Lesson 4: How Incentives Affect Innovation

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Concepts

incentives	profit	competition
entrepreneurship	economic growth	innovation

National Voluntary Content Standards in Economics

The background materials and student activities in lesson 4 address parts of the following national voluntary content standards and benchmarks in economics. Students will learn that:

Standard 13: Income for most people is determined by the market value of the productive resources they sell. What workers earn depends, primarily, on the market value of what they produce and how productive they are.

• Changes in the structure of the economy, the level of gross domestic product, technology, government policies, and discrimination can influence personal income.

Standard 14: Entrepreneurs are people who take the risks of organizing productive resources to make goods and services. Profit is an important incentive that leads entrepreneurs to accept the risks of business failure.

• Entrepreneurs compare the expected benefits of entering a new enterprise with the expected costs.
• Entrepreneurs accept the risks in organizing resources to produce goods and services, and they hope to earn profits.
• Entrepreneurial decisions affect job opportunities for other workers.
• Entrepreneurial decisions are influenced by government tax and regulatory policies.

Standard 15: Investment in factories, machinery, new technology, and the health, education, and training of people can raise future standards of living.

• Economic growth is a sustained rise in a nation’s production of goods and services. It results from investments in human and physical capital, research and development, technological change, and improved institutional arrangements and incentives.
• Historically, economic growth has been the primary vehicle for alleviating poverty and raising standards of living.
• The rate of productivity increase in an economy is strongly affected by the incentives that reward successful innovation and investments (in research and development, and in physical and human capital).

Key Points

1. Overview: This lesson focuses on the role played by a nation’s institutions in generating creativity, invention and innovation, and analyzes how innovation promotes the economic growth that raises standards of living and alleviates poverty. It offers evidence for 2 conclusions:

• • Innovation benefits the poor
  • Because of the incentive structure of markets, capitalist economies are uniquely able to generate innovation.
• Invention and the accompanying increases in knowledge are not enough to generate prosperity. Instead, it is innovation, the application of knowledge to productive processes, that is the secret of capitalism’s success.
  • Knowledge is a pure public good; those who have it can give it away without reducing how much they have. If the main reason that some countries are richer than others were that the rich countries know things the poor countries do not, then the simple solution would be to teach them. But transferring knowledge has not been enough to alleviate poverty.
  • By increasing quantity and lowering price, innovation transforms knowledge into economic well-being.
• Under capitalism, innovation has become one of the key strategies firms adopt in order to survive in the competitive environment of the market.
  • The result is that innovative activity in capitalist economies is much more pervasive and innovations spread more quickly than in non-market economies.
  • Non-market economies can, and occasionally do, innovate. They do not, however, set up the feedback cycle between producers and consumers that sustains innovation.
    • History is replete with examples of societies in which genius spawned invention, but made little or no impact on standards of living. The Soviet Union is the classic modern example of a society that invented many marvels, but did not translate invention into the innovations that change people’s lives. (See Appendix 1 below.)

2. Key Terms and Concepts

• Technological change is an increase in a body of knowledge: what we know and have recorded. Technology exists in people’s minds as a collective body of knowledge; it is not simply a collection of tools, artifacts or even pages of manuals.
  • In its basic form, technology consists of instructions for making goods or supplying services. These recipes are based on background knowledge of natural phenomena and regularities that can be tapped to yield the instructions. As people learn more about the physical world, they can write better recipes and enjoy better ways to manage resources for production.
  • Technological progress occurs when innovation grows out of invention.
    • Invention is the discovery of new knowledge
    • Innovation consists of recognizing the implications of inventions and putting them into productive use.
• Innovation is inextricably connected to entrepreneurship, the willingness to bear the risks of production. When entrepreneurs are willing to innovate, they become the engineers of economic growth.

3. The sustained rise in standards of living that followed the Industrial Revolution resulted from changes in the processes that generated technological advance.

