Jobs, Living Standards and Well-Being

Translating Innovation Into Increases in Living Standards

Andrew Sharpe

In principle, innovation spurs productivity growth, which leads to rising incomes and living standards. In practice, this relationship is not quite so simple. The linkage, or nexus, between innovation and productivity and living standards is by no means automatic. There are significant measurement issues, and the relationship between productivity and real wages is complex. However, policies can help to tighten the relationship between innovation and broad-based improvements in living standards.

UNDERESTIMATING INCREASES IN LIVING STANDARDS

Innovations are very diverse in nature and range greatly in their impact on well-being and consumer welfare. Innovations have traditionally been divided into process innovations that reduce costs in the production process and product innovations that change the nature of the product consumed or develop new goods or services. The impact of process innovations on productivity and living standards is relatively straightforward. Process innovations reduce costs and, in competitive markets, prices fall. These price declines are captured in a lower rate of growth (or absolute fall) in the Consumer Price Index. For a given gain in nominal wages or incomes, the population is better off in real terms.

The impact of product innovation, which results in improved or new products, on measured living standards must also pass through changes in prices indices. But there is a problem. Improvements in product quality, and even more so the appearance of new products, are not captured in price indices. To be sure, statistical offices have a long history of attempting to adjust prices for quality, starting with the automobile and continuing with computers. But many economists feel that these adjustments are grossly inadequate, especially for new products. And consequently, official data greatly underestimate real improvements in living standards. Indeed, William Nordhaus from Yale University writes:

During periods of major technological change, the construction of price indexes that capture the impact of new technologies on living standards is beyond the practical capability of official statistical agencies. The essential difficulty arises from the obvious but usually overlooked reason that most of the goods consumed today were not produced a century ago.

Nordhaus points out that the standard methodology for measuring prices captures small changes but misses the revolutionary improvