by Robert Litan
Brynjolfsson’s and McAfee’s optimism about future productivity growth is shared in a shorter study published in 2013 by Martin Baily, former chair of President Clinton’s Council of Economic Advisers and some of his colleagues at the McKinsey Global Institute.32 MGI subsequently put out a much lengthier report identifying twelve disruptive technologies that should continue to power growth in the future. Most of these technologies already exist and some are already commercialized, including: the wireless Internet, increased cloud computing, driver-less cars, and 3D printing, among others—but the MGI authors argue that they will improve in quality and in market penetration, and thus impact, over time.33
Former Federal Reserve Chairman Ben Bernanke weighed in on the debate over future productivity growth in a commencement address he gave at Bard College in May 2013, siding with the optimists. After discussing how radically different the life of an average American has changed over the past century, due to the development or diffusion of a wide range of innovations that make up modern life as we know it now, Bernanke did what most economists do when they talk about the future: They extrapolate, in some broad sense, and say there is no reason why the future should differ fundamentally from the past.34 The story of civilization is one of continued innovation, at least since the Industrial Revolution, and why should that story change?
This debate about the pace of future growth in the U.S. economy and elsewhere surely will continue as long as there is human activity. The outcomes matter, for a number of reasons. First, as noted earlier, how fast the economy grows determines the rate of improvement in average living standards (admittedly putting aside that pesky issue of distribution). For example, if per capita income (one way of measuring productivity) grows at 2 percent, average incomes and thus living standards will double every 36 years. Raise the growth rate to 3 percent, and the doubling time shortens to 24 years.
Second, not only the pace but also the nature of innovation and in which industries it is concentrated determines the rate at which major social challenges and problems are solved or at least abated. For example, advances in battery lives could dramatically change the mix of autos on the road. Or different kinds of medical breakthroughs will extend the lives and ideally improve the quality of life of people with the affected diseases. Continued improvements in pollution control or carbon storage technologies, among others, will have important impacts on the nature and pace of climate change. And so on.
Third, the rate of productivity growth will have an important effect on the trajectory of the federal budget deficit in the future. Every official governmental body that has looked at this issue—the Congressional Budget Office, the General Accountability Office, and the trustees of the Medicare and Social Security trust funds—has projected that without some combination of major changes in benefits of the major entitlement programs (Social Security, Medicare, Medicaid, and potentially health care under the Affordable Care Act) and tax increases, the long-term outlook for federal deficits is not sustainable. At some point, investors (domestic or foreign) will demand much higher interest rates on the debt issued to finance these programs and the rest of the government, and those higher rates will lead to much slower growth or most likely a deep recession.
These budget forecasts all assume continued productivity growth of about 1.5 percent and total growth (counting continued growth of the labor force) at about 2 percent. If future growth falls short of that projection, then the day of reckoning will come sooner rather than later; conversely, if productivity turns out to grow more rapidly than currently projected, federal policy makers have more time to make these very difficult political choices (which, to date, very few elected officials have wanted to make). Other advanced countries that have even more rapidly aging populations than the United States and broad social safety programs face similar challenges.
In short, the pace of innovation could not be more important to the welfare of residents here and elsewhere around the world. Yet when virtually all those with an interest in the subject think about innovation, they think of physical or at least virtual things: new and better machines, software, or apps. The same is true of economists, who tend to focus on easily measureable indicators of innovation, such as research and development expenditures (which are an input into the innovative process rather than measures of innovative outputs), or patents (which are very rough measures of innovation but do not reflect its commercial value). The key point is that each measure, however flawed, has some connection to new products, services, or processes of production.
The Bottom Line
Economists are fond of saying “there is no free lunch.” By that they mean that an inherent fact of the world is that there is scarcity at any one time. There isn’t enough capital or oftentimes the right labor, or people with the right skills, to go around, and so the central problem in any society is how to allocate them.
The economic answer, at least in capitalist societies, is to let markets allocate, and they do this principally by setting prices—or actually, allowing all economic units, households, and firms, to set prices through the combined effects of their willingness to supply and pay for goods and services.