• The world’s economic growth rate for more than a thousand years before the Industrial Revolution was essentially zero.
  • Only tiny fractions of society experienced anything other than poverty before 1750. Even the well-off had little beyond the products that had been available in ancient Rome. (See introductory essay, “A Brief History of Human Progress,” for a more detailed history of economic growth.
• Before 1750, periods of growth were occasionally sparked by notable improvements in technology, but more often by the occurrence of favorable harvests or successful ventures. They tended to be extremely short-lived and were separated by long periods of stagnation.
  • Each episode of growth ran into an obstruction or resistance – most commonly, population increase – that brought the growth spurt to an end
    • Increases in income generated by economic growth allowed the population to increase; the resulting population pressure on resources then stifled the rise in income
  • For most of history, technological advance was serendipitous. More importantly, it was not associated with scientific inquiry as is routinely the case today.
    • Scientists are conspicuously absent from lists of early innovators. To note a few examples, the modern textile factory system in England traces its roots to Richard Awkright, a wigmaker, and to Edmund Cartwright, the clergyman who invented the power loom. Confectioner Nicholas Appert discovered the canning process that provisioned Napoleon’s armies
  • The first Industrial Revolution, the wave of technological improvements from about 1750-90, was followed by a ripple of related inventions and innovations. Together, they initiated a sustained downward trend in production costs and an upward trend in productivity that continued into the 19^th century.
    • The combination of these two trends results in the lower prices and greater supply that improve standards of living.
  • Often overlooked, but of great significance in the history of economic growth, is the second industrial revolution that began about 1875. By 1914 this second industrial flowering had instituted a process of sustained innovation that firmly established the countries of the North Atlantic as the dominant economies of the world.

Case 2: Sustained vs. Episodic Growth – The “Rule of 72”

Spasmodic economic growth that began with the Industrial Revolution in 1750 gradually become sustained in areas that supported capitalist institutions. (For a more complete discussion of the history of world economic development, see Gary Walton’s Introductory Essay “A Brief History of Human Progress.”)

• By 1850, consistent growth allowed for dramatic increases in standards of living.

Sustained increase in the growth of per capita income, resulting from the power of compounding, is illustrated by the Rule of 72: 72/R = T

• R = rate of economic growth and T = doubling time. If we know the rate of economic growth, we can figure out how long (T) it will take for incomes — and therefore, standards of living — to double.
  • If the rate of economic growth is 3.5%, standards of living double in 20 years.
  • If the rate of economic growth is 7%, doubling occurs in only 10 years.

In the past 150 years, per capita incomes in market economies have increased from several hundred to several thousand percent (Baumol 3).

• For most of history, economic growth rates were a fraction of 1% yearly, meaning that it took several generations for standards of living to change significantly.
• By the late 19^th and early 20^th centuries, annual growth rates moved into the 1% – 2% range.
• By the last decades of the 20^th century, many places consistently experienced growth rates that produce doubling more than once within the average person’s lifetime.

• A key development of post-1875 innovation was the rise of industrial science, which differed from the traditional approach of “pure” science in that the guiding principle of research became the potential for economic gain.
• In their acclaimed 1986 study, How the West Grew Rich, economist Nathan Rosenberg and legal scholar L.E. Birdzell credit the rise of industrial science with the institutionalization of growth-promoting innovation in capitalist economies:
  • “[The rise of industrial laboratories]. . . bridged the traditional gap between science and the economic sphere and translated scientific explanations into economic worth. . . . . [The economies of the North Atlantic] developed what amounted to a system for innovation, first at the level of the firm and then at the level of the economy as a whole. The bridge was anchored at one end in industrial research laboratories invented to apply scientific methods and knowledge to commercial problems and, at the other end, in consumer purchase and use of a product or service embodying that knowledge.” (243)
• Using the history of the United States as representative of the trend replicated in other capitalist economies, we can trace the developing partnership between science and production.
  • The first industrial research labs were opened by chemists in Boston and Philadelphia in 1836, as independent laboratories.
  • Laboratories established by businesses soon followed. Examples include the 1870s opening of testing laboratories by the Pennsylvania and Burlington railroads that led to improved rail strength and durability, and the employment of a research chemist to fine-tune the resource inputs and lower the production costs in Andrew Carnegie’s steel mills.
  • By 1898, there were 139 research labs in the U.S. alone. The proliferation of the labs and the willingness of industry to pay for them testifies to the competitive advantage in cost-savings associated with increases in knowledge about materials and processes used in the manufacturing enterprises.
  • By 1918, the number had grown to 553, many now engaged in the development of new products and processes.

