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Anatomy of a Crash

Why did high_tech stock market values fall so far in the last year-and-a-half? What does the crash of the NASDAQ (and of smaller IT exchanges around the world) tell us about the future of the "new economy"? As we move away from those events, a clearer assessment is possible.

Conventional wisdom holds that the NASDAQ crash exposed the "new economy" as a conjuring trick of smoke and mirrors. It incarnated the irrational exuberance that often breaks out as a boom peaks and did not deliver deeper permanent changes in the economy. A more likely explanation, however, is that the NASDAQ crashed because it became clear that dominant market positions in high tech_based businesses were not sources of profits unless accompanied by substantial barriers to entry for new potential competitors--and that such barriers to entry were becoming remarkably hard to create.

Over a wide range of activities, the dominant effect of the "new economy" has been to make competition more effective, not to create new advantages based upon economies of scale. The high-tech crash was thus the result of a realization by investors that the "new economy" was, in most sectors and for most firms, unlikely to lead to large quasi_rent type profits from established market positions, but rather to heightened competition and reduced margins.

The exuberance that pushed the NASDAQ so high in 1999 and early 2000 rested on the belief that a technological leap forward in data processing and data communications technologies had created a host of "winner_take_all" markets in which increasing returns to scale were the dominant feature. An information good--a computer program, a piece of online entertainment, or a source of information--needs to be produced only once and can then be distributed to a potentially unlimited number of consumers at very little (if any) additional cost. The larger the market, the larger the cost advantage.