Public Lecture at Popper Room of Central European University on March 7, 2003 Beyond the Internet: Lessons from Estonia and Slovenia Meelis Kitsing International

Public Lecture at Popper Room of Central European University on March 7, 2003

Beyond the Internet: Lessons from Estonia and Slovenia

Meelis KitsingInternational Policy FellowCenter for Policy Studies

(affiliated with the Open Society Institute and Central European University)


Outline

Why does Internet diffusion matter? Methodology and theoretical framework Why are Estonia and Slovenia chosen for cases? Outcomes in Estonia and Slovenia Characteristics of Estonia Characteristics of Slovenia Political economy explanations Lessons for other countries Policy options


Why does the Internet diffusion matter?Formal reasons

Enlargement of the European Union

The eEurope+ 2003 initiative “The EU candidate countries … avoid a digital divide with the EU.”

Other countries are engaged in promoting the diffusion of ICTs; it is crucial not to be left behind.

World Bank, UNDP and other international organization give aid and encourage countries to develop ICTs.


Why does the Internet diffusion matter?Political reasons

“Technology will make it increasingly difficult for the state to control the information its people receive. The Goliath of totalitarianism will be brought down by the David of the microchip.” --Ronald Reagan

Freer flow of information Reduced transaction costs for accessing information and

public services New means for civic activism (organizing protests,

participating in the organization et al)


Why does the Internet diffusion matter?Economic reasons

Productivity gains

“Progress can be measured by how few workers - not how many - are needed to get the job done. The joke is that the factory of the future will employ only one man and one dog. The man is needed to feed the dog. The dog's job is to keep the man from touching the computer.” -- Robert D McTeer, (president of Federal Reserve Bank of Dallas)

Productivity gains are quite visible on the micro level.


Why does the Internet diffusion matter?Economic reasons

Productivity gains are quite visible on the micro level.

No proof of productivity gains on macro level outside of the United States (Daveri 2002, Pohjola 2001, Stiroh and Jorgenson 2002)

“Although there is increasing evidence that IT investment is associated with an improvement in company performance in industrial countries, studies that look at the bigger macroeconomic picture find little correlation between IT investment and overall productivity – and some studies even find a negative correlation.” -- Matti Pohjola


Why does the Internet diffusion matter?Political economy reasons

Network externalities - Metcalfe’s law states that the value of a network grows with the square of the number of people connected to it.

The law is grounded in basic microeconomics: There are externalities of being connected to the certain classes of goods and “bads” (negative goods).

Value of telephone networks and the Internet is higher when all people can use them for communicating with each other, as opposed to only a limited number of people being able to use them.



Many negative externalities occur with the use of ICT networks as increasing dependence makes individuals and organization more vulnerable (privacy concerns, cyber crime, cyber terror, emails from “bad” person).

The law indicates that positive network externalities prevail in the case of ICT networks.

It is crucial to find a fine balance between open and smart networks.



An open network fosters innovation and competition because it is by nature a dumb network, i.e. applications are hosted at the edge of the network by anyone.

A smart network decreases both negative and positive externalities by imposing higher levels of control, as the applications are hosted at the network’s core.

Positive externalities and openness determine the value and importance of the Internet, and it makes sense to diffuse ICT as networks rather than specific ICTs. The concepts of network externalities and open network capture both political and economic benefits of the Internet.


Telecosm - No longer just a fantasy

“At wavelengths running from the millimeters of microwaves down to the nanometers of visible light -- is the new frontier of the millennium, empires of air and fiber that command some 50,000 times more communications potential than all the lower frequencies we now use put together. A purely human invention, they provide

the key arena of economic activity for the new century.” -- George Gilder


Methodology and theoretical framework

A qualitative approach. Two detailed case-studies.

Dependent variable is Internet penetration.

Explanatory variables are institutions – both informal and formal.

The theoretical framework is heavily based on the theories of neo-institutional economics.

Institutions are the rules of the game in society, and can be divided into formal (laws, regulations) and informal institutions (customs, traditions).


Methodology and theoretical framework

Institutions determine the cost of transactions. When cost of transacting is too high, people may not undertake particular activities (e.g. connect to the Internet, start an ISP).