4. Markets funnel increases in knowledge into innovation and economic growth.

• We turn again to Rosenberg and Birdzell for the reasons capitalist economies are best able to exploit the growth potential of technology:
  • • i. Entrepreneurship multiplies the sources of innovation.
    • ii. There is a diversity of research organizations, including research universities, and industrial, independent, and government research facilities
    • iii. Markets incorporate strong incentives for innovation
  • Entrepreneurship: Economies in which entrepreneurship is allowed and encouraged are the most innovative
  • Invention may result from individual initiative, but innovation demands using ideas to generate products that consumers will buy. As such, innovation is the outgrowth of entrepreneurship.
    • “The rewards of innovation go primarily to enterprises, rather than to inventive individuals. The payment of a reward is dependent on the commercial success of the innovation. Since commercial success requires the manufacturing and marketing resources of an enterprise, the rewards of innovation can be captured only by enterprises. . . .” (Rosenberg 259)
  • Additionally, economies that rely on entrepreneurship in markets rather than on central direction reap the benefits of having an expansive and diverse range of people generating possibilities for innovation.
    • The more sources of innovative inquiry and risk-taking, the more likely it is that successful innovation will occur
    • Though recent, the personal computer is a representative example of the role entrepreneurship has played in the sustained flow of innovation since the Industrial Revolution. This life and business-altering innovation entered the world economy from a young man’s garage, not from established computer makers, or researchers in the Soviet Union, or even from centralized efforts directed by the governments of capitalist countries like France and Japan
  • Because innovation relies on the willingness and ability to question the established ways of doing things, innovation flourishes in economies where openness, clearly defined property rights, and established rule of law make it easy to start new enterprises
• Decentralization: Economies with sustained gains from innovation typically incorporate a range of funding agents and research organizations that interact both cooperatively and competitively.
  • For example, the existence of strong intellectual property rights encourages university researchers to focus on work with economic potential and encourages entrepreneurs to contract with researchers.
    • The Association of University Technology Managers reported that in 2002 U.S. universities collected almost $1 billion by commercializing inventions of their research faculties, made over 3700 licensing deals, and filed for 6500 patents. The universities own the inventions developed by faculty, but professors and graduate students usually receive about one-third of the income generated by their inventions (Blumenstyk)
  • Legal arrangements like patents and copyrights strengthen the incentives for creativity by giving innovators realistic expectations of receiving the profit their creative endeavors generate. (See Lesson 2 for a more detailed discussion of property rights.)
    • NASA’s Space Shuttle program lists contracts with private companies for a wide range of commercial “spin-offs” from space technology research, including the artificial heart, NASCAR racing insulation, infrared cameras and thermometers, land mine removal devices, prosthesis material, and bar code labels – to add to the list of space-generated products that began with Tang.
• Incentives: Markets incorporate strong incentives – both negative and positive – for innovation.
  • Entrepreneurs willing to risk and capable of innovating and raising productivity are rewarded by profit, which has proven to be a particularly strong positive incentive for innovation.
  • Equally strong is the negative incentive created in a competitive market by the threat of failure hanging over any business that does not keep up with (or lead) the technological developments in its industry.
• The generation and diffusion of technology and innovation occurs in capitalism because of a feedback loop between entrepreneurs and consumers that makes innovation a key competitive tool for businesses.
  • Competition for profit among producers creates incentives for entrepreneurs to pursue innovation in order to:
    • meet consumers’ wants and needs through refinement of existing goods and services or the creation of new ones, and
    • reduce the costs of production and exchange.
  • The existence in markets of the feedback loop between consumer and producer helps to explain why innovation in capitalist economies acts as a sustained, rather than spasmodic, impetus for growth. Entrepreneurs in markets must always be alert to the next possibility, the next improvement, or the next incremental reduction in cost.
    • While other types of economies have been able to innovate, they have not been able to set up the feedback cycle that sustains innovation.
      • The Chinese junk was the most efficient ocean-going vessel of the 15^th century – better even than the caraval with which western economies began their Age of Discovery. However, the Chinese junk of the 19^th century was essentially the same as that of the 15^th.
      • In the same period, innovation spurred by commercial success changed western ships from 15^th century carracks, to 16^th century galleons, to East Indiamen of the 18^th century, to 19^th century steam-ships. (For more detailed discussion of these and other examples, see Rosenberg and Birdzell 257-262.)

5. Innovative activity has been institutionalized in modern, developed economies and the benefits are spreading to those developing nations taking steps toward greater openness.

