International Think-Tank on Innovation and Competition
The Impact of a General Purpose Technology on Business Creation in Europe: the Case of Cloud Computing
February 25, 2009
Download the new study on The Economic Impact of Cloud Computing on Business Creation, Employment and Output in Europe by F. Etro (February 2009)
The introduction of a general purpose technology can provide a fundamental contribution to promote growth and competition, and it can help the economy to recover from a severe downturn as the current one. In the article "The Economic Impact of Cloud Computing on Business Creation, Employment and Output in Europe" we study the economic impact of an innovation in the hardware-software field which is going to have a profound effect on the market structure of many sectors and on the global macroeconomic performance in the next years. This innovation is associated with cloud computing, a technology through which information will be stored in servers and provided on line as a service to clients in a pay-as-you-go manner. Firms will be able to adopt this service on demand, so as to avoid large up-front costs (that are currently necessary for hardware and software equipment) and spend in ICT according to their production necessities (see Armbrust et al., 2009, "Above the Clouds: A Berkeley View of Cloud Computing", mimeo, UC Berkeley RAD Laboratory). This will have a large impact on the cost structure and through it on the production possibilities of all firms, especially small and medium size enterprises (SMEs). Our focus is mainly on the theoretical impact of this innovation and on the empirical evidence about this impact for the European economy.
The introduction of cloud computing is going to reduce drastically the fixed costs of entry and production, turning them into variable costs proportional to the production necessities. This will have a positive impact on entry and competition in all sectors where fixed ICT spending is crucial. The positive association between ICT innovations and competition is well known, and policymakers recognize that it may work in both directions: on one side competitive sectors adopt ICT innovations earlier and become more productive, on the other side ICT adoption enhances competition. For instance, the important survey e-Business Watch (2008) of the European Commission notices that, "[w]hile it seems obvious that increasing levels of competition can push companies to adopt and use ICT, the opposite might well also be the case. In fact, ICT and the usage of the internet have drastically impacted on certain sectors such as banking and reshaped the competitive scenario".
Our approach in the evaluation of the impact of the diffusion of a new general purpose technology as cloud computing is based on macroeconomic theory and macroeconomic data. We emphasize the effect that this innovation has on the cost structure of the firms investing in ICT and consequently the incentives to create and expand new business, on the market structure and on the level of competition in their sectors, and ultimately the induced effects for aggregate production, employment and other macroeconomic variables. Our methodology is based on standard and advanced macroeconomic analysis belonging to the field of the dynamic stochastic general equilibrium (DSGE) models calibrated on a real economy and perturbed with a realistic structural change to the cost structure to study the short and long term reactions of the economy. Therefore, our methodology is based on a solid theoretical framework and it provides results that can be easily replicated by economists. However, this methodology has some limitations that we need to point out. First of all, while the methodology is useful to estimate the aggregate impact of a shock on the macroeconomy, it is less so at the microeconomic level. For this reason, our results for the impact on the EU economy as a whole are on average more reliable than those for disaggregated sectors and also for single countries. Second, the experiment we present is highly speculative because the nature of the cost shift (due to the introduction and diffusion of cloud computing) can only be conjectured (it will depend on many future macroeconomic and policy factors), and also because we are in a moment of high macroeconomic uncertainty. For this reason, we will focus on the "net expected" impact of cloud computing on the economy, meaning the expected additional impact above and beyond the cyclical behavior of the macroeconomic variables (associated with any other motivations). Moreover, we will present estimates for different scenarios - of slow and rapid adoption of the new technology - that should cover the range of possible outcomes with a good approximation. Third and last, our approach neglects some of the positive effects exerted by the introduction of cloud computing, mainly the creation of new network effects and the positive externalities due to energy savings. Their consideration would be subject to excessive uncertainty, but because of this we can look at our estimates of the impact of cloud computing on the economy as conservative estimates.