Transaction costs do not matter only at the corporate level (Coase 1937); they hold importance for the whole development of society (Coase 1960). Effective and low-cost enforcement of contracts are the key to progress.

Performance of economies is a consequence of the incentive structures, which are in turn determined by the institutional

framework.


Why were Estonia and Slovenia chosen for case-studies?

Estonia and Slovenia have achieved similar outcomes in Internet diffusion

Estonia and Slovenia have different political economy models

Different paths of transition from socialism to a market economy

Both are small, open economies close to the European Union

Both countries were part of a larger union and have had to build-up a nation-state


Outcomes in the Internet diffusion

Country Internet users in 1999 2000 2001 (per 10 000 inhabitants)

Czech Republic 682 971 1363Estonia 1387 2721 3005Greece 705 947 1321Hungary 597 715 1484Italy 1430 2304 2758Latvia 430 619 723Lithuania 279 609 679Poland 542 725 978Portugal 1000 2494 3494Romania 267 357 447Slovakia 1112 1203 1203Slovenia 1257 1507 3008Spain 703 1343 1828


Explaining outcomes - geography, size and wealth

Geography – it matters but certainly not as much as one would expect

Size – also matters, but many examples exist of “small” countries with low levels of Internet diffusion

Wealth – important indicator in general terms, but Estonia is 2.5 times poorer than Slovenia, and many countries with a similar per capita GDP to that of Estonia and Slovenia have lower levels of Internet diffusion.


Explaining outcomes - civil liberties and democracy

Civil liberties and democracy – statistical research by Dimitrova has indicated that the status of civil liberties and democratization is strongest predictor of country-level Internet use.

Extremely important factor for post-communist countries known for violating civil liberties and authoritarian rule.

But this finding is not helpful for explaining outcomes in comparing these two cases to the other EU candidates.


Explaining outcomes - computers and main lines

Number of personal computers – regression analysis demonstrates that Estonia is a clear outlier as it has more Internet users than availability of personal computers would predict. Slovenia is an outlier in opposite sense as many of the PCs are not connected to the Internet.

Main telephone lines – it matters in the case of less-advanced countries where main line penetration is extremely low.However, most EU candidate countries have a fairly similar penetration of main telephone lines.

Regression analysis demonstrates that Estonia and Slovenia are clear outliers – it means that Internet penetration is significantly higher than the number of main telephone lines would predict.


Characteristics of Estonia - Soviet heritage

Until the break-up of the Soviet Union, Estonia benefited from an extremely limited diffusion of Western ICTs. COCOM imposed tight export controls on the exports of ICTs.

However, the infrastructure of main telephone lines was more advanced than in most other parts of the Soviet Union.

Presence of Soviet light industry and the demand for electronics skills benefited the development of the “epistemic IT community.” The Soviet IT specialist developed a pirated version of Macintosh called AGAT and a pirated IBM called EC. Estonian IT specialists developed a PC called JUKU, which was not pirated.


Characteristics of Estonia - Government

In the early 1990s, the local IT community became crucial in setting government policies in terms of IT spending, procurement and use (a certain percentage of general budget category is dedicated for IT spending).

Use of Internet in government affairs and making services available for citizens.

Spending on Internet access in the schools and public Internet points.

Active promotion of use of Internet and e-government.


Characteristics of Estonia - Private sector

Establishment of local PC assemblers, such as Microlink and Astrodata, and later Ordi, which gained a significant market share and benefited from government spending on IT.

Mid-1990s establishment of Internet banking services by the leading banks.

Active use of Internet by companies for communication with outside world and within companies


Characteristics of Estonia - Telecomm market liberalization

Monopoly in the fixed lines over voice telephony until the end of 2000 (competition in mobile telephony)

Free market in data transmissions, ISPs and backbone providers.

Leased lines and alternative uses of infrastructure use was partially liberalized before the end of 2000.


Characteristics of Estonia - Privatization of the incumbent telecomm company

A concession agreement between Sonera/Telia and government in 1992, which granted a monopoly position for a limited time.