• While change has long been recognized as a hallmark of capitalist economies, understanding of the implications of capitalist dynamics evolved more slowly.
  • The ability of capitalist economies to generate new methods of production was recognized early on by Karl Marx and Friedrich Engels
  • In 1847, they predicted that capitalism’s dependence on “constantly revolutionizing the instruments of production” would spell its demise
  • Although their characterization of capitalist competition as dynamic was accurate, their prediction of the end of capitalism clearly was not
• In the 20^th century, Joseph Schumpeter more accurately analyzed the “revolutionizing” character of market competition.
  • He coined the term “creative destruction” to describe the dynamic process by which capitalism continually renews itself
  • However, he argued that the incentive structure that encourages change and innovation in capitalist economies is a source of strength rather than the weakness Marx thought it to be.
• In 2002, Princeton research economist William Baumol noted (in The Free Market Innovation Machine) that because of the fast pace of technological change in the modern age, business firms must innovate or their products and processes will be rapidly eclipsed by those of competitors. To guard against this ultimate blow, businesses, especially large and high-tech enterprises, incorporate innovation as part of their routine business operations.
  • Today, more than 70% of research and development (R&D) expenditure in the United States is done by private industry. Innovation has become part of firms’ day-to-day activities (Baumol 5).
  • Rather than being a drain on resources, the routine incorporation of R&D generates a positive externality for society. The feedback loop established in market economies at the time of the Industrial Revolution is intact in the modern day: innovation begets innovation.
    • The intellectual spillover from successful innovation generates momentum in a variety of ways:
      • “[N]ew products have often given others the idea for related new products that serve as superior substitutes (for example, the jet airplane as substitute for propeller planes) or serve as supplements to the preceding new products or service (for example, the electric refrigerator as something that followed the creation of the electricity network)” (Baumol 11).
      • The profit from successful marketing of innovations acts as a magnet that attracts more time and energy to innovative endeavors.
  • The negative incentives associated with innovation have also persisted into modern day markets.
    • When technological changes are spreading, firms that do not adopt innovations lose out in the marketplace to those that do – either because progressive firms are able to lower costs and cut prices or because customers prefer the new designs and products made by the progressive firms.
• The rapid growth of technology in the modern age has also changed business attitudes toward knowledge and information in a way that offers benefits for the developing world and for the poor.
  • Although barriers to dissemination continue to exist, firms are, increasingly, finding that there are good reasons to sell or rent knowledge.
    • “Because of licensing and technology trading, innovations are now disseminated with historically unprecedented rapidity. Rather than benefiting just a severely limited sub-sector of the industry and the economy, leaving other producers to fend with obsolete techniques and products, the advantages of technical advances are quickly made available to all. This, too, can be expected to make a significant contribution to economic growth” (Baumol 26-27)
  • Globalization, and the reduction of barriers to trade, not only offers the benefits of increased competition (See Lesson 3.), but also strengthens incentives for cost- and price-reducing innovation.
    • The size of the reward for successful innovation depends not on any innate characteristics of the innovation itself, nor of the innovator, but on its success in the market – and bigger markets mean bigger rewards.
      • Opening international trade increases the size of the market and thus the potential reward for innovation.
        • As the economies of developing countries like China and India open, their huge populations draw the attention of profit-motivated innovators and entrepreneurs.

6. Throughout history and continuing into the 21^st century, technological change has generated disproportionately greater gains in standard-of-living for the poor than for the wealthy.

• Common-sense analysis suggests that a 10% increase in well-being, which would just add to the comforts of the wealthy, may actually lift the poor out of life-shortening misery.
• This intuitive expectation is supported by historical evidence asserting that the sustained period of innovation that began with the Industrial Revolution conferred its greatest benefits on the lowest classes:
  • i. Commonly-used measures of well-being – both economic (real wages, real consumption per capita) and social (physical stature, infant mortality) – indicate that living standards increased slowly during the first century of the Industrial Revolution, and then, after 1850, spread to greater and greater numbers of people.
    • After 1850, the evidence is unequivocal:
      • GDP per capita more than doubled in every western country between 1850 and 1914, and income distributions became less unequal.
      • Food and housing consumption grew enormously and mortality declined.
  • ii. Other evidence that the Industrial Revolution benefited the poor comes in the form of population studies. In 1798, Malthus predicted that population growth would result in famine and epidemic, but in the century from 1750-1850, British population tripled, and because of economic growth, his dire predictions did not materialize.
    • Industrialization gave England the capacity to provide food and housing – albeit meager by modern standards – to an increasing number of people.
      • The more developed economy of England could not only produce more, but when famine threatened, it had the resources to purchase food from overseas
    • On the other hand, in areas like Ireland, where new technologies spread more slowly, devastating famine continued to throw up barriers to population growth and rising standards of living.
• Although it is difficult to measure the degree of improvement with precision, quality of life clearly improved as people at all income levels experienced greater comfort and security.
  • Wealth has always allowed those at the top of the income scale to escape drudgery and to reduce discomfort and risk by paying someone else to bear hardships for them.
  • As the examples below illustrate, the innovations that reduce the cost of additional comforts to the wealthy conferred life-changing benefits on the poor.