Our experiment is focused on Europe. Therefore, all our data derive from official EU statistics (EUROSTAT), mainly for number of firms, which is basically equivalent to any measure of the number of small and medium size enterprises (SMEs), employment and gross domestic product. In particular, we used data for the twentyseven EU member countries, but excluded detailed analysis for Cyprus, Malta and Luxembourg (because of their limited size), and added Norway for which we had complete data. Moreover, we focused on a few aggregate sectors for which we have detailed and comparable EU statistics: Manufacturing, Wholesale and retail trade, Hotels and restaurants, Transport storage and Communication and Real estate renting and business activities. These aggregate sectors cover the majority of firms in terms of number (more than 17 million firms) and the majority of employment for the European countries (more than 113 million workers), and include all the sectors where the effects emphasized in our analysis are relevant, namely manufacturing and service sectors, where the use of ICT capital and the role of entry costs and competition effects are more relevant. We ignored other aggregate private sectors (as electricity, gas and water supply) and the public sector, where we believe that our mechanisms are weaker or absent, or sectors where comparable data were not available (as part of the financial sector). All the results are based on the numerical simulation of a calibrated model. However, country specific heterogeneity and sectorial differences were taken in consideration on the basis of statistics on the labor market and the entry/competitive conditions at the level of EU countries and their aggregate sectors.
Starting from conservative assumptions on the cost reduction process, the analysis shows that the diffusion of cloud computing will provide (in a medium term range of five years) a positive impulse to the annual growth rate, contributing to create about a million new jobs through the development of a few hundred thousand new SMEs in the whole EU-27. Our empirical exercise shows a strong impact on the creation of new SMEs (besides we report our estimates for the medium term in the scenarios of slow and fast adoption of cloud computing). Notice that the effect is permanent and tends to increase over time: the creation of new SMEs is not going to vanish, but it is going to persist, with a permanent impact on the structure of the economy. Moreover, the effect is deeper in countries where the diffusion of SMEs is particularly strong, or where ICT adoption has been generally rapid. In absolute terms, Italy is estimated to have the largest impact in terms of new business, followed by Spain, France, Germany, United Kingdom and Poland.
The driving mechanism behind the positive contribution of cloud computing to output works through the incentives to create new firms, and in particular SMEs. One of the main obstacles to entry in new markets is represented by the high up-front costs of entry, often associated with physical and ICT capital spending. Cloud computing allows potential entrants to save in the fixed costs associated with hardware/software adoption and with general ICT investment, and turns part of these costs into variable costs. This reduces the constraints on entry and promotes business creation. The importance of such a mechanism is well known at the policy level, especially in Europe, where SMEs play a crucial role in the production structure. Again the e-Business Watch (2008) of the European Commission emphasizes this aspect clearly: "SMEs form significant industry segments in the EU and account for the majority share in EU employment. Thus, they require specific policy attention. While their strength lies in the flexibility with which they can adjust to changing market conditions, their small size makes them less able to face high up-front costs. For ICT, this does not primarily mean the investment in hard- and software, since competition on the respective markets keeps them at economically reasonable levels. Rather, it means the costs of gathering additional information which SMEs lack. In particular, the small size of many companies typically requires their managers to focus almost exclusively on operational activities. Little time remains for strategic planning, so new issues that require substantial up-front information are difficult to deal with".
Our analysis emphasizes other mechanisms as well. Through business creation, the adoption of cloud computing is going to enhance competition in each sector and to increase production and lower mark ups. This will have a positive impact on consumption so as to contribute to the recovery of the EU economy. We need to notice that our approach neglects other positive effects exerted by the introduction of cloud computing, mainly the creation of new and multilateral network effects and the positive externalities due to energy savings, whose consideration would be subject to excessive uncertainty. Therefore, we can look at our estimates of the impact of cloud computing on the economy as conservative estimates. Finally, part of the above effects of cloud comptuing are going to be positively related to the speed of adoption of the new technology. For this reason, our investigation suggests that policymakers should promote as much as possible a rapid adoption of cloud computing. Concrete possibilities in this direction include fiscal incentives and specific promotion of cloud computing in particular dynamic sectors.