In return, government got a strategic shareholder and investment in infrastructure

In 1997, 24 percent of the shares owned by the government went for sale through initial public offering.

Government’s stake is reduced to 27 per cent and it has a golden share. Telia/Sonera have 49 per cent and other investors have 24 per cent.


Characteristics of Estonia - Trade and FDI

Estonia radically liberalizes its trade barriers by moving to unilateral free trade in 1995 and re-orientating its trade flows to the West.

Hence, it makes it possible to exploit the benefits of liberalization of COCOM regime to the full extent.

It achieves the highest trade to GDP ratio in the Central and Eastern Europe.

Open foreign direct investment regime attracts investors mainly from Finland and Sweden by creating a positive spillover for the diffusion and use of Internet within Estonia.


Characteristics of Slovenia - Yugoslav heritage

Limited technology transfer was possible before the break-up of Yugoslavia. COCOM regime impact was not as strong as in the other East bloc countries (Yugoslavia was not a member of COMECON).

Technology transfer was made possible due to the extensive trade relations with the Western Europe (mainly Germany). 50 percent of the exports went to the West in the 1980s.

IT-related research and education was established in the mid-1970s. In the early 1980s the secondary schools began to install mainframe computers.


Characteristics of Slovenia - Yugoslav heritage

Development of local “epistemic IT communities” was possible due to the existence of local technology industry (Iskra Delta).

Decentralized control of economy and “social ownership” of companies created incentives for development of creative solutions (compared with the Soviet command economy). Iskra Delta was broken up before the dissolution of Yugoslavia.

Foreign direct investments in high-tech were made usually in Slovenia. Siemens started a joint-venture with Iskratel in 1989.


Characteristics of Slovenia - Government

Government has pursued a pro-active industrial policy which has benefited the IT industry.

Government has encouraged the use of Internet in government affairs and made the crucial information available on the Internet. However, e-services are currently not available for the citizens. Ministry of Information Society was created in 2001.

Government has also carried out specific projects to increase the diffusion of Internet at schools, public libraries and research institutions.


Characteristics of Slovenia - Private sector Slovenia has a wide range of medium-sized hardware

and software companies.

Many multinationals (Siemens, Cisco, Microsoft) have invested in Slovenia or partnered with Slovenian companies.

Slovenian companies are in relatively high positions in the value chains of Western multinationals.


Characteristics of Slovenia - Telecomm market liberalization

Originally, Slovenia planned to open the market for competition by the end of 2000. However, Slovenia formally ended the monopoly in fixed lines over voice telephony in 2001. Implementation of the decision was constantly postponed.

Slovenia had officially liberalized the market in data transmissions but it was a monopoly in reality. ISP services were partially liberalized but licenses were required.Leased lines and alternative infrastructure use was partially liberalized.

Market opening has been subject to constant pressure by the EU.


Characteristics of Slovenia - Privatization of the incumbent telecomm company

State agency was split into Telecom and Post in 1995

Government owns 74 percent, employees 13 percent, and state investment funds the rest of the share of Telekom Slovenije.

The Slovenian government engaged in building a “national champion” of the telecomm company.

Privatization has been constantly discussed with the EU, and currently, the decision has not been made.


Characteristics of Slovenia - trade and FDI In the 1990s Slovenia has gradually increased the share

of the EU in its trade.

Step-by-step, the trade barriers have been liberalized but further reduction are required for entering into the EU.

The ratio of FDI to GDP remains well below average in the region. WTO, OECD and other international organization see main barriers in an open privatization policy and a stable regulatory environment.


Political economy explanations

Path-dependence: Slovenia certainly had a better initial starting position than Estonia. (infrastructure, skills, trade openness = technology transfer)

Slovenia’s and Estonia’s policies towards the telecomm sector also reflect the general path of reform and chosen political economy models in both countries.

Estonia had a radical, shock therapy-type approach to the transition and relatively free market economy.

Slovenia chose a gradual reform path and a political economy

system similar to social democratic corporatism.



However, incertainty in market opening and privatization of telecomm in Slovenia reflects a higher degree of regulatory capture and the prevalance of an “old boy network” than in Estonia.

