Shaping the Economy
Signs of innovation are everywhere in our daily lives. The cellular
phone has gone from being an exclusive, expensive novelty to being common
for millions. New pharmaceuticals enter the market regularly. The Internet,
unavailable to most of us a decade ago, is accessed by millions of
people every day for information, communications, and transactions.
Even traffic lights have been improved through the use of low energy
Innovations also are changing our lives at work, making us more productive.
The improvement in productivity can be traced to innovations in the equipment
and software we use in our factories, farms, warehouses, offices, and
stores as well as innovations in the organization of our workplaces.
What makes the recent experience especially notable is that key breakthroughs
in technologies are having an ever-growing application in production
processes. In this regard, the current period is taking on the look of
previous pivotal episodes in our history in which innovations such as
the steam engine and electrification had protracted and extensive positive
effects on productivity. Given this past experience, the expanding scope
for innovation along with the continued emphasis by businesses on improving
productivity build a convincing case that the higher productivity growth
we are experiencing will persist.
The prospects for continued innovation and heightened productivity growth
are important to all of us. As we move ahead in the 21st century, the
path of innovation and productivity growth will shape improvements in
our economic well-being. It also will influence the mix of goods and
services available to us as well as the jobs we perform.
History in the Making
The remarkable strength of productivity growth has been a hallmark of
the economy in recent years. The most familiar measure of productivity,
labor productivity, is measured by real (inflation-adjusted) output
per labor hour. Prior to the second half of the 1990s, the U.S. economy
had endured a more than twenty-year slump in labor productivity growth.
From 1973 through 1995, for example, labor productivity grew at an
average rate of only about 1.4 percent per year. In the past eight
years, labor productivity growth has averaged an impressive 3.0 percent
The rise in productivity and the proliferation of innovation in recent
years tell us that something new, though not unprecedented, is going
on in the economy. Similar boosts to the economy from innovation and
productivity growth were evident at other junctures in our economic history.
Breakthroughs in energy generation via the steam engine, electrification,
and the internal combustion engine as well as innovations in wired
and wireless communication are examples of key innovations that led
to substantial increases in productivity earlier in our economic history.
Key innovations such as these, that have a formative impact on productivity,
often are referred to as general purpose technologies since they are
widely used throughout the economy. Typically, their initial effects
take some time to show up, but afterward they can affect economic growth
for decades. One reason for this pattern is that general purpose technologies
are refined and improved over time. In the case of electrification, competing
camps initially argued over what technology to use—direct current
(DC), favored by Thomas Edison, or alternating current (AC). The DC technology
was safer, but AC power could be transmitted over longer distances. The
AC camp eventually won, with the rollout over time influenced in part
by the pace of improvements in electrical power generation and transmission.
Another reason it takes time for a technology to become adopted throughout
the economy—a process known as “diffusion”—is
because it takes time for people to figure out ways to use the technology.
Diffusion of electricity depended on the development of effective electric
motors, improvements in lighting technology, and changes in the organization
of manufacturing processes, as well as the invention of machines and
consumer appliances powered by electricity.
Agriculture – Producing
More with Less
Over time, taking advantage of an array of
technologies such as tractors and other farm equipment, advances
and genetic engineering, and land management practices greatly
increased crop yields. As a result, today it takes only about
two to three labor hours to produce 100 bushels of corn, while
near the turn of the last century it took more than 10 times
as much labor input. With advances in productivity such as these,
it now takes only 2 percent of the U.S. population to work the
farms and ranches to feed the country, compared to close to 40
percent at the beginning of the 20th century. Such capacity to
produce more with less in agriculture as well as other sectors
allows people to engage in other productive activities—expanding
the economic pie and, more importantly, increasing the size of
the pieces of pie per person.
As we move further into the 21st century, it looks more and more as
though we are witnesses to another pivotal episode of innovation and
productivity growth. A few fundamental breakthroughs in technology provide
most of the basis for the recent rise in labor productivity. The microchip
is one of the most dominant innovations. Others that are complementary
to the microchip include lasers, digital data storage devices, and software.
Today, we are seeing stunning improvements in these technologies and,
more importantly, rapid expansion of their application in production
processes and products. Microprocessors, for example, are not just the
brains of our personal computers: they are in digitally controlled manufacturing
equipment; they help control heating and cooling systems in offices;
they are in autos, trucks and planes, and even basic home appliances.
