International Think-Tank on Innovation and Competition

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The Economics of Cloud Computing

March 1, 2010

aLook at the 2010 Global Information Technology Report of the World Economic Forum

See the IIEA Talk on Cloud Computing (Dublin, Ireland, May 21, 2010)

The new big thing of the IT world is “cloud computing”, a general purpose technology that could provide a fundamental contribution to promote efficiency in the private and public sectors and promote growth, competition, and business creation.

Cloud computing is an Internet-based technology (hence “cloud”) which stores information in servers and provides it as an on-demand service. The economic impact of cloud computing will be substantial on both households and companies.

- On one side, consumers will be able to access all of their documents and data from any device (the home or work PC, the mobile phone, an internet point), as they already do for email services or social networks.

- On the other side, firms will be able to rent computing power (both hardware and software in their latest versions) and storage from a service provider, while paying on demand, as they already do for other inputs such as energy and electricity.

The former application will affect our lifestyles, but the latter will have a profound impact on the cost structure of all the industries. For instance, it can provide huge cost savings and greater efficiency in large areas of the public sector including hospitals and healthcare (especially to provide information and technologies in remote or poorer locations), education (especially for e-learning) and the activity of government agencies with periodic spikes in usage. Moreover, substantial positive externalities are expected because of energy savings: the improvement of energy efficiency may contribute to the reduction of total carbon emissions in a substantial way.

If we look at the private sector, again the introduction of cloud computing can provide cost savings. It can create multilateral network effects between businesses, and it can promote entry and innovation in all the sectors where IT costs are restrictive and are drastically reduced by the adoption of cloud computing. This last effect can have a large effect on the wider economy.

Cloud computing is probably going to develop along different concepts, focused on the provision of infrastructures (renting virtual machines), platforms (on which software applications can run) or software (renting the full service, as for email). In preparation for its introduction, many large high-tech companies are building huge data centres loaded with hundreds of thousands servers to be made available for customer needs in the near future.

The first mover in the field has been Amazon, which has provided access to more than half a million developers by way of Amazon Web Services. Google provides word processing and spreadsheet applications online, while software and data are stored on the servers. Google App engine allows software developers to write applications that can be run for free on Google's servers. Microsoft has started later but with high investments in the creation of new data centres and with the introduction of a cloud platform called Windows Azure that is able to provide a number of new technologies: a Windows-based environment in the “cloud” to store data and to run applications, an infrastructure for both on-premises and cloud applications, a cloud-based database, and an application tool which allows users to synchronise and constantly update data across systems joined into a "mesh" (for all the personal devices). Oracle has introduced a cloud-based version of its database programme and is merging with Sun Microsystems to prepare further expansion in the field. Yahoo! is developing server farms as well.

The competition for the clouds between these companies is going to reshape the IT market structure, just as PC distribution did in the 1980s. However, the need to create network effects in the development of a cloud platform and the likely efforts of the market to insure appropriate standardisation will keep prices low and maximise the speed of diffusion of cloud computing. Therefore, in the long run, we expect a rather competitive situation on the supply side.

It is crucial to understand the economic impact on growth of the introduction of such a general purpose technology. The first and most relevant benefit is associated with a generalised reduction of the fixed costs of entry and production, in terms of shifting fixed capital expenditure in IT into operative costs depending on the size of demand and production. This contributes to reduce the barriers to entry especially for small-and medium-sized enterprises, as infrastructure is owned by the provider, it does not need to be purchased for one-time or infrequent intensive computing tasks, and it generates quick scalability and growth. The consequences on the endogenous structure of the markets with largest cost savings will be wide, with entry of new companies, a reduction of the mark ups, and an increase in average and total production. The economic impact of the diffusion of this new general purpose technology may be quite large, as it happened, for instance, with the diffusion of telecommunications infrastructures in the 70s and 80s or the introduction of the internet in the 90s.

In recent research we have adopted a macroeconomic approach emphasising the effects that this innovation has on the cost structure of the firms investing in IT and consequently the incentives to create and expand new businesses, on the market structure, on the level of competition in their sectors, and ultimately on the effects for aggregate production, employment and other macroeconomic variables.

My methodology is based on a dynamic stochastic general equilibrium calibrated model augmented with endogenous market structures in line with recent developments in the macroeconomic literature.This model includes a realistic structural change to the cost structure with the purpose of studying the short- and long-term reactions of the economy. Starting from conservative assumptions on the cost reduction process associated with the diffusion of cloud computing over five years, I estimate that the diffusion of cloud computing could provide a positive and substantial additional contribution to the annual growth rate (up to a few decimal points), helping to create about a million new jobs through the development of a few hundred thousand new small- and medium-sized enterprises across the EU. Empirical exercises under different scenarios show a strong impact on the creation of new businesses, in the magnitude of a few hundred of thousand within the EU. Moreover, the effect is expected to be deeper in countries where the diffusion of smaller companies is particularly strong or where IT adoption has been generally rapid. In absolute terms, Italy is expected to have the largest impact in terms of new business (with about 80,000 new small- and medium-sized enterprises in the medium run under fast adoption), followed by Spain (55,000), France (50,000), Germany (40,000), UK (35,000) and Poland (32,000).

The driving mechanism behind the positive contribution arises from the incentives to create new firms, and in particular new small- and medium-sized enterprises. 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 IT capital spending. Cloud computing allows potential entrants to save in the fixed costs associated with hardware and software adoption and with general IT investment, and turns part of this capital expenditure into operative expenditure, that is in 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 smaller companies play a crucial role in the production structure.

Policy implications from cloud computing

Part of the positive effects of cloud computing will depend on the speed of its adoption, so policymakers should promote rapid adoption. Concrete interventions include:

- international agreements in favour of unrestricted flow of data across borders (since data centres are located in different countries with different privacy laws, data portability remains a key issue for the diffusion of cloud computing);

- agreements between EU authorities and industry leaders on a minimum set of technological standards and process standards to be respected in the provision of cloud computing services to guarantee data security and privacy and promote a healthy diffusion of the new technology;

- expansion of the broadband capacity;

- introduction of fiscal incentives for the adoption of cloud computing and a specific promotion in particular dynamic sectors (for instance, governments could finance, up to a limit, the variable costs of computing for all the domestic and foreign firms that decide to adopt a cloud computing solution).

These policies may be studied in such a way to optimise the process of adoption of the new technology and to strengthen the propagation of its benefits within the country.

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