Discussion of Nordhaus on Alchemy and the New Economy

1. Discussion of Nordhaus on Alchemy and the New Economy Robert J. Gordon Northwestern University and NBER CRIW, Cambridge MA, July 30, 2002

2. The Long Tradition Continues • Grad School Office-Mates in 1966-67 • I have been pilloried many times by incisive WDN discussant comments • “Darwinian t-statistics” • More varieties in supermarkets? It’s all honey/apple/cinnamon Cheerios (he reads out the brand names . . .)

3. What is this Paper About? • Are fruits of innovation appropriated by inventors? • Were new economy innovations appropriated more or less than usual? • Empirical measure of appropriability is the behavior of various concepts of the profit share

4. What Should We Expect ex-ante? • Case 1: Steady stream of innovations • RR => electricity => auto => radio/TV • New economy just more of the same • Profit Share? • Would be constant • Would be higher, the more of the steady stream of innovations are appropriated • But we would have no way of identifying the appropriability share

5. Uneven Stream of Innovations • Industrial Revolution #1 • Steam engine, cotton gin, RR, steam/steel ships • Industrial Revolution #2 • Electric motor, electric light, motor transport, air transport • Hiatus: 1970’s, 1980’s • New Economy: IR #3?

6. When Innovations are unevenly timed • If no appropriability, no effect on profit share • With appropriability, profit share will be positively correlated with pace of innovation • Using MFP growth as a proxy for pace of innovation, profit share would be correlated with MFP growth • That’s what his model says, and it is a correct and interesting implication

7. What We Already Know • Labor’s Share, i.e., Profit Share Constant for a Century, with one exception • One-time-only jump in LS in late 1960s • Consistent with Steady Innovation • Was the jump in LS in late 1960s a marker of a decline in innovation? • How could New Economy (IR#3?) have been appropriated when we know in advance that LS did not decline? • While the question is intriguing, we know the answer in advance from the macro data on LS

8. What New Economy Skeptics Already Knew • New Economy a Pipsqueak compared to the “Great Inventions” (electricity + internal combustion engine) • Much New Economy Innovation was a substitute for other activities • Surfing the web vs. TV • E-commerce vs. mail-order catalogues (Land’s End rules!) • Sears buys Land’s End? The Chicago hinterland rules! • Brutal competition competed away any profits, gains went to consumer

9. Key steps to understanding paper • Figure 1 • Innovation cuts C0 to C1 • With no Schumpeterian profits, P declines fully • With Schumpeterian profits, P falls partially • Dynamic implications • Without S profits, P and C decline at same rate after the initial period • With S profits, P declines at (1-a) the rate of change of C, profit share in economy approaches a

10. Example with no decay (λ = 0) • Cost declines at 10 percent per period, assume a = 0.5 as in Figure 1 • Cost 100, 90.5, 81.9, . . . , ~0 • Price 100, 95.2, 90.9, . . . , 50 • Profit 0, 4.8, 9.1, . . . , 50 • Notice in equations (4) and (6), the profit share in equilibrium = a when λ = 0

11. Thus the decay factor (λ) is critical • Radical sensitivity of profit share to λ decay rate, equation (6), assume h* = .02 • With λ successively = 0, 0.1, 0.2, 0.3 • Profit share (goes from a to 0.25a to 0.11a to .07a • In my example based on a=0.5 and with λ = 0.2 rather than 0.0, profits reduced from 50 to 5.5 • With a more plausible a=0.1, from 5 to 0.5 • Conclusion: to get a realistic profit share, we need some combination of a low a and high λ

12. The paper’s main results depend on the choice of λ • Theory: only example considered is λ= 0.2 • Example on pp. 15-16 • Empirical results in Tables 1 and 3 • Since decay = 0.2 implies Schumpeterian profit share is trivial, the paper’s results are largely true by assumption

13. What about the dynamic results in Tables 2 and 4? • Tables 2 and 4 return λ = 0.16 to 0.31, seeming to validate assumed λ = 0.2 • But the estimated equations involve explaining level of profit share by lagged dependent variable and the growth rate of productivity • High estimated λ just measures serial correlation in profit share, doesn’t tell us anything about decay in Schumpeterian profits • Low estimated alpha tells us level of profit share has a low correlation with the growth rate of productivity

