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Jeff Bezos Makes Us 49 Times Richer Than We Make Him.

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This article, summarizing a National Bureau Of Economic Research working paper, is a bit technical but we present it to make a point. Many decry the excessive wealth of founder-innovators and CEO’s of today’s leading tech companies. But those executives and shareholders capture very little of the total value they create for customers. They are making us richer more than they are making themselves richer.

With the sharp rise in productivity growth over the last decade, economists have been curious about the extent to which the fruits of higher productivity are captured by innovating firms. Is the rapid technological change in the New Economy – with double-digit rates of productivity growth in computers and a phenomenal increase in new products and services via the Internet – leading to a similar rapid rise in the profits of New Economy firms?

In Schumpeterian Profits in the American Economy: Theory and Measurement (NBER Working Paper No. 10433), author William Nordhaus studies the impact of new technology on profits, emphasizing three important implications: first, understanding the role of innovational profits in total profits; second, identifying the impact of innovation in stock market returns; and third, gaining greater understanding of technology’s wealth effect on aggregate demand, as defined by Federal Reserve Chairman Alan Greenspan (an effect he labels the “Greenspan effect.”)

Nordhaus begins by considering the impact of technological change on prices and profits. Do technological improvements primarily result in lower prices for consumers or in higher profits for producers? If producers are able to capture (or appropriate) most of the social returns to innovation, then profits will rise and prices will fall relatively little.

How much of the profits from a new technology are captured by innovators will vary greatly across industries. For sectors where knowledge is in the public domain, such as weather forecasting, the new knowledge cannot be appropriated and productivity improvements are passed on in lower prices. In other industries with well-defined products and strong patents, such as pharmaceuticals, producers may be successful in capturing a large fraction of social gains in “Schumpeterian profits.”

Nordhaus begins by developing a model for explaining the size of Schumpeterian profits. In this context, Schumpeterian profits are profits above those that are associated with the normal return to investment and risk-taking. The Schumpeterian profit margin, defined as the ratio of Schumpeterian profits to total revenues, is determined by three parameters: the rate of innovation-driven total factor productivity; the instantaneous appropriability ratio; and the depreciation rate on Schumpeterian profits. The only novel parameter is the instantaneous appropriability ratio, which measures the fraction of the social surplus that is captured by the innovator in the first year. Depreciation is particularly important for Schumpeterian profits because they are often eroded by such factors as the expiration or non-enforcement of patents, the ability of competitors to imitate or to innovate around original innovations, and the introduction of superior goods and services.

Nordhaus presents a numerical example of the outcome of the model. If the rate of innovation-driven total factor productivity is 2 percent per year, the instantaneous appropriability ratio is 50 percent, and the depreciation rate on Schumpeterian profits is 10 percent per year, then Schumpeterian profits would be 2 percent of total sales. If the rate of profit on capital is 10 percent per year and the capital-output ratio is 2, then in this simple example, Schumpeterian profits would be half of the return to capital.

Another application of the model would be to the New Economy (computers, software, telecommunications, and similar industries). To what extent, he asks, did the phenomenal rise in the stock prices of New Economy firms in the late 1990s reflect rapid innovation and high appropriability in that sector. He suggests the following example: The new economy amounts to 5 percent of nominal output. Assume that, after 1995, costless productivity growth in this sector shot up from 5 percent per year to 15 percent per year. The new economy would then be adding about $75 billion in social surplus in the initial years. If the new entrepreneurs could capture 90 percent of the new economy surplus in Schumpeterian profits, then with other plausible parameters, the increase in value of new economy firms would be $6 trillion. This in fact is close to the increase in value of new economy firms from 1995-2000.

But is this parable plausible? For the entire postwar period and for the nonfarm business sector, Nordhaus estimates that innovators are able to capture about 2.2 percent of the total surplus from innovation. This figure results from an instantaneous appropriability estimated at 7 percent and a rate of depreciation of Schumpeterian profits of 20 percent per year. This number implies that Schumpeterian profits were 0.19 percent per year of the replacement cost of capital over the period 1948-2001.

Using these estimates for the New Economy suggests that entrepreneurs could capture only $400 billion, not $6 trillion. Nordhaus speculates that part of the New Economy bubble might have arisen because investors overestimated the appropriability of innovations in that sector. Indeed, there is some evidence that appropriability in New Economy sectors is even lower than in Old Economy sectors. The new economy’s industries are marked by easy entrance and exit: bright ideas were readily funded, but imitators are just as quick to follow. Additionally, information is expensive to produce but inexpensive to reproduce, a factor that will erode the value of intellectual property rights and reduce the durability of Schumpeterian profits in that sector.

Nordhaus next considers the role of Schumpeterian profits through the Greenspan effect, which Nordhaus defines as the impact of rising productivity on aggregate demand through the wealth effect on consumption. Nordhaus’s calculations suggest that the Greenspan effect on aggregate demand through consumption is about one-quarter of the effect on potential output. In other words, the impact of productivity growth on potential output is about three times the effect on aggregate demand.

These estimates of Schumpeterian profits may seem implausibly low, Nordhaus says, given the inventiveness of the American economy. But they do fit into one of the major puzzles of corporate America: Why is the rate of profit on corporate capital so low? The rate of profit after tax on non-financial corporations over the past 40 years has averaged 5.9 percent annually, which was very close to the cost of capital. How could the rate of profit be so low, considering that profits include so much (such as monopoly and Schumpeterian profits) and the denominator omits several important assets (such as land and intangible investments)? At least part of the answer lies in Nordhaus’s finding that only 20 basis points of the rate of return to capital were attributable to Schumpeterian profits.