The challenge of established businesses or those founding new businesses is to use the prices that the markets are setting to guide their future activities. Those firms earning high profits at current prices stimulate others to enter their markets, thinking that they can do a better job at a lower price. Even harder, but crucial to economic advance, is for firms and entrepreneurs to figure out what markets are not delivering to people now that consumers would want if only someone gave it to them. In the age of the Internet, entrepreneurs have been making money developing new platforms like eBay or Amazon that make it possible for many other entrepreneurs to build their businesses, some of which satisfy those latent consumer desires.
Markets fail for any number of reasons, however. This is where government can play a useful role helping them work better. But as we will see in later chapters, government can make mistakes, too, just like businesses. Only it’s often more difficult in the political world to get rid of an institution or a practice than it is in the ruthless world of the market, which drives out of business what isn’t working.
The central premise of this book is that economists and their ideas can and have played an important role in helping many businesses and entrepreneurs in many different industries be successful. In the process, economists have the same or similar impacts on productivity and human welfare as the more conventional kinds of innovation that come to mind when economists and non-economists alike think about this subject. It is surprising, at least to me, that of all people, economists haven’t figured this out, or done more to promote the value of what they do for a living.
I have one conjecture why this is so, and to find out what it is, turn the page to the introduction to the first section of the book.
Notes
1. Herbert A. Simon,“Rational Choice and the Structure of the Environment,” Psychological Review 63, no. 2 (1956): 129–138.
2. See, for example, Barry Schwartz, The Paradox of Choice: Why More Is Less (New York: Ecco Harper Collins, 2003). For another critique of the rationality assumption, see Robert J. Shiller, “The Rationality Debate, Simmering in Stockholm,” New York Times, January 18, 2014, BU6, http://nyti.ms/1j49qDf.
3. Milton Friedman, Essays in Positive Economics (Chicago: The University of Chicago Press, 1953).
4. This description is drawn from Milton Friedman, “Milton Friedman,” in Lives of the Laureates: Twenty-three Nobel Economists, ed. William Breit and Barry T. Hirsch (Cambridge, MA: MIT Press, 2009), 65–77.
5. Steven E. Rhoads, “Marginalism,” in David R. Henderson, Concise Encyclopedia of Economics, www.econlib.org/library/Enc/Marginalism.html.
6. Library of Economics and Liberty, “Margin and Thinking at the Margin,” www.econlib.org/library/Topics/College/margins.html.
7. Cass Sunstein and Richard Thaler, Nudge: Improving Decision
s about Health, Wealth and Happiness (New York: Penguin Books, 2009).
8. Daniel Kahneman, Thinking, Fast and Slow (New York: Farrar, Straus & Giroux, 2011). See also the landmark article he coauthored that helped launch behavioral economics: Daniel Kahneman and Amos Tversky, “Prospect Theory: An Analysis of Decision under Risk,” Econometrica 47 (1979): 263–91.
9. Several years ago, I collaborated with two wonderful colleagues in exploring four basic types of capitalism practiced around the world and their varying effectiveness. See William J. Baumol, Robert E. Litan, and Carl J. Schramm, Good Capitalism, Bad Capitalism, and the Economics of Growth and Prosperity (New Haven, CT: Yale University Press, 2007). Five years later, I joined one of these coauthors to elaborate the advantages of one particular form of capitalism, that in which entrepreneurs are the central actors, Robert E. Litan and Carl J. Schramm, Better Capitalism: Renewing the Entrepreneurial Strength of the American Economy (New Haven, CT: Yale University Press, 2012).
10. Surowiecki, James, The Wisdom of Crowds (New York: Anchor, 2005).
11. Ronald H. Coase, “The Problem of Social Cost,” Journal of Law and Economics 3, no. 1 (1960), www.jstor.org/sici?sici=0022-2186(196010)3%3C1:TPOSC%3E2.0.CO;2-F.
12. Library of Economics and Liberty, “Arthur Cecil Pigou,” www.econlib.org/library/Enc/bios/Pigou.html.
13. Ibid.
14. Laura D’Andrea Tyson, “The Myriad Benefits of a Carbon Tax,” New York Times, June 28, 2013, http://economix.blogs.nytimes.com/2013/06/28/the-myriad-benefits-of-a-carbon-tax/.
15. William D. Nordhaus, “Schumpeterian Profits and the Alchemists Fallacy,” Yale Working Papers on Economic Applications and Policy, Discussion Paper No. 6, http://www.econ.yale.edu/ddp/ddp00/ddp0006.pdf.
