Why has digital innovation not created business value so far?

10 Dec

by Agnes Horvath

Once computers were large machines operated by technical staff working in specially constructed centers. Today, computers are used by everybody and microprocessors have become ubiquitous, present on desktops, automobiles all through to greeting cards.

Still, as Robert Solow from MIT put it: “You can see the computer age everywhere but in the productivity statistics”. It seems that the digital revolution does not seem to deliver in terms of increased productivity performances. What we see is that businesses had been making massive capital investments in IT, but at the very same time macro-level productivity growth was stagnant or even declining in most of the advanced countries – a concept economists define as the ‘productivity puzzle’.

Raising labor productivity or output per work hour is the key to lifting wages and living standards on the one side but also to increasing the profitability of firms and tax revenues of governments on the other. In fact economic growth itself is to a large extent productivity driven. Productivity is the measure of our work efficiency, i.e. how much more goods and services we can produce without increasing the number of hours we work.

How can we improve labor productivity? We can use more and newer technology, improve organization and communication, manage people more effectively or increase our skills through education or job training. In addition, the importance of legal and political institutions has also been realized. A worker with the same skills and equipment is producing less added value in a country with poor institutions, as resources are wasted on corruption, rent-seeking, insuring against an uncertain business environment and unpredictable political developments.

Previous technological advances (like the steam engine, electricity, the internal combustion engine, new polymers and synthetics or improvements in transportation systems and modes) significantly boosted productivity not only at the firm but also at the macro level, bringing higher overall welfare. However, productivity growth in recent years hasn’t been strong despite the emergence of the mobile, broadband and cloud economy. We are now in fact living through one of the lowest productivity-growth periods ever recorded. Since 2007, labor productivity in the US has grown just 1.3% on average p.a. That is less than half the average rate of 2.8% of the golden productivity age (1947-1973) (see also graph). But this is not an American problem, productivity growth has been on a declining path in most of the mature economies for a decade.


Source: US Bureau of Labor statistics, http://www.bls.gov/lpc/prodybar.htm


What are the potential explanations for the recent sluggish productivity growth? Part of the story is definitely the economic downturn following the 2008-2009 crisis.

Decreasing productivity is by definition the result of output falling faster than employment or employment increasing faster than output. There were examples for both cases during the Great Recession. First, it took some time until market participants realised that the low global demand that prevailed after the financial crises would be more prolonged than previously thought. During an economic downturn it is worth for companies to keep their employees for some time (called ‘labor hoarding’) if the people have special skills or they expect a recovery soon. Indeed, this was the reason for poor productivity performance in a number of countries, including Hungary, after the 2008-2009 crises. Second, there is evidence (e.g. in the UK) that job-creation was disproportionally strong in low value-added (low-paid) professions over the recent years. If we accept that during low-profitability times (like recessions) it is the low-productivity employees who are fired first predominantly, then when it comes to upturn, these low-productivity people enter the workforce again, bringing down the average productivity.

The question is why does the impact of digital innovation not counteract the effect of the abovementioned cyclical forces? A very common answer is that the problem lies in measurement, i.e. that productivity is improving in ways that are simply not being reflected in ‘old-fashioned’ statistics. In particular, GDP cannot capture the consumer benefits from new digital products and services and sharing platforms. For example, the value-added does not quantify the happiness that comes from being able to contact friends and relatives instantly, i.e. the value of social media.

Alternatively, one can argue that the benefits of the digital-driven productivity are actually there but they are counteracted by the cyclical factors. Hence, once we have fully recovered from the crisis, the productivity benefits would be felt in their full strength. There is one important drawback to this reasoning, namely that productivity growth has already began to fall before the crisis.

Moreover, one can argue that the impact of the digital era has already been over as the early 2000s saw an almost as high productivity growth in the US as it was during the golden age. This rather pessimistic view would imply that no significant further productivity boost is expected in the coming years due to the digital revolution. Robert Gordon goes on and argues that the effects of slowing technological progress on potential growth will be reinforced by a number of headwinds, including population aging, a plateau in education levels, rising income inequality, energy/environment, globalization, and the debt overhang.

Fortunately, there are “techno-optimists” as well. Many believe that it will simply take a while before we will see the impact of digitalisation. Companies need to do a lot more than buying cloud services to go through the digital transformation process. For example the ability to turn data analytics into insights that help to generate new product and service offerings needs also new, more flexible organizations, workforce trainings and not just increased spending on IT services. Another good example is the well-known fact that a number of companies are working to make driverless cars a reality. Currently they put a lot of working time with no measurable economic output into this project, bringing down firm-level productivity. Still, if they succeed, productivity would increase immediately, most likely at country level as well.

Taking into account that institutional changes are slow, one can argue that the impact of digital innovations may come in waves. In particular, technology diffusion to sectors like health care, education or construction, that are typically less productive, is probably still ahead of us. These are industries, where there is little technological innovation and insufficient productivity growth, drag down average productivity. But just because an industry has some traditional characteristic which makes innovation hard to implement (e.g. inefficient market structures), it doesn’t mean that prospects for technological progress and productivity growth will follow past patterns.

The recent very low productivity figures in advanced economies are a clear early warning signal for economists. If things remain the same, our grandchildren will need the same amount of time to do work as we do today. Hence, they will not be able to get richer than we are, cementing the current the living standards. On the other hand, if the impact of digitalization on productivity only takes more time, as many believe, a new era of high-growth period might be ahead of us.

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