Establishing a Ministry for Information Society with the aim of dealing with telecom market issues is a good example. The current inability to deliver an e-government in Slovenia indicates a lack of incentives in the cozy government relationships.

Both countries achieved a similar outcome in Internet penetration under the conditions of monopoly in the fixed lines. Internet access costs were significantly lower than in the Czech Republic, Hungary, Latvia, Lithuania, Poland and Slovakia.



Before and after the market was liberalized in Estonia, Slovenia was able to maintain somewhat lower prices for Internet access than in Estonia, especially so in the peak hours. However, under monopoly conditions local calls are usually subsidized by international calls.

This indicates that, in general, the Slovenian and Estonian governments were able to keep the incumbent telecom company to the account.

This can be explained by the interest group pressure: “social ownership” in Slovenia and FDI in other ICT sectors (backbone, mobile telephony, ISPs) in Estonia.



Hence, trade openness and FDI is crucial for Estonia; it increased the competitive pressures and helped overcome the gap in the initial starting position with Slovenia.

Estonia has been more radical in changing its formal institutions for reducing the transaction costs in the diffusion of the Internet.

Slovenia’s change of formal institutions has been more gradual. However, informal institutions embedded in the system and Yugoslav heritage has facilitated the reduction

of transaction costs.


Policy lessons for other countries

Estonia and Slovenia demonstrate that it is possible to achieve a similar outcome with different ways of transition.

Both cases indicate it is hard to change telecomm policy without a change in the broader political economy framework. Hence, liberalization of telecoms without liberalization of other economic policies may not work.

Internet diffusion may spread under the conditions of monopoly in the fixed lines when a country’s government is able to keep control over the incumbent and regulatory capture is avoided. However, such a situation may not be sustainable in the long run.


Policy lessons for other countries

However, Slovenia’s outcome is strongly explained by the path-dependence derived from the former system.

Hence, the countries without such advantages may find it difficult to implement Slovenia’s model.


Policy option I

Partially opening up a telecom market. Setting a firm deadline for a complete market opening.

Sustaining a monopoly fixed lines or partial monopoly (e.g. rural areas) for returns in investment into infrastructure.

Privatization of incumbent telecom company combined with a Liberal foreign direct investment regime

Independent regulatory agency, by naming key decision-makers for a long period of time (like an independent central bank)


Policy option I

Actively promote the use of Internet by government bodies, offer public services online

Unintended consequences of such policy could be

unpredictability of technological developments, which may undermine the monopoly;

difficulty in determining the exact period of monopoly; or possible lobbying by the monopoly to change the rules

of the game.


Policy option II

Open telecom market for competition

Privatize incumbent telecomm company and Ensure a liberal foreign direct investment regime

Build infrastructure with government resources in the areas where is a market failure (e.g. rural areas).

Create an independent regulatory agency by naming key decision makers for a long period of time (like an independent central bank)


Policy option II


An unintended consequence of such policy might be hidden in the definition of a market failure, which may lead

to the possibility that government competes with private structures.


Policy option III

Open telecom market for competition

Privatize incumbent telecomm company and ensure a liberal foreign direct investment regime

Create an independent regulatory agency by naming key decision-makers for a long period of time (like an independent central bank)



Policy option III

An unintended consequence of such policy might be inequality of access in urban and rural areas.


Policy option IV

Open the telecomm market for competition

Do not privatize the incumbent telecom company but set a firm long-term deadline for privatization and lock it in (through international organizations and/or constitutional means).

Ensure a liberal foreign direct investment regime

Create an independent regulatory agency by naming key decision-makers for a long period of time (like an independent central bank)


Policy option IV


Unintended consequences of such policy might be difficulties in determining the length of monopoly, unpredictability of technological developments that may

undermine the monopoly, credibility of lock-in mechanism, and the perception that a

government-backed company hinders competition.


Thank you

Working papers are available. Presentation and policy paper will be made available at www.policy.hu/kitsing

Documents

Public Lecture at Popper Room of Central European University on March 7, 2003 Beyond the Internet: Lessons from Estonia and Slovenia Meelis Kitsing International