16. For one highly persuasive optimistic projection about the future of the news business, which runs counter to the rampant pessimism among those currently in the business itself, see Marc Andreessen, “The Future of the News Business: A Monumental Twitter Stream All in One Place,” http://a16z.com/2014/02/25/future-of-news-business/.
17. Michael J. Sandel, What Money Can’t Buy: The Moral Limits of Markets (New York: Farrar, Straus & Giroux, 2012).
18. Timothy Besley, “What’s the Good of the Market? An Essay on Michael Sandel’s What Money Can’t Buy,” Journal of Economic Literature, LI, no. 2 (2013): 478–496, www.aeaweb.org/articles.php?doi=10.1257/jel.51.2.478.
19. Paul A. Samuelson, “Paul A. Samuelson,” in Breit and Hirsch (2009), 49–64. My portrait of Samuelson draws heavily on this autobiographical essay.
20. Jeffrey A. Miron, “A Little Humility Would Help,” New York Times, www.nytimes.com/roomfordebate/2012/04/01/how-to-teach-economics-after-the-financial-crisis/a-little-humility-among-economists-would-help.
21. Ibid.
22. Robert Reich, “The Biggest Risk to the Economy in 2012, and What’s the Economy For Anyway?” Robert Reich, http://robertreich.org/post/16773820312.
23. Julia B. Isaacs, Isabel V. Sawhill, and Ron Haskins, Getting Ahead or Losing Ground: Economic Mobility in America (Washington, DC: The Pew Charitable Trust, 2008).
24. Jonathan Gruber, Public Finance and Public Policy (New York: Worth Publishers, 2005), 1–22.
25. Thomas Piketty, Capital in the 21st Century (Cambridge, MA: Belknap Press, 2014).
26. Claudia D. Goldin and Lawrence F. Katz, The Race between Education and Technology (Cambridge, MA: Belknap Press of Harvard University Press, 2008).
27. Tyler Cowen, Average Is Over: Powering America Beyond the Age of the Great Stagnation (New York: Dutton, 2013).
28. Tyler Cowen, The Great Stagnation: How America Ate All the Low-Hanging Fruit of Modern History, Got Sick, and Will (Eventually) Feel Better (New York: Dutton, 2011).
29. Gordon outlines his arguments in two papers: Robert J. Gordon, “Revisiting U.S. Productivity Growth over the Past Century with a View of the Future,” National Bureau of Economic Research, www.nber.org/papers/w15834; and Robert J. Gordon, “Is U.S. Economic Growth Over? Faltering Innovation Confronts the Six Headwinds,” National Bureau of Economic Research, www.nber.org/papers/w18315.
30. Erik Brynjolfsson and Andrew McAfee, Race against the Machine: How the Digital Revolution Is Accelerating Innovation, Driving Productivity, and Irreversibly Transforming Employment and the Economy (Lexington, MA: Digital Frontier, 2012).
31. Erik Brynjolfsson and Andrew McAfee, The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies (New York: W.W. Norton, 2014).
32. Martin N. Baily, James M. Manyika, and Shelabh Gupta, “U.S. Productivity Growth: An Optimistic Perspective.” International Productivity Monitor, March 2013, 3–12, www.csls.ca/ipm/25/IPM-25-Baily-Manyika-Gupta.pdf.
33. James Manyika et al., “Disruptive Technologies: Advances That Will Transform Life, Business, and the Global Economy,” McKinsey Insights & Publications, www.mckinsey.com/insights/business_technology/disruptive_technologies.
34. Ben S. Bernanke, “Economic Prospects for the Long Run,” Bard College Commencement speech, www.federalreserve.gov/newsevents/speech/bernanke20130518a.htm#fn2.
