Undergraduate Writing

At first sight this might seem a rhetorical question. Indeed, how is it possible to protect privacy when there are 300 million publicly accessible pages on the Internet, it's use is doubling every 100 days, as of March 2000 there were over 324 million Internet users, and the Bankers Roundtable study estimated traceable electronic based payments of $450 trillion per year and cash payments of only $2.7 trillion! This has lead many to believe that privacy is doomed for those of us that want to take advantage of the digital revolution.

However, instead of concluding here, we can use the tools of economics and common sense to tackle the question at hand. First, lets see why we want to protect privacy. Normative social sciences claim that privacy is a right that should be fully protected by the government at any cost. However, this approach does not provide an answer when privacy is at odds with other government services, such as national security. A more dynamic perspective is one that recognizes privacy as a good or service with a specific value. This viewpoint allows us to extrapolate that the cost of regulations for protecting privacy should be equal to the value of privacy that they are providing, at the margin. At the same time privacy holds value relative to other goods and services, and being excludible and rival, this value can be determined in the free market.

One might think that all we have to do is determine how much privacy we want and force everyone to respect it. But our decision on how to protect privacy is intertemporal, in the sense that current decisions affect also the choices available in the future. Too high costs can diminish our future well-being and our ability to protect privacy. As an example, suppose that we find out the level of privacy that each of us would ideally want to have, and the cost of forcing everyone to comply with it is 200% of GDP. Should we regulate the protection of privacy? This sort of inquiry is not a trivial exercise in dispensing hypothetical situations, but rather a way to help understand that we cannot afford to protect privacy simply through regulations. So what should we do? To explore this lets imagine that privacy is like a river. Its breadth depends on the position of its two banks. One side is determined by the economic costs of governmental regulations about privacy. The higher are these costs, the less the privacy we should obtain. The second one reflects the level of privacy supplied in the free market, which clearly increases our overall level of privacy. More formally, this method is based on the Simpson-Paradox , referring to a tri-variate statistical problem in which a contingency between two variables, x and y, can be accounted for by a third variable, z.

What is the cost of governmental regulations? As on too many other occasions, the economists' answer to this question has been entangled with political implications. However, we cannot rely on subjective judgments for deciding on this very tangible aspect of the economy. A key feature of the endogenous growth models is that the long-run growth rate can depend on government actions, since government policy actions--taxation, provision of infrastructure, protection of intellectual property, regulations, and so on--can affect the underlying rate of inventive activity. Government, therefore, has great potential for harm in these models.

Government regulations do not allow for an economic allocation that is efficient according to the Pareto criterion. Regulations that cause industry to allocate financial resources in order to meet government standards leave the industry with a lower than desired rate of capital accumulation, resulting in a reduced rate of long-term economic growth. Regulations retard innovation by reducing the amount of technological research and development undertaken in the area of new products and new production processes. Moreover, regulations result in a longer time span between the development and actual marketing of products, which may discourage producers from developing new products or make those that are developed more expensive. In the case of the digital revolution the stakes are even higher. Over-regulation might halt electronic commerce altogether, inflicting a huge cost on the economy. When the European Union adopted very stringent policies on privacy, the Chief Executive of the Irish Trade Board warned that an Internet deficit is adversely affecting Europe's ability to compete effectively against companies in the US. Furthermore, business models must evolve rapidly to keep pace with the break-neck speed of change in the technology; government attempts to regulate are likely to be outmoded by the time they are finally enacted, especially to the extent such regulations are technology-specific.

Businesses use the new digital technology to lower purchasing costs, reduce inventories and cycle times, provide more efficient and effective customer service, lower sales and marketing costs, and realize new sales opportunities. In other words, these developments are expected to narrow the gap between economic theory and practice by, for example, enabling the market to come closer to the idealized supply-demand equilibrium found in macroeconomics textbooks. Information is the life-blood of most of these new service-based businesses. Without their growing databases, firms would not be able to tailor their products to individual tastes, handle secure electronic transactions, offer streamlined payment and delivery, or target their advertising and promotion. Another source of government regulations are law enforcement agencies that want to have easy access to the encryption tools used for private communications. This invasion of privacy might seem as a contradiction with the government regulations that intend to protect it. In order to explain this apparent dualism we borrow from political theory, which tells us that the first priority of any state is the protection of its government. Therefore, governmental agencies automatically aim to control the economic environment by creating regulations. However, if businesses believe that confidential documents and credit-card transactions can be easily intercepted, goods will not be purchased. Parties should be able to enter into legitimate agreements to buy and sell products and services across the digital arena with minimal government involvement or intervention. Unnecessary regulation of commercial activities will distort development of the electronic marketplace by decreasing the supply and raising the cost of products and services for consumers the world over. Governments argue that they need to have unlimited access to private digital communications in the name of national security. However, there is no need for regulations that ensure special access since new technologies also enhance the ability of law enforcement to intercept and analyze communications and track individuals. These enhancements are coming about without government intervention, as the unintended consequences of market-driven changes in technology. Legislation should protect the innovation and competitiveness that have fueled the digital revolution. Strong encryption, authentication, password controls, firewalls, etc, widely available and regularly used, will enhance computer and communications security and prevent crime. On balance, the crime prevention benefits of strong encryption outweigh the impediments it poses to law enforcement practices.