Let’s Hear It For The Middleman: A Critical Player In Economic Growth And Prosperity.

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I heard on the radio an ad for Mervis Diamond Importers. Ronnie Mervis, the owner, boasted that “by importing directly, Mervis eliminates the middleman” — and, thus, sells diamond jewelry at unusually low prices.

This stratagem of claiming to “eliminate the middleman” is common in advertising done by retailers. The great frequency of the use of this stratagem testifies to its believability, for the claim that money is saved by eliminating the middleman does indeed seem sensible. After all, wholesalers and other middlemen don’t work for free; they must be paid. So if a retailer eliminates the middleman, that retailer apparently has “savings” that it “passes on to you!”

But if middlemen raise retailers’ costs, why would any retailer ever use such parasites? Simply to ask this question about middlemen is to cast doubt on the widespread myth that middlemen raise the retail costs of goods.

It’s true that middlemen (and, of course, middlewomen) must be paid for their services. But these services are paid for only because they are valuable. And these services are valuable only because, and only insofar as, they reduce the prices that consumers pay at retail. Middlemen who don’t enable retailers to lower their prices go bankrupt. These middlemen are indeed “eliminated” — by the market. In contrast, successful middlemen reduce the costs that consumers pay at retail.

A Role of Retailers

To see the economic value of middlemen, it’s helpful to realize that retailers themselves are middlemen. A man wishing to acquire an engagement ring could “eliminate the middleman” by steering clear of all retail jewelers and himself personally go mining for diamonds and gold. But doing so would obviously be a much more costly means of presenting an impressive ring to his sweetheart than buying the ring from a jeweler, despite the fact that the jeweler must be paid for his services.

Or recognize that, say, the furniture retailer that brags of “eliminating the middleman” by “buying direct from the factory” doesn’t itself manufacture sofas, beds, and dining room tables. That retailer instead specializes in purchasing inventories of furniture and then assembling these in locations that consumers find convenient to visit.

And understand that you yourself could buy furniture for your home directly from furniture manufacturers and at prices lower than you pay at retail furniture stores. But you almost never do so. You typically buy furniture from retailers. The reason you don’t “eliminate the middleman” — the retailer — when you buy furniture is that this middleman saves you money.

To “eliminate the middleman” here would require that you buy or rent a large truck and drive it (depending on where you live) hundreds of miles to the nearest furniture factory. Although the factory owner will charge for the likes of chairs and bookcases prices lower than you’d pay at retail, these price discounts are seldom worthwhile.

The cost of “eliminating the middleman” in this manner is not only that you must spend time and money driving to and from the factory. There’s also this inconvenience: once at the factory, you can’t directly compare that factory’s offerings with those of competing furniture producers. To make such comparisons, you have to climb back into your truck and drive to many other furniture factories.

By the time you do all this driving around, the price reductions that you get on furniture by “eliminating the middleman” won’t be worthwhile. You’ll bankrupt yourself by avoiding the middleman markup!

A Role of Wholesalers

Wholesalers supply services to retailers similar to the services that retailers supply to final consumers. No supermarket grows its own lettuce, churns its own butter, or cans its own soups. It buys these and each of the other tens of thousands of different items on its shelves from wholesalers. And just as retailers lower your cost of buying goods for you and your family, wholesalers lower retailers’ costs of acquiring inventories.

Wholesalers specialize in transporting goods from around the country, or even the world, and assembling these in accessible, central locations at which retailers’ delivery trucks can be loaded. Also like retailers, wholesalers also generally vouch to their customers for the quality of the goods they supply.

Nothing said here implies that retailers (or wholesalers) never innovate in ways that indeed enable them to profitably “eliminate” some middlemen and genuinely pass some of these savings on to consumers. If a retailer discovers a way to itself produce some retail item at a cost lower than the price it must pay to a wholesaler, that retailer will eliminate the middleman wholesaler and produce that item itself. And this retailer will turn this cost saving into a competitive advantage by passing along to consumers at least some of these lower costs in the form of lower retail prices.

Our Economy Is a Vast Complex of Middlemen

But it’s important to remember that eliminating a supplier from a supply chain merely because that supplier charges for its services is foolish. If those services are valuable — if those services reduce retailers’ costs of acquiring some good for resale — then for retailers to refuse to purchase that supplier’s services causes retailers’ costs not to fall, but to rise. Any retailer who “eliminates” middlemen in this foolish way will itself soon be eliminated by its more competent competitors.

Because in our modern economy every one of us purchases from others nearly everything we use, our economy is a vast complex of middlemen. Its supply chains span the globe. And because these supply chains have been crafted by decades of relentless, innovation-driven competition, they are mind-bogglingly efficient. (If you doubt this last claim, ask yourself what makes possible the inexpensive blueberries that Minnesotans and New Yorkers routinely purchase from supermarkets in January.) And so let’s applaud middlemen, for without them we would all — or, rather, the few of us who would somehow manage to survive — be mired in unimaginable poverty.

Donald J. Boudreaux is a senior fellow with American Institute for Economic Research and with the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center at George Mason University.

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