PART I
THE POWER OF ECONOMIC IDEAS: DIRECT USE IN BUSINESS
As promised in Chapter 1, this first part of the book contains chapters outlining how economic ideas have directly made money for firms, by enhancing revenues, cutting costs, facilitating innovation, or some combination of all three. In some cases, the entrepreneurs or businesses that implemented these ideas were acutely aware of them and their origins, and so the line between idea and outcome is easy to grasp. In other cases, businesses used an economic idea without knowing it, and economists later validated it, theorized about it, or quantified its impact. In a few cases, economists and businesses pursued their ideas in parallel, each seemingly unaware of the ideas or efforts of the other, though I suspect this may change over time (maybe some from each camp will read this book and make this prediction come true). All routes to business success are broadly consistent with the overall thesis of this book and with the quote from Keynes about the power of defunct (and not-so-defunct) economists and their ideas.
Chapter 3 begins with a discussion of how economic ideas have influenced how firms set prices. To be sure, in highly competitive markets, firms are price-takers: They take what the market dictates. But in a surprising number of situations, markets take a while to settle down and, especially in new markets or circumstances, economists have offered useful advice about how those markets should be created and prices set.
Chapter 4 turns to the other side of the coin: minimizing costs. Here, too, business can figure out how to cut costs to the bone without the help of an economist. But in many kinds of businesses where things must be moved around (like planes or trucks) or supplies, materials, and inventory must be managed, minimizing costs becomes a lot more difficult to do without the aid of some formal techniques. Indeed, an entire field of study, known as operations research, grew out of the work of mathematical economists. You’ll meet the founders and the work they spawned in this chapter.
Chapter 5 addresses a seemingly technical subject, empirical economics, which leads in surprising directions. Economists test their propositions through the use of increasingly sophisticated statistical techniques, so in one sense economics is part applied statistics, part theory. After providing a brief history of how the uses of these techniques in the business world has changed over time, I introduce a surprise: the extension of similar techniques into sports. That’s right, sports. With the publication of Moneyball, the same kinds of techniques economists have long used to test their hypotheses and to generate forecasts of economic variables have been applied by a new generation of quants to the performance of certain athletes and teams, and thus indirectly to the financial performance of their owners. In “Beyond Moneyball” I only scratch the surface in discussing how what started as a hobby in the garage of baseball guru Bill James has now spread to multiple sports, while creating a new academic specialty to boot
(couldn’t resist the pun).
Chapter 6 discusses the one exceptional pattern in this part, the parallel interests in experimentation in the worlds of economics and business. Of the two fields, experiments are newer and more unconventional among economists, who traditionally either theorized about the working of the economy or its constituent components (in increasingly sophisticated mathematical terms), or used the statistical techniques profiled in Chapter 5 to test their theories. It is hard to stop the real world, apply a treatment to one population, and compare what happens to a control group, as medical researchers commonly do. Nonetheless, you will learn in Chapter 6 that this is changing, and there is growing interest in and work among economists in using human subjects (students and businesspeople) to test theories. As for business, experiments have long had a place in this world: What else, after all, do most entrepreneurs and many established firms do except constantly experiment until they get things right so that people or other firms want to buy what they have to sell? With the rise of the Internet, running experiments has become far less costly, and the testing of the look and feel and the specific content of websites, among other things, has become routine.
Chapter 7 addresses a topic you won’t find (at least yet) in many textbooks: the economics of matchmaking. This is a relatively new branch of the field, and it addresses markets where non-price attributes are even more important than prices for allocating resources. Think about the job market, or the dating market, and you get the idea. The chapter outlines how economists have made important contributions to our understanding of these markets, and growing matchmaking businesses, facilitated by the Internet, have listened to them. I loved (again pun intended) working on this chapter and hope you have as much fun reading it.
In Chapter 8 I finally get around to the topic with which I opened the book, the world of finance and how it has been affected by the ideas of the economists (or financial economists, as they may prefer to call themselves). I know in the wake of the financial crisis the temptation of some (maybe many) readers is to ask: What good have economists been for finance; aren’t they partially to blame for the crisis? I will address that issue in the policy part of the book in Chapter 12. Chapter 8, however, outlines for you a number of important positive contributions of economists and their ideas to finance that have led to new financial products (think indexed mutual funds and exchange traded funds) or that have greatly facilitated the pricing of other products (think options, which have been a mixed blessing). For those inclined to think better of economists, the positive tone of Chapter 8 will not be a surprise: If economists can’t help those in the financial world, which is all about money, then how can they possibly be of use to firms in other industries? It turns out, if you are persuaded by Chapter 8, that economists needn’t worry about the answer to that question.
