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Why The Biggest Gains Are from Innovation, Not Efficiencies

Economists and economic theory can, more or less, explain only about 20 percent of the worldwide growth in per-capita income over the last 200-plus years. After economists account for factors such as labor, capital, natural resources, they ascribe the remaining growth to something referred to as “residual” growth.

The Lesson to be Learned

This isn’t a boring lesson in economics.

The lesson to be learned here, I believe, for executives and managers everywhere, is that if you are spending your whole career focused on attempting to eke out tiny incremental efficiencies from your labor force and your capital equipment, you are doomed to gains that are tiny.

I dare say: no company in the history of mankind has become wildly successful or hugely profitable with a focus on costs and efficiencies. Even Henry Ford’s success in the auto industry—while based on achieving efficiencies in production—was due to his innovations around FLOW and how those efficiencies were attained, and not by the efficiencies themselves. In his day, the innovation was that his company was the only company doing things that way.

Efficiencies in the use of labor, capital and natural resources account for about 20 percent of economic growth: the remaining 80 percent of growth comes from innovation and creativity.

Consider These Amazing Numbers

Between 1800 and 2012, world population grew seven-fold. If all factors had remained equal, economic growth over the same period should also have been roughly seven times. If that had been the case, then worldwide per-capita economic productivity would have remained steady—no gain and no loss in per-capita productivity.

That, however, was not the case.

Instead, over the same 212-year period, per-capita economic output grew 17-fold (1,700%). Therefore, if we take into account the growth in population, the world economy grew by 7 times 17, or 119-fold (in absolute terms) over those 212 years.

If the availability and efficiencies related to labor, capital and natural resources can explain on about 20 percent of this miraculous 119-times growth in economic output, what factor(s) can account for the remaining 80 percent of economic growth?

This is Worth Reading (take my word for it)

The following excerpt from George Gilder’s Knowledge and Power helped me understand where all this “residual” economic growth originates. Take time to read it:

In a paper entitled "Do Real Income and Real Wage Measures Capture Reality? The History of Lighting Suggests Not," [William Nordhaus of Yale] shows that for half a million years, from cavemen's fires to the candles that illuminated the palace of Versailles, the labor cost of a lumen-hour of light dropped by perhaps 75 percent. Then between 1711 and 1750, the British government embarked on an anti-light program, taxing candles and windows, increasing the cost of illumination up by 30 percent. On the eve of the Industrial Revolution—the very time that Malthus and Ricardo were formulating their lugubrious theories—Great Britain entered a "little dark age," a period of stagnation when no one envisioned the possibility of major economic advances.

How could a tax produce a dark age? Traditional economics has an answer, and that answer is not wrong: tax a thing and you get less of it; tax light and darkness encroaches. It is hard-earned wisdom, often forgotten today by even sophisticated thinkers like David Warsh [an eminent economic journalist]. The experience curve might deepen the explanation: slowing the volume of candle sales by a tax also retards candle innovation and price reduction.

What followed, however, renders these sensible observations nearly trivial. The little dark age was not dispersed by repealing the tax and restoring sensible incentives to candle makers, prudent though such a policy would have been.

What happened was that everything changed. Over the course of the nineteenth century, Britain became increasingly open to innovation and trade around the globe. The labor cost of light plunged, with gas light costing one-tenth as much as candlelight and kerosene light one-tenth as much as a gas light. Fossil fuels were the salvation of whales. The arrival of electricity in the 1880s produced another thousand-fold drop. In other words, one of the most astonishing increases in wealth in the history of mankind, a million-fold increase in the abundance and affordability of light itself, took place through a process of invention and innovation not comprehensible to economics in the ordinary sense of that word. No mapping of economic efficiencies can explain it. Economics could give an account of the sudden abundance of light only if it focused on the condition of human creativity itself.

Gilder, George F. Knowledge and Power: The Information Theory of Capitalism and How It Is Revolutionizing Our World. Washington, DC: Regnery Publishing, 2013.

Summing It Up

The efficiencies and factors related to labor, capital (e.g., tools, equipment, land, factories) and natural resources account for about 20 percent of economic progress. The remaining 80 percent of economic growth and progress can only be accounted for when innovation and creativity are considered.


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