Selected Examples from History

(Note: Teachers are encouraged to add to this list, and to expand on the long-term effects of various innovations on the well-being of ordinary people.)

Innovation Changed the Lives of Ordinary People

The advances of the Industrial Revolution were awe-inspiring technological accomplishments. It is easy, therefore, to understand why historical studies often focus on the inventions and innovations themselves rather than on incremental changes they effected in the lives of everyday people. Cotton underwear, cheaper bread, and canned vegetables seem mundane when compared to steam engines and tractors, but they are bits and pieces that added up to healthier, more comfortable lives for ordinary people in western economies.

Cotton clothing

• Innovations in cotton processing – carding, spinning, weaving, and dyeing – led both to large increases in the supply of cotton cloth and sharp declines in price, which made cotton clothing available to the masses.
• Cotton has many advantages over the coarser textiles then in general use. It was ideal for making comfortable undergarments because it chafed much less than other fabrics; it was easily laundered, which improved sanitation and health; and it could be cheaply printed with colorful designs.

Transportation

• Improvements in transportation came in the 18^th century and with noted technological advances appearing in the early 19^th century, first with the steamboat and then with railroads.
  • Lower transportation costs reduced the prices of bread and other bulky products that had to be transported long distances.
  • Use of steam engines to transport coal greatly reduced the cost of home heating, which increased comfort and health.

Occupational Safety

• Other inventions resulting from the Industrial Revolution improved working conditions in occupations held largely by the poor.
  • Steam engines were used to pump water from coal mines.
  • The “miner’s friend” improved mine safety by spreading lamp flame through a wire gauze to prevent explosions
• Innovations reduced the danger and misery of life in the military, one of the few options available to poor, landless young men.
  • The marine chronometer improved navigation and reduced the occurrence of shipwrecks
  • Ships made with iron, and later with steel, further improved the seaworthiness of ocean-going vessels.
    • (And when, in 1912, the Titanic revealed all too clearly the shortcomings of metal-clad ocean liners, the wireless telegraph put out the call for help.)

Health and Medicine

• Of all the late 18^th century innovations, the smallpox vaccine, created by Edward Jenner in 1796, probably provided the greatest good for the greatest number.
  • Various historical records indicate that from the time of the ancient Egyptians, smallpox devastated populations, averaging a 30% or higher fatality rate.
  • In the century before the Industrial Revolution, annual smallpox deaths in London ranged from 500 to 3500. Throughout the period 1675-1800, smallpox deaths outnumbered births in the city. (Population growth continued, however, because of migration.
  • As vaccination became more widely available after 1800, the decline in small pox was dramatic, as a London case study attests:
    • . . . [W]ith roughly half of the population of youth being vaccinated during the period, the annual rates fell from the previous half-century by more than one-third. . . . Significantly, the number of deaths, which in peak years during the previous century, had ranged between 500 and 3500, never exceeded 2000, and averaged fewer than 1500 per year. That figure is particularly significant in that, at the same time as smallpox deaths were reduced, London’s population more than doubled, growing from 1,096,000 in 1800 to 2,651,000 in 1850. (Heinbokel 19)

Food

• Innovation in agriculture has dramatically reduced the cost and increased the availability of food. Although there have been hundreds, even thousands, of innovations in agricultural production, the tractor was undoubtedly one of the most revolutionary.
  • Like many staples of modern production, the history of the tractor is a story of innovation that greatly increased operating performance at the same time that it reduced purchasing price.
    • The early gasoline tractors were patterned after giant steam plows. They were useful for plowing, harrowing, and belt work but not for cultivating fields of growing crops or for powering towed farm equipment.
      • Innovations between 1910 and 1940 included mass production (by Henry Ford), the ability to cultivate among growing row crops, improved air and oil filters, rubber tires, and hydraulic systems, all of which greatly increased tractor life-span and usefulness
  • The spread of the tractor not only reduced the cost of food, but actually increased the amount of land available in the United States for growing human food.
    • As population density increased after the closing of the American frontier in 1890, the number of acres of cropland harvested increased, a trend that continued until about 1920
    • Beginning in the 1920s, tractors replaced draft animals and farmers converted the land used to grow animal feed into cropland producing food and fiber for people.
      • The amount of farm land used in production for humans increased until about 1960, adding nearly 80 million acres of cropland.
      • The reduction in the number of horses and mules allowed an additional 80 million acres of pastureland to be converted into use by dairy cows and beef cattle.