In fact, today, a majority of semiconductors are produced for uses other
than personal computers and computer servers.
Impact of IT
The cause of the productivity growth slowdown
of the 1970s remains mysterious. By contrast, nearly all agree
that the causes of the productivity growth speed-up in the 1990s
lie in the information technology sector.1
Brad DeLong, University of California, Berkeley
As with general purpose technologies of the past, the effects of the
microchip and other related innovations took time to show up in the productivity
numbers. The first commercial microprocessor, for example, was introduced
in 1971, and by the 1980s many businesses were making major investments
in computers and other information technology (IT) equipment and software.
Yet, as the numbers indicate, average labor productivity growth in the
U.S. was below par for most of the 1970s continuing into the early 1990s.
For individual firms, there was a dearth of evidence that IT investments
boosted productivity or added to their bottom lines as recently as the
first half of 1990s. Even after 1995, when aggregate productivity growth
in the U.S. appeared to accelerate, economists debated whether the economy
was experiencing an increase in trend productivity growth or merely a
Impact of IT
With the advantage of time, revisions to various economic data series,
and a considerable volume of additional research, it is clearer today
that we are seeing a rise in underlying productivity growth and not
just a cyclical upswing. Most economic research shows that the IT sector
has contributed significantly to the strengthening in productivity
growth—and the gains in the IT sector itself are an important
part of the contribution. Producers of IT products—especially
manufacturers of computers and semiconductors—have posted astounding
gains in labor productivity. In the case of the semiconductor industry,
productivity gains have come in part from dramatic increases in the
computing power of microprocessors. In a little over 30 years, the
number of transistors on a processor chip has increased from 2,350
to 125 million. The leaps in technology have been coupled with astounding
declines in prices on microprocessors. The advances in this technology
provide a poignant example of how getting more from less, for cheaper,
through higher productivity, can shape the economy.
The improvement in productivity growth in recent years also is evident
among businesses investing in IT equipment and software. Some of the
biggest strides forward are in the retail sector. In that sector, for
example, scanning technology that combines laser and IT technologies
can not only speed up checkouts, it also can reduce resources needed
for inventory control and purchasing. Agriculture also has posted strong
productivity gains, in some cases through additional automation that
More than just IT
But IT is not the entire story. Part of the pickup in productivity since
the mid-1990s appears to be due to factors other than just investment
in IT. In agriculture, for example, biotechnology has contributed to
improved yields for many crops. Research also points to innovations
in work practices such as those affecting workplace organization (including
manufacturing production processes), employee training, and incentive-based
pay programs as sources of productivity growth. In some cases, investments
in IT may enable changes in workplace organization. This is similar
to what happened in the 1920s when Henry Ford was able to use electric
motors to power automobile assembly lines. The electric motor was an
enabling technology, but much
of the productivity gains could be appropriately attributed to the innovation
of reorganizing the production process.
Rising Standard of Living
Innovation and the pace of growth in labor productivity set the path
for improvement in our economic standard of living. A commonly used
measure of the standard of living is real (inflation-adjusted) income
per capita. To raise real income per capita in our economy, we can
work more—meaning working longer hours or having more people
in the population working—or be more productive—meaning
producing more output per hour worked. Over the past half century,
Americans demonstrated a remarkable capacity to increase the average
standard of living. Since the late 1940s, real disposable personal
income per capita has increased from about $7,000 to close to $27,000.
While both working more and working smarter have contributed to this,
the more than threefold increase in labor productivity accounts for
the bulk of the nearly fourfold gain in our economic standard
Looking ahead, with the evolving demographics in the U.S.—in particular,
with baby boomers, representing about a third of the population, approaching
retirement years—we are going to have to rely almost exclusively
on gains in productivity to push up income per capita. Maintaining the
improvement in productivity growth in the U.S. will make a big difference
to us. Although the actual growth rate is unpredictable, if the average
growth in labor productivity were 2.5 to 3.0 percent per year, per capita
real income could double in roughly 25 years. However, if labor productivity
growth were to fall back to, say, 1.5 percent per year, it could take
twice as long to realize the same increase in our economic standard of
Changing Mix of Goods and Services
The combination of innovations and rising incomes also affects the mix
of products we buy. As incomes rise, the share of our budgets going
to different products changes—we typically reduce the share of
our budgets allocated to buying staples such as food and increase the
share going to more discretionary items such as entertainment. In addition,
innovations mean new products and services become available. Over the
past half century, we dramatically reduced the share of our income
spent on nondurable goods, which include foods, while our spending
on durable goods, like cars, has been relatively stable. Now we are
spending a growing share of our budgets on services, which include
cell phone services, financial services, medical services, and a large
part of recreation and tourism.
