Returns to innovation

By Paul Walker 07/01/2015

Recently Tim Worstall has been reminding us of a 2004 paper on Schumpeterian Profits in the American Economy: Theory and Measurement by William D. Nordhaus. The point of the paper is that entrepreneurs gain less than 3% of the social returns to their innovation. The paper’s abstract reads:

The present study examines the importance of Schumpeterian profits in the United States economy. Schumpeterian profits are defined as those profits that arise when firms are able to appropriate the returns from innovative activity. We first show the underlying equations for Schumpeterian profits. We then estimate the value of these profits for the non-farm business economy. We conclude that only a minuscule fraction of the social returns from technological advances over the 1948-2001 period was captured by producers, indicating that most of the benefits of technological change are passed on to consumers rather than captured by producers.

Back in 2004 Don Boudreaux blogged on the paper at the Cafe Hayek blog. He said,

In a recent NBER working paper – “Schumpeterian Profits in the American Economy: Theory and Measurement” – Yale economist William Nordhaus estimates that innovators capture a mere 2.2% of the total “surplus” from innovation. (The total surplus of innovation is, roughly speaking, the total value to society of innovation above the cost of producing innovations.) Nordhaus’s data are from the post-WWII period.

The smallness of this figure is astounding. If it is anywhere close to being an accurate estimate, the implication is that “society” pays a paltry $2.20 for every $100 worth of welfare it enjoys from innovating activities.

Why do innovators work so cheaply? One possible reason is alluded to by Nordhaus himself: excess optimism. Nordhaus suggests that over-optimism might explain the late 1990s tech-market equity bubble. The social gains from innovation were in fact very large, but the ability of investors to capture more than a small sliver of these gains – rather than see these gains flow to consumers in the form of lower prices and improved products – proved undoable.

Another possible explanation for why innovators work so cheaply is that the prospects, few as they might be, for capturing gargantuan shares of the gains from innovation are sufficiently attractive that even rational, well-informed entrepreneurs and investors perform and fund innovating activities, each hoping that he or she will be among the tiny but inordinately lucky handful of entrepreneurs and investors who personally do capture a much-much-greater-than-normal share of the value of their innovative endeavors.

Whatever the reason, Nordhaus’s empirical evidence supports (at least my) casual observation that innovative economic activity yields benefits that are both enormous and widespread.

Boudreaux has now added an Addendum to the above blog posting noting the implications of Nordhaus’s paper for the current debate about income inequality. He writes,

Nordhaus’s findings are relevant also to discussions of income inequality. His findings show that successful entrepreneurs have already, in the very process of succeeding in the market and becoming wealthy, increased the wealth of ‘society’ – have ‘given’ to others – far more than each successful entrepreneur has increased his or her own individual wealth. This process of enhancing the economic well-being of countless others through successful market innovation is neither intended nor choreographed by government, but this fact doesn’t make the results any less real or significant.

True, in a society in which people are not all equally innovative and driven and risk-tolerant, the measured monetary results of such successful innovation are that some individuals (the successful entrepreneurs) gain more wealth than is gained by other individuals (those who passively prosper simply by being a consumer and worker in an innovation-filled market economy). Measured monetary incomes, therefore, do become less equal.

But why do we so seldom never hear from the fairness-obsessed, we’re-all-in-this-together crowd any expressions of concern about the great inequality of net contributions to total wealth? Where is the concern over this “unfairness”? Compared to successful market entrepreneurs, people who choose to consume much leisure or who remain consistently afraid to risk their wealth on entrepreneurial ventures enjoy over their lifetimes a higher ratio of wealth-increases to their own contributions-to-wealth. If we are to be concerned with cosmic fairness or “social justice” or “inequality,” why is this inequality one that is or ought to be ignored?

I still find, like Boudreaux, the smallness if the 2.2% figure astounding. This does tell us that “society” gets a very good deal out of entrepreneurs and thus instead of complaining about the absolute size, in terms of the number of dollars, of the 2.2% we should just be very happy with our 97.8%. Incentives matter and such a small percentage is a small price to pay for the incentive it gives for the generating of innovation and growth.