Case 2: Innovation and Sub-Saharan Africa

Overview

The poorest of the world’s poor nations are in Sub-Saharan Africa, an area plagued by famine and war. People with next to nothing are opting to spend their meager incomes on cell phones.

• “A rich man’s toy for most of the past decade, mobile phones are now transforming Africa, helping the continent to leapfrog one of the obstacles to its development. All of sub-Saharan Africa has fewer fixed telephone lines than Manhattan alone. That lack of infrastructure inhibits foreign investment and economic growth. . . . Incredibly for a continent where half the people survive on less than $2 a day, African mobile-phone users now spend more time — and more money — on calls than their counterparts in Europe. In Botswana, more than one person in eight has a mobile phone. In South Africa there are more than 8 million mobiles, compared with just 5 million conventional lines. In chronically war-torn Somalia, mobile phones are popular because they don’t depend on overhead wires that are vulnerable to looters hunting for copper” (Ashurst, Quiet 32).

Cell phones – the everyone-has-one-and-they’re-always-ringing toys of western society – in Africa? What are they thinking? What they’re thinking is that cell phones offer them a step up on the ladder out of poverty.

• Newsweek reports that Trevor Meintjes, a 14 year old street kid in Johannesburg, South Africa, uses his to make a living guarding parked cars (Ashurst, Ringing 16).
• A Nigerian street vendor uses hers to create just-in-time delivery. She brings her produce to town every day, but she can’t always anticipate demand. Stopping by her stand at lunch, her customers know that if she doesn’t have what they want, she’ll call back to her family and neighbors. Their orders will be in the afternoon produce shipment, ready for pick-up when they get off work.
• A farmer with a broken plow orders the part by phone, saving the day’s work that the trek to town and back to place the order would have taken him in the past.

Innovation Makes Cell Phones a Tool of the African Masses

• Africans have long suffered from the lack of the transportation and communication technology that people in developed economies take for granted. Cell phones are helping to overcome that obstacle.
  • Newsweek reports that in 5 years, Africa gained over 12 million mobile phone connections. By comparison, the whole region had gained only 9 million fixed phone lines in the past 40 years! (Ashurst, Ringing 16)
• Entrepreneurs with creativity and daring are finding ways to bring this life-altering technology to the masses living on less than $2/day.
  • “Strive Masiyiwa is an entrepreneur on a mission. As earnest as his own first name, Masiyiwa, 42, wants to make the mobile telephone a communications tool for Africa’s masses – as cheap and basic as the hand-cranked party line was for Americans early in the last century. ‘Yes, you can make a lot of money out of 10,000 very rich members of your society,’ says Masiyiwa, whose company, Econet, serves mobile-phone customers in six African nations, including his native Zimbabwe. “But you can have packages that bring down the cost and put mobile phones within the reach of ordinary men and women” (Ashurst, Quiet 32).
• Where people do not have credit cards or even bank accounts, the pre-paid phone plan proved to be the innovation that made cell phones useful to ordinary Africans.
  • “When Vodafone UK sent Michael Joseph to Kenya in July 2000 to set up Safaricom, a cell-phone service operator . . . he did not expect the subscriber base to grow beyond 50,000 connections. Today, both Safaricom and rival KenCell Communications . . . have nearly 1.3 million cell-phone subscribers . . . . Wireless technology has had a tremendous effect on people’s lives in Kenya,’ said Joseph. Topping up mobile-phone air time using ‘scratch cards’ is now a common activity for millions of citizens who before had to walk many miles to make a phone call” (Wachira 32).
• Wired News reports that other entrepreneurs have gone a step further, innovating by challenging the traditional conception of cell phones as individual, personal possessions. (And also illustrating that sometimes, the most innovative entrepreneurs are not those offering new things, but those willing to risk new ideas and ways of doing business.)
  • “. . . [M]arketing cell phones, which cost around $100, has not been taken lightly in a region where more than half the population lives on less than $2 a day. Two words have revolutionized the spread of cell-phone usage in Africa: community access. While most people here cannot afford a cell phone, this has not prevented thousands of poor villagers from transforming their friends and families into walking communications nodes. This setup is deeply rooted in the traditional African communal mode of living, which many urban dwellers haven’t abandoned. Francis Nyamnjoh, an associate professor in the sociology department at the University of Botswana, says African cell-phone operators are finding they can mine profits from these communal setups and, at the same time, transform telecommunications services into mass-market products. . . . He says in many situations it takes a single individual to own a cell phone or computer for whole groups of communities to benefit. . . . This community access model is also proving to be a rainmaker for cell-phone carriers. Recent research by Merrill Lynch indicates that the average monthly revenue per cell-phone user in Nigeria is much higher than that of South Africa and the United States. Nigeria’s economy is six times smaller than that of South Africa and 1,000 times smaller than that of the United States. This suggests that the economic and social value of a cell phone in countries like Nigeria is much higher than it is in Western nations. . . ” (Wachira 32).

