Who Gains from Innovation?

"Part of the New Economy bubble might have arisen because investors overestimated the appropriability of innovations in that sector."

With the sharp rise in productivity growth over the last decade, economists have been curious about the extent to which the fruits of higher productivity are captured by innovating firms. Is the rapid technological change in the New Economy - with double-digit rates of productivity growth in computers and a phenomenal increase in new products and services via the Internet - leading to a similar rapid rise in the profits of New Economy firms?

In Schumpeterian Profits in the American Economy: Theory and Measurement (NBER Working Paper No. 10433), author William Nordhaus studies the impact of new technology on profits, emphasizing three important implications: first, understanding the role of innovational profits in total profits; second, identifying the impact of innovation in stock market returns; and third, gaining greater understanding of technology's wealth effect on aggregate demand, as defined by Federal Reserve Chairman Alan Greenspan (an effect he labels the "Greenspan effect.")

Nordhaus begins by considering the impact of technological change on prices and profits. Do technological improvements primarily result in lower prices for consumers or in higher profits for producers? If producers are able to capture (or appropriate) most of the social returns to innovation, then profits will rise and prices will fall relatively little.

How much of the profits from a new technology are captured by innovators will vary greatly across industries. For sectors where knowledge is in the public domain, such as weather forecasting, the new knowledge cannot be appropriated and productivity improvements are passed on in lower prices. In other industries with well-defined products and strong patents, such as pharmaceuticals, producers may be successful in capturing a large fraction of social gains in "Schumpeterian profits."

Nordhaus begins by developing a model for explaining the size of Schumpeterian profits. In this context, Schumpeterian profits are profits above those that are associated with the normal return to investment and risk-taking. The Schumpeterian profit margin, defined as the ratio of Schumpeterian profits to total revenues, is determined by three parameters: the rate of innovation-driven total factor productivity; the instantaneous appropriability ratio; and the depreciation rate on Schumpeterian profits. The only novel parameter is the instantaneous appropriability ratio, which measures the fraction of the social surplus that is captured by the innovator in the first year. Depreciation is particularly important for Schumpeterian profits because they are often eroded by such factors as the expiration or non-enforcement of patents, the ability of competitors to imitate or to innovate around original innovations, and the introduction of superior goods and services.

Nordhaus presents a numerical example of the outcome of the model. If the rate of innovation-driven total factor productivity is 2 percent per year, the instantaneous appropriability ratio is 50 percent, and the depreciation rate on Schumpeterian profits is 10 percent per year, then Schumpeterian profits would be 2½ percent of total sales. If the rate of profit on capital is 10 percent per year and the capital-output ratio is 2, then in this simple example, Schumpeterian profits would be half of the return to capital.

Another application of the model would be to the New Economy (computers, software, telecommunications, and similar industries). To what extent, he asks, did the phenomenal rise in the stock prices of New Economy firms in the late 1990s reflect rapid innovation and high appropriability in that sector. He suggests the following example: The new economy amounts to 5 percent of nominal output. Assume that, after 1995, costless productivity growth in this sector shot up from 5 percent per year to 15 percent per year. The new economy would then be adding about $75 billion in social surplus in the initial years. If the new entrepreneurs could capture 90 percent of the new economy surplus in Schumpeterian profits, then with other plausible parameters, the increase in value of new economy firms would be $6 trillion. This in fact is close to the increase in value of new economy firms from 1995-2000.

But is this parable plausible? For the entire postwar period and for the nonfarm business sector, Nordhaus estimates that innovators are able to capture about 2.2 percent of the total surplus from innovation. This figure results from an instantaneous appropriability estimated at 7 percent and a rate of depreciation of Schumpeterian profits of 20 percent per year. This number implies that Schumpeterian profits were 0.19 percent per year of the replacement cost of capital over the period 1948-2001.

Using these estimates for the New Economy suggests that entrepreneurs could capture only $400 billion, not $6 trillion. Nordhaus speculates that part of the New Economy bubble might have arisen because investors overestimated the appropriability of innovations in that sector. Indeed, there is some evidence that appropriability in New Economy sectors is even lower than in Old Economy sectors. The new economy's industries are marked by easy entrance and exit: bright ideas were readily funded, but imitators are just as quick to follow. Additionally, information is expensive to produce but inexpensive to reproduce, a factor that will erode the value of intellectual property rights and reduce the durability of Schumpeterian profits in that sector.

Nordhaus next considers the role of Schumpeterian profits through the Greenspan effect, which Nordhaus defines as the impact of rising productivity on aggregate demand through the wealth effect on consumption. Nordhaus's calculations suggest that the Greenspan effect on aggregate demand through consumption is about one-quarter of the effect on potential output. In other words, the impact of productivity growth on potential output is about three times the effect on aggregate demand.

These estimates of Schumpeterian profits may seem implausibly low, Nordhaus says, given the inventiveness of the American economy. But they do fit into one of the major puzzles of corporate America: Why is the rate of profit on corporate capital so low? The rate of profit after tax on non-financial corporations over the past 40 years has averaged 5.9 percent annually, which was very close to the cost of capital. How could the rate of profit be so low, considering that profits include so much (such as monopoly and Schumpeterian profits) and the denominator omits several important assets (such as land and intangible investments)? At least part of the answer lies in Nordhaus's finding that only 20 basis points of the rate of return to capital were attributable to Schumpeterian profits.

-- Matt Nesvisky


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