Article 3-4
INNOVATION​:
Deflationary Innovation & Contractionary Innovation

Originally published February 2, 2015
Last edited: December 8, 2016
By Michio Suginoo
This essay addresses the question of whether innovation is always positive for the aggregate economy. It is not automatically clear whether the positive economic notion of innovation is always true.

Innovation by itself is deflationary. It reduces production costs and lowers price levels. With rudimentary neoclassical synthesis, innovation, with other factors remaining constant, would shift the supply curve to the right. This would increase output while reducing price level. This is a supply-driven deflation, which is benign, at least from a GDP growth perspective. Therefore, innovation, with other factors constant, would lead to benign deflation.

There is another view that the impact of innovation might not necessarily prove benign from an employment perspective. In other words, innovation might be contractionary. If this statement is counter-intuitive from an orthodox framework such as Solow’s neoclassical total factor productivity (TFP) model and Romer’s endogenous growth model, we can imagine a futuristic world where innovation has transformed artificial intelligence (AI) to exceed the capacity of the human brain and robots to be more versatile than human workers. In such futuristic settings, both AI and robots could replace human labour on a substantial scale in both decision-making and production work.

Consequently, it could create an additional outcome: job destruction. In brief, innovation can destroy jobs, and as a result, consumers lose wages. Thus, innovation may end up destroying demand. From an employment perspective, one could infer the unorthodox notion that the net effect of innovation can be negative for the economy. It creates a paradoxical mechanism of economic reality, especially for the orthodox view.

Some intellectuals advocate the notion of “contractionary innovation.” Jarvis observes such economic reality in our contemporary innovation. Stiglitz and Greenwald contemplate the notion in a historical case, the Great Depression. Broadberry’s analysis of the innovative transformation of industry during the late 19th century and early 20th century provides us with a comparative basis to better understand recent innovative developments.

​Moreover, this paradoxical economic behaviour might be illustrated by a simple rudimentary neoclassical synthesis. As Hyman Minsky points out, neoclassical synthesis is an over-simplified, even deceptive, representation of reality: therefore, we must be cautious in its use. Limited to its rough illustrative uses, the rudimentary neoclassical framework might help us to grasp “contractionary innovation” in a more simplistic manner.
[1] Jarvis
Innovation brought efficiency and reduced the margin of economic rent, waste, jobs, and prices, according to Jeff Jarvis’s observation of developments in the IT space: “Much of the innovation we’ve seen lately hasn’t led to growth but instead to efficiency – that is, shrinkage.” (Jarvis, 2009 June 12).

 Jarvis presents the two examples below to illustrate his view.

Amazon, e-Bay, and the Internet:
They brought price transparency, eliminated inventory and warehousing costs, cut down administration and logistical waste, increased critical-mass efficiency, etc. (Jarvis, 2009 June 12)

Google:
“Google revolutionized advertising by selling performance, providing a return on investment.” (Jarvis, 2009 June 12)

In other words, IT innovation brought lower prices to consumers and eliminated cost-inefficient suppliers, retailers, and other intermediaries, reducing the per-unit margin of economic rent as well as costs such as inventory, warehousing, administration and logistics. This was done through transparency; transparency was created by critical mass and network externality; the network externality was incorporated through a consolidation of intermediary processes into a small number of frontier innovative systems—Google, Amazon, e-Bay, etc.
​
Innovation, while reducing the per-unit economic rent margin of many businesses, managed to aggregate them on a massive scale into centralized, innovative systems such as Amazon, e-Bay, Google, Craigslist, etc. From a macro-perspective, the margin of economic rent might have been reduced; but from a micro-perspective, or individual corporate basis, innovation has created new profit opportunities where only a few successful, innovative IT companies can benefit on a large scale. Jarvis summarised this as the management of abundance, rather than scarcity. (2009 June 12)

By achieving network externalities through their systems, those few innovative enterprises raised the bar too high for latecomers to compete. Google copycats are not currently doing well without regulatory protection, which some countries provide. Whether good or bad (such moral judgment is beyond the scope of this article), it remains an important aspect of the of innovation discussion.

This sounds like a self-contained paradox, since it could translate into an oligopoly, or arguably even into a monopoly model that theoretically pursues high economic rent in aggregate. This reminds us of the story of Rockefeller, who gained power by consolidating oil refinery businesses under Standard Oil. Standard Oil shut down small, wasteful, inefficient units in order to focus exclusively on larger ones with economies of scale, which improved the industry’s profit-generating capacity.

​“In the 1880s, for instance, the average refinery had a capacity of between 1,500 and 2,000 barrels per day. Its average cost was about 2.4 cents per gallon. The costs in the refineries owned by the Standard Oil Trust were stated by the company to be 0.534 per gallon.” (Shaffer, 1983, p.p. 20-21: citing Williamson and Daum).

On one hand, there were questionable approaches in the way Rockefeller gained such egregious power, including the manipulation of freight rates, rebates, industrial espionage and threats against distributors who bought from his competitors. On the other hand, Rockefeller’s monopoly, which only survived temporarily, eliminated waste and brought down the price of oil. (Shaffer, 1983)

​“(T)he story of Standard seems to illustrate the argument, now better understood than it was then, that temporary monopolies may benefit the public interest.” (Johnson, 1997, p603).