The Impact of Spreading Cell Phone Access

• Widespread poverty and a low level of commercial activity make it difficult to measure precisely the impact of cell phones on the everyday well-being of Africans. However, the continually growing demand testifies strongly that the benefits are real. Other indicators include evidence, reported by Newsweek, about consumer preferences and business spillovers:
  • Beer sales have long been regarded as a reliable indicator of average Africans’ buying power. Newsweek reports, however, that South African Breweries, one of the largest conglomerates on the African continent, conducted consumer research to find out why beer sales were falling. The unsettling discovery for the Brewer was that consumers were spending more of their income on mobile phone calls
  • “Research in other developing countries suggests that every dollar invested in telecoms generates up to $6 of economic activity in other sectors — from old-fashioned manufacturing and retail to new cybertechnologies” (Ashurst, Ringing 16)
• The spread of cell phones in African countries is having political and social, as well as economic, impact:
  • “[M]obile phones have transformed everything from Africans’ sense of empowerment to the way their countries work. . . . Modern digital networks have given citizens unprecedented power to scrutinize – and criticize – their leaders. Governments intolerant of dissent have grown to fear the mighty mobile. And its proliferation has forced greater transparency in government and business alike . . .” (Ashhurst, Ringing 16).
    • For example, the cell phone is credited with helping to end 40 years of one party rule in Senegal, where volunteers with cell phones relayed the results of each ballot box to journalists on the country’s radio stations.

7. Technological change typically creates “losers” as well as “winners.” Nonetheless, there are net gains to society in the progress generated by innovation.

• It is difficult to think of any technological change that does not hurt some people or some groups of people, despite the overwhelming benefit it may confer upon others.
• The advent of both the railroad and the automobile hurt harness makers. The tractor hurt horse breeders. The hand-held calculator put slide-rule makers out of business. Even something as beneficial as penicillin and other antibiotics postponed the work of undertakers.
• It is important to remember, however, that displacement of workers by technological change has always been matched and then exceeded by new positions. Historically, there has never been a long-run rise in unemployment from technological change (or from any other source, for that matter).
  • Schumpeter’s concept of “creative destruction” captures this process, in which, as change occurs, some enterprises fail, releasing resources to be used in more valuable ways. (See point 5, above.)
  • While business failure and job loss are a necessary part of economic growth, it is important to understand that they are part of a process that creates new business success and new jobs.
• Capitalist economies outpace all others in economic growth because they accept that change creates both winners and losers.
  • The churning in market economies that may contribute to relative poverty has always existed and will likely continue to do so; technological change – in rich nations and in poor – helps some people and hurts others. (See the discussion of the difference between absolute and relative poverty in Lesson 1 outline.)
    • The process of creative destruction, while it may hurt some poor people, does not single them out. It also hurts the not-so-poor and the rich.
      • The owners of businesses, the holders of obsolete patents, the skilled craftsmen replaced by machinery or those with different skills, the owners of buildings that house technologically obsolete businesses – all pay the price of growth.
  • As with many other features of capitalism, methods of dealing with economic change vary from economy to economy. Some nations do little and others do much to care for those who bear the costs of economic change in loss of income.
  • All capitalist economies, however, share a willingness to accept the inevitable failure and loss that accompany change. Their willingness to do so rests on understanding that, in comparison to losses, gains are far greater and more widespread.

