later stage in this study.

Certain sectors may also experience considerable in-creases in demand indirectly through the expansion ofthe Internet. Industries which supply inputs to theInternet, such as the information technology industry in

particular, are likely to experience growing sales.Computer training is likely to be another sector benefit-ting indirectly from growing electronic commerce.


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Lower transaction costs will stimulate competition,both domestically and internationally, resulting inmore diversity, better qual

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