Some months ago, in a semiserious post, I offered a “Second Law of Strategy” in the form of a dictum that “all profits come from routine innovation.”  This second “law”, like the first, was aimed more at consultspeak than economic theory.  Inspired by some airplane reading, I lumped Gary Pisano’s quadrant-diagram varieties of innovation into “strategic” and ”routine” innovation, and drew some heavy lines under his point that most serious money is made from the latter.   The buzz from professional business strategists may be guiding firms towards “disruptive” or model-shattering inventions, but day-in day-out store-minding product improvement is where business success really happens.  Or so I claimed.

Correctly, as it turns out – if economists are to be believed more readily than consultants.  In their recent “How Destructive was Innovation?” Daniel Garcia-Macia, Chang-Tai Hsieh, and Peter Klenow (“GHK”) conclude that, between 1976-1986 and 2003-2013, 75% of US Total Factor Productivity growth results from own-product improvements by incumbent firms, as opposed to “creatively destructive” replacement product development by entrant or rival firms.  Or, as a consultant might put it, reports of the Uberized death and rebirth of American business have been greatly exaggerated.

While it’s easy to declare victory, it’s tempting to quit rather than try to explain GHK’s experiment, reasoning, and conclusions.  What they have done in their paper is design and run a simulated economy – and then use the parameters suggested by the simulation to test a “parsimonious growth model” against the growth of Total Factor Productivity from the first to the second of the periods named above.  The set of parameters that caused the model to best fit the performance of the economy featured incumbent firms, improving their own products, accounting for 75% of the TFP growth.

What is interesting is that GHK’s “parsimonious” – what an elegant way to say intentionally incomplete – growth model does not bear much resemblance to the traditional, aggregate, “top down” models that are the stock in trade of economic growth theory.  Such models feature simple, economy-wide inputs for factors of production, and in their earliest form contained a simple exogenous parameter to represent cumulative technical progress.  The classic ”Solow Model” example might be written as:

In the above, Y stands for total output, or GDP, K and L for capital and labor, and A for technical progress, with the exponents representing “elasticities of output” that, in the Cobb-Douglas functional form shown here, also correspond to shares of output paid to capital and labor.  The classic example, obviously, hugely oversimplifies the workings of an actual economy and is subject to a thousand objections; nonetheless, for developed economies, in numerous studies, K and L have correlated well to the explained, and A to the unexplained, portions of GDP.

By contrast, GHK take a bottom-up approach.  Their production function sums the output of a range of j products, with each product having a quality input q and a labor input l:

Normally, I don’t go for this disaggregated, “microfoundations” sort of production function – but in this case I am trapped.  My Second Law operates at the firm level, and that’s exactly the level at which this function allows GHK to work some magic.  Specifically, they parameterize the function to allow three types of firms to be modeled (and tracked) within it:

1. Firms that improve on existing products – and thereby harm or even replace the firm that makes existing product. This is the dynamic that growth economists have labeled as “Schumperterian”, after that writer’s doctrine of “creative destruction”.
2. Firms that create whole new product varieties, aka the consultants’ beloved “disrupters”, so-called because the new products can embody new business models that can work creative destruction across an entire industry.
3. Firms that improve their own products.

So while in the Solow Model world of equation 1.0, the growth of capital and labor (and ultimately output) was governed by a set of parameters s (savings-investment rate), d (depreciation rate), n (workforce growth rate), and g (growth rate of technical progress) that operate at the macro economy level, GHK are able to deploy parameters that operate at the firm and product level, including:

• λ_i            Probability of own-variety product improvement by incumbent firms.
• δ_e         Probability of creative destruction by entrants.
• δ_i          Probability of creative destruction by incumbents.
• κ_e           Probability of new product varieties by entrants.
• Κ_i         Probability of new product varieties by incumbents.

I won’t claim for a minute to be 100% able to follow this model.  Since GHK are telling me I’m 75% right, I’m undoubtedly biased in my willingness to accept their results.  But it’s fascinating to grapple with GHK’s play-of-firms approach to growth accounting and also with their method of using simulation to generate trial ranges of parameter values to run through their “parsimonious” model.

Truth is, I may be happier with GHK’s actual findings than they are.  Many economists lament the decline in the US of what they call “economic dynamism”, the ability of firm turnover to generate greater net job growth than the more organic job gains of existing firms.  GHK cite a 2014 Journal of Economic Perspectives article by Decker, Haltiwanger, Jarmin, and Miranda (“DHJM”), that discusses the declining rate of startups in the US.  And from my investment adviser days, I can remember cruder forms of the no-pain, no-gain growth hypothesis, such as James Grant’s 1996 The Trouble with Prosperity.

My take is to look for something else to worry about.  DHJM admit that the “optimal pace” of business dynamics is unknown.  And Schumpeter said that an important dynamic of creative destruction was to instill competitive “discipline” even in seemingly secure incumbents.  That one of the best ways to discourage competitors was to improve one’s own products was obvious both to Pisano and to me.  I see no reason to interpret GHK’s findings as anything other than Schumperterian discipline manifesting itself as routine innovation – just as it should.

References

Decker, Ryan, et al. “The role of entrepreneurship in US job creation and economic dynamism.” The Journal of Economic Perspectives 28.3 (2014): 3-24.

Garcia-Macia, Daniel, Chang-Tai Hsieh, and Peter J. Klenow. “How Destructive is Innovation?.” (2015).

Grant, James. The Trouble with Prosperity: The Loss of Fear, the Rise of Speculation, and the Risk to American Savings. Crown Publishing Group (NY), 1996.

Pisano, Gary P. “You need an innovation strategy.” Harvard Business Review 93.6 (2015): 44-54.

Schumpeter, Joseph, A. “Capitalism, socialism, and democracy.” 3^rd Ed., Harper & Row (NY), 1950.