Conclusion

The crowning achievement of capitalism has not been producing silk stockings for Louis XIV and his entourage, but providing cell phone service to poor African vegetable sellers; not producing cheaper candles for those who could afford them in the first place, but creating electric lighting that is within the reach of just about everyone. If the Industrial Revolution had provided more luxuries for those who already lived luxuriously, we could not regard it as a turning point in the struggle out of poverty. The fundamental success of the sustained cascade of innovation that began with the Industrial Revolution and continues to improve standards of living today is attributable to incentives that encourage creativity and reward entrepreneurial risk-taking – incentives that are embodied in open markets and secure rights to intellectual property.

Appendix 1

Non-Market Economies Do Not Sustain Wealth Producing Innovation: The Soviet Union

The history of the Soviet Union illustrates that while invention may be necessary for wealth-producing technological change, it is not sufficient. Only through innovation are the implications of invention translated into the production of goods and services that improve people’s lives.

A country with a vaunted system of scientific education, a culture that admired and exalted scientists, and a government that patronized scientific research with the money and resources that enabled them to rock the complacency of the west by leaping into space, the USSR could only provide its citizens a per capita income less than half that of Americans. The reason is clear, and it lies in the Soviet Union’s institutions – or more accurately, its lack of markets, the most basic institution of capitalism. Without markets, there was no mechanism for the advances in Soviet government-funded research to move from the military and the bureaucracy into the consumer economy.

Background – The Soviet Union Was Resource-Rich

• 1980s population: 290 million (about the same as that of the United States).
• Area: 22,402,200 sq. km. stretched across 9 time zones, incorporating a vast wealth of natural resources (dwarfing the 9,363,520 sq. km. of the United States).
• In 1920, shortly after the communist take-over, the USSR had only a 25% literacy rate, but the Soviet state-run school system effectively transformed the nation into one of the world’s most educated.
• By 1950, there were 1.2 million university-level students.
• By 1980, the literacy rate was one of the highest in the world, outranking those of the U.S. and many western European nations.

Background – The Soviet Union Was a World Leader in Scientific Research

• Acclaim for Soviet technical education was widespread in the world’s scientific community.
• On October 4, 1957, the USSR launched Sputnik 1, a tiny satellite that orbited the planet. By being first in space, the Soviets proved their technological supremacy.
• In 1985, the Soviet Union had 1.5 million research scientists paid by the state, the world’s largest group of scientific researchers.
• The collapse of the USSR set off competition among nations and among private companies. A technology-scouting company, Scientific Dimensions, was started by a New York patent law firm specifically to hire Russian scientists and inventors.
• In 1961, they asserted their leadership again, when Yuri Gagarin became the first man in space.
• Soviet military researchers mastered many problems that American researchers could not. For example, the U.S. space shuttle cannot be launched in rainy weather, but Soviet-designed rocket boosters can be launched anywhere, anytime – even in the snow, wind and cold of the Asian Steppes.

No Markets = No Spillover

• Most people are familiar with bright orange Tang, one of the best-known examples of American innovation – the transfer research knowledge into consumer-goods production. A spin-off from the freeze-drying process developed by the U.S. National Aeronautics and Space Administration (NASA) to feed astronauts, Tang is only one of thousands of products of the sustained cycle of innovation and feedback that powers economic growth in capitalist economies.
  • (NASA maintains a website and publication to highlight successful spillovers from space science and technology to the commercial sector. For more information, see http://www.nasatech.com/spinoff/ .)
• The Soviet Union, despite its scientific prowess, its well-educated, inventive researchers, and its many technological firsts, could not translate inventive prowess into improved well-being for its citizens: 
  • Soviet GNP was $2,659.5 billion, less than half of the United States’ $5,233.3 billion. 
    • Soviet per capita income was $9,211, compared to Americans’ $21,082. 
    • Infant mortality rates had risen from 22.9/1000 in 1971 to 33/1000 in 1989. 
    • In rural areas where 1/3 of Soviets lived, half the hospitals had no sewers and 80% had no hot water. 
    • Everyday goods and services taken for granted in capitalist societies were in perennial short supply in the Soviet Union, and standing in line for hours to purchase food and other basics was a routine part of Soviet life
    • The glaring economic reality of life in the Soviet Union was that a country comparable to the U.S. in so many dimensions in 1990 was not able to offer its citizens anything remotely close to the standard of living Americans enjoyed.

(For additional background and teaching materials on the non-market economy of the USSR, see the FTE’s high school curriculum unit, “The Economic Demise of the Soviet Union.)

Classroom Activities	Lectures
It’s Not Rocket Science	Entrepreneurship and Innovation (18 min.) Innovation and Poverty (15 min.)