The genius and explosive success of the digital revolution can be attributed in part to its decentralized nature and to its tradition of bottom-up governance. Governments should refrain from imposing unnecessary regulations and bureaucratic procedures on commercial activities that take place in the digital market place, since their costs are overwhelmingly higher than their benefit.

Does the free market provide privacy protection? Advocates of regulatory policies claim that, unless government intervenes, individuals will have no control over the collection, use, and distribution of their personal information. This argument is built on two key assumptions: that businesses abuse their power to collect information and that profit incentives contradict privacy interests. Both these assumptions are false.

The marketplace is becoming smarter and more demanding. Consumers expect--even demand--customization of goods and services to meet their individual needs , and they want it now. The leverage of knowledge through innovation becomes critical. People can decide whether they want privacy or the other benefits: safer streets, cheaper communications, more entertainment, better government services, more convenient shopping, and a wider selection of products.

When users express concerns about their privacy, businesses respond and alleviate these concerns. The consumer demand on the market will create a niche for firms that become brokers of information between consumers and other companies, giving consumers privacy protection and also earning them some revenue for the information they are willing to release about themselves . Such firms will have the strongest possible stake in maintaining their reputation for privacy protection. If consumers were willing to pay for such brokerage, infomediaries will succeed on the Internet and other mediums of digital communications. In practice, many companies already declare that they will not sell information they collect about customers. The Internet, the frontline of the privacy battlefield, has already spawned anonymous remailers, firms that forward e-mail stripped of any identifying information. Through www.annonymizer.com the Internet can be browsed anonymously. Electronic digital cash, for use on or off the Internet, may eventually provide anonymity of purchases.

Who should take the lead? The role of government should be to create an institutional environment that is conducive to the creation and diffusion of new knowledge and technologies. This, in turn, requires an institutional framework that rewards individual effort and entrepreneurial activity. The laws should be used not to obstruct the recording and collection of information, but to catch those who use it to do harm. Governments must allow electronic commerce to grow up in an environment driven by markets, not burdened with extensive regulation, taxation or censorship. For electronic commerce to flourish, the private sector must continue to lead. Innovation, expanded services, broader participation, and lower prices will arise in a market-driven arena, not in an environment that operates as a regulated industry. Perhaps both sides, government and industry, should stop regulating and let users decide what is best for themselves.

Notes
i-An example for the Simpson-Paradox: One supermarket may be more expensive on aggregate (correlation between supermarket (x) and price (y)), but only because the latter supermarket sells more high-quality products (correlation between supermarket (x) and the percentage of high-quality products (z), correlation between price (y) and the percentage of high-quality products (z)). Considering high and low-quality products separately, the seemingly more expensive supermarket may turn out to be cheaper at any quality level.
ii-Under the EU approach, personal data may be processed only if the data subject has consented "unambiguously".
iii-Perhaps the most annoying aspect of junk mail is that direct mail operations do not know enough about consumers. One is bound to be annoyed, for example, by calls trying to sell auto club memberships if one does not have a car. Thus, restricting the collection and transfer of personal consumer information may actually increase the proportion of unwanted junk mail by hindering targeted marketing.
iv-Implicit in the argument that "customers should be able to choose" whether their information will be included in databases or not is the argument that giving them the right to choose would do little harm. If you establish a right--whether it's for clean air, privacy, a pound of potatoes or a copy of a newsletter--that right will be allocated efficiently in a free market, regardless to whom the right is initially assigned.

References
The Graphic, Visualization and Usability Center at Georgia Tech University, "The Graphic, Visualization, and Usability Center's World Wide Web User Survey," Georgia Tech University, November 1999, pp.4-32.
Y. Li, "Money and middlemen in an economy with private information," Economic Inquiry, January 1999, 37(1), pp. 1-12.
S. Singleton, "Privacy as Censorship: A Skeptical View of Proposals to Regulate Privacy in the Private Sector," Cato Policy Analysis, No. 295, January 22, 1998.
J. Hagel III and J. Rayport, "The Coming Battle for Customer Information," Harvard Business Review, January-February, 1997, p. 54.
F. Mihlar, "The Cost of Regulation in Canada", Public Policy Sources, Number 12, 1998 Edition, Fraser Institute.

Copyright 2000, Dorian Hajno