14. Step back from paper, cross-section • If we were trying to explain cross-industry variation in profit share, what factors would we consider? • Surely on the list, ahead of productivity growth would come monopoly power • Microsoft, Intel yes (Nordhaus p. 24) • But also monopoly “Old Economy”: Coca-Cola, Anheuser-Busch, Gillette, Proctor & Gamble (toothpaste for $5.99 a tube), over-counter drugs, prescription drugs, and one of Bill’s favorite industries, breakfast cereals

15. Hi-Tech Brand Names, U. S. Only, BW, August 5, 2002, p. 95 • Rank, Company, 2002 Brand Value ($B) • 2 Microsoft 64, 3 IBM 51, 5 Intel 31 • 14 HP 18, 16 Cisco 16, 17 AT&T 16 • 23 Oracle 12, 27 Compaq 10, 28 Pfizer 10 • 31 Dell 9, 50 Apple 5 • Total $245 Billion

16. Non-Hi-tech Brand Names, US only, BW, August 5, 2002, p. 95 • Rank, Company, 2002 brand value • 1 Coca-Cola 70; 4 GE 41; 7 Disney 29; 8 McDonalds 26 • 9 Marlboro 24; 11 Ford 20; 13 Citibank 18 • 15 Amex 16; 19 Gillette 15; 24 Budweiser 11 • 25 Merrill Lynch 11; 26 Morgan Stanley 11 • 29 JP Morgan 10; 30 Kodak 10; 35 Nike 8 • 37 Heinz 7; 39 Goldman Sachs 7; 40 Kellogg 7 • 45 Pepsi 6; 46 Harley-Davidson 6; 47 MTV 6 • 48 Pizza Hut 6; 49 KFC 5 • Total $372 Billion

17. Whatever happened to multiple regression? • If profit share depends both on monopoly power and rate of innovation • Why just show us simple correlations when multiple correlations are required? • Maybe Schumpeterian coefficient is actually zero when MS and Intel are eliminated from his hi-tech sample • The “Weakest Link”: What actually creates the observed differences in profit share across industries

18. Step back from paper, time series • If we were trying to explain time-series variation in profit share, what factors would we consider? • Surely, rather than regressing level of profit share on growth in productivity, we would model the behavior of both productivity and profit share growth in response to cyclical changes in the output gap • Change in hours gap responds partially and with a lag to changes in the output gap • Inflation equations show that only 10-20 percent of productivity gap changes affect prices, remainder spills over to a change in profits

19. Real Profits through Identities (please note: identities are a non-controversial branch of macro) • PY ≡ WN + RK • 1 ≡ (WN/PY) + (RK/PY) • 1 ≡ S + (1-S) • Lower case letters are growth rates • 0 ≡ Ss + (1-S)(1-s) • 0 ≡ Ss + (1-S)(r-p – (y-k)) • r-p ≡ -(S/(1-S)s + y - k

20. Productivity Growth Revival and y-k • Y = AF(N,K) • y = a + Sn + (1-S)k • y – k = a – S(k – n) • Was the post-1995 productivity revival a result of an increase in a or in k-n? • An autonomous increase in a raises y – k • An autonomous increase in capital deepening reduces y - k

21. Profit Margins are the Flip Side of Labor’s Share

22. How is the Profit Share related to the Productivity Growth Trend?

23. Real Profits through Identities (please note: identities are a non-controversial branch of macro) • PY ≡ WN + RK • 1 ≡ (WN/PY) + (RK/PY) • 1 ≡ S + (1-S) • Lower case letters are growth rates • 0 ≡ Ss + (1-S)(1-s) • 0 ≡ Ss + (1-S)(r-p – (y-k)) • r-p ≡ -(S/(1-S)s + y - k

24. Computing the Change in the Real Return on Capital (r – p) 1959-73 1973-95 1995-2000 s 0.37 -0.03 0.23 -S/(1-S)s -0.88 0.07 -0.57 y – k 0.32 0.23 -0.39 r – p -0.56 0.30 -0.96

25. Conclusion #1 • The paper is exactly right: New Economy innovations went to workers and consumers, not shareholders • We already knew that from macro data • Cross-section results cannot reveal appropriability because monopoly-type variables are omitted

26. Conclusion #2 • Time-series results contaminated by common co-movement of MFP with profits due to an omitted variable, the Keynesian output gap • What fraction of gains from innovation have been appropriated over the last two centuries? An interesting question for Bill’s next paper