Changing Mix of Jobs
The mix of jobs created in the economy also is changing. Since the mid-1950s,
the share of employment in the manufacturing sector has declined, while
the share of service jobs has risen. This changing job mix mirrors
the changes in the composition of our consumer spending. However, gains
in labor productivity have been the key to making this shift possible.
The capacity to produce more with less in some sectors allows people
to engage in other productive activities (see box on agriculture, page
9). In effect, the gains in labor productivity have increased the productive
capacity of the economy, producing more from less, for cheaper—which
is fundamental to improving our standard of living.
Dealing with Change
While the realignment of jobs is part of the long-run process that allows
us to realize a higher standard of living, not everyone realizes the
same net benefits from innovation and productivity. For one thing, shocks
to productivity can have regional effects. In recent years, for example,
the gains in productivity have been especially notable among several
of the states in the West. This in part reflects direct contributions
of the IT sectors—IT firms in the West generally posted greater
gains in productivity than IT firms elsewhere, and IT producers are relatively
more important to the economies of several metropolitan areas in the
West, such as the San Francisco Bay Area, Seattle, and Portland.
. . . all of the progress that the U.S. has made
over the last couple of centuries has come from
. . . figuring
out how to produce more goods with fewer workers, thereby releasing
labor to be more productive in other areas. It has never come
about through permanent unemployment, but temporary unemployment,
in the process of shifting people from one area to another.
Milton Friedman, 1976 Nobel Prize winner
in Economics Sciences
More generally, the impact of innovation and productivity gains on jobs
is a common concern. The recent economic recovery, for example, apparently
generated relatively few net payroll jobs from late 2001 through late
2003, as exceptionally large increases in productivity accounted for
most of the growth in output. At the same time, the second half of the
1990s illustrated that relatively high productivity and strong employment
growth can go hand-in-hand, though the job destruction and creation did
not leave all individual workers better off.
Innovations in the workplace are changing the demand for the types of
skills needed on the job, which in part explains the differential effects
on workers. For example, evidence tells us that the returns from investments
in higher education for workers in the U.S. have risen. Wage premiums
also appear to be connected with the use of computers in the workplace.
This is consistent with research indicating that the adoption of computer
technology in production processes tends to replace routine tasks, while
complementing less routine tasks that involve higher cognitive skills.
Advances in technology have made services more tradable in a global
economy. Over time, opportunities for foreign trade benefit society.
However, as with domestic productivity gains, the benefits from trade
are not distributed evenly. Improved IT capabilities, for example, make
it feasible for some businesses to provide services to their U.S. customers
through call centers located in countries such as India. This means lower
costs to consumers, but also means the loss of certain jobs domestically.
At the same time, our trading partners have increased their demand for
other IT services from U.S. firms—the foreign trade data show a
rising surplus in overall IT services favoring U.S. firms.
Are the Source of Growth
Over the past half century,
the increase in the value of raw materials has accounted for
only a fraction
of the overall growth of U.S. gross domestic product. The rest
of that growth reflects the embodiment of ideas in products
and services that consumers value.
Alan Greenspan, Chairman
Federal Reserve Board
Continuing the Search for Ideas
Today’s remarkable economic times appear to be taking on the look
of previous pivotal episodes in our history in which innovations have
had protracted and extensive positive effects on productivity. In recent
years, much of the acceleration in productivity can be traced to innovations
affecting capital equipment and software as well as to improvements in
our business practices.
The gains, however, have not come from thin air. The intriguing stories
of fortuitous inventions such as the microwave oven, VELCRO,® and
Post-its® aside, innovation and productivity gains have been the
result of investment. This includes spending on research and development
and investments in the education and training of those involved in
research as well as those implementing new technologies in the workplace.
Looking forward, improvements in our standard of living as well as
our capacity to deal with change will depend importantly on the extent
to which we make such investments in the search for new ideas.