Reduction in per-unit economic rent was incorporated into reality. It was done so because monopoly-minded entrepreneurs managed to gain power by consolidating the sector either under one single monopoly or a few oligopolies, to attain even larger profits in aggregate. Otherwise, none of the multiple small enterprises would have had the self-destructive appetite to reduce per-unit economic rent. The same analogy might be relevant in Jarvis’s claim. It may also be in action at the time of this writing (2014-2015) in the metal and energy  sectors. (Click to Article 2-1: Oligopoly Price Cycle)

[2] Stiglitz and Greenwald 

Stiglitz and Greenwald consider “contractionary innovation” in their historical interpretation of the Great Depression.

“At the beginning of the (Great) Depression, more than a fifth of all Americans worked on farms. Between 1929 and 1932, these people saw their incomes cut by somewhere between one-third and two-thirds, compounding problems that farmers had faced for years. Agriculture had been a victim of its own success. In 1900, it took a large portion of the U.S. population to produce enough food for the country as a whole. Then came a revolution in agriculture that would gain pace throughout the century—better seeds, better fertilizer, better farming practices, along with widespread mechanization. Today, 2 percent of Americans produce more food than we can consume.” (Stiglitz, 2012 January)
​
​[Broadberry: Historical Analysis The late 19th Century
​– The early 20th Century]
Broadberry (2006) characterises the industrialisation between the late 19th century and the early 20th century as “the transition from a world of customised, low-volume, high-margin businesses organised on the basis of network, to a world of standardised, high-volume, low-margin business with hierarchical management.” A shift to a “lower margin & higher volume management” destroyed a cluster of cost-inefficient businesses. Such modern management style was brought to life initially in the railway sector of the Unites States, slowly spreading into its domestic logistic and finance sectors. Gradually it spread further abroad to countries such as the UK and Germany. (Broadberry, 2006) In summary, based on Broadberry’s analysis, we can infer that innovation could exert contractionary impacts as well as deflationary ones: cost-efficiency conveys the notion of “deflationary innovation”; cost-inefficient business destruction coveys “contractionary innovation.”
​
A comparison between Jarvis’s modern innovation and Broadberry’s case of the late 19th to early 20th centuries highlights a contrast between the two periods: while historical precedent promoted standardised, high-volume, low-margin businesses, the recent innovative transformation promotes a customized, decentralized form of conducting businesses. Network externalities incorporated by modern innovative systems now make it easier and cheaper for locally based, small-scale entrepreneurs with customized products to expand their market access to a wider geographical area without having a large hierarchical organization. This is a new ecosystem and a big contrast from the historical episodes described above.
[3] Illustration by Neoclassical Synthesis
Now, using rudimentary neoclassical synthesis, let us investigate the notion of “contractionary innovation”—that innovation could lead to economic contraction. Since neoclassical synthesis is an over-simplified representation of reality, the example below will provide a rough illustration of the notion. Estimating the economic impact of the consequences would require a more sophisticated model.
​
Innovation-led productivity gains shift the long-run aggregate supply curve (LRAS) to the right. Consequently, rather than temporarily oscillating around the existing potential GDP, it would result in an expansion in the potential GDP. In other words, innovation yields a benign supply-driven deflation accompanying by positive economic growth. As we have discussed previously, this does not always result in a happy ending.

Further, it might lead to another phase. Should  higher efficiency lead to higher unemployment or even lower wages at the aggregate level, it could trigger a negative demand shock and a shift in demand-curve to the left. Now higher unemployment and lower wages transform the driver of deflation from a positive supply shock to a negative demand shock. Demand-driven deflation now yields negative consequences to output, creating economic contraction.

Whether the second phase of deflation kicks in or not depends on whether the economy can create sufficient labour demand somewhere else to absorb the incremental unemployment yielded by the efficiency.

When the economy allows innovation to eliminate jobs on a large scale, while failing to create new jobs to absorb incremental unemployment that innovation accounted for, it may imply an aggregate, net implication that the cumulative innovation has reached maturity; i.e., the completion of one innovative cycle. It might suggest that rebooting economic growth would require a shift to a new paradigm in job culture.

[4] Black Box of Growth Theories

Two orthodox growth theories, Solow’s neoclassical model and Romer’s endogenous growth model, incorporate technological progress into the economic growth model. However, both assume that technological advancement can yield only positive impact on growth and seem to exclude the potentiality of its negative economic impact. Both are black boxes in this regard.

The neoclassical model treats technological advancement as an externality, measuring it as the residual in the total factor productivity (TFP) model. The residual may have resulted from errors in the measurement of other variables. We can only guess what components constitute the residual TFP. One way or the other, it fails to define directly what technological progress is.

The endogenous growth model assumes that investments in R&D and human capital would generate positive externalities of social returns and prevent “diminishing marginal return to capital.” Although it attempts to incorporate technological progress as endogenous to the model, such an assumption simply excludes potential negative consequences that technological progress can yield.
Reference
  • Broadberry, S. (2006). Market Services and the Productivity Race, 1850–2000; British Performance in International Perspective. New York: Cambridge University Press.
  • Homer, S. & Sylla, R. (2005). A History of Interest Rates. (4 ed.). Hoboken, New Jersey: John Wiley & Sons, Inc.
  • Jarvis, J. (2009, June 12). When Innovation Yields Efficiency. Retrieved from: http://buzzmachine.com/2009/06/12/when-innovation-yields-efficiency/
  • Johnson, P. (1997). A History of the American People. New York, Harper Perennial. 
  • Shaffer, E. (1983) The United States of America and the Control of World Oil. New York, St. Martin’s Press, Inc.
  • Stiglitz, J. E. (2012, January).  “The book of job.” Vanity Fair. Retrieved from: http://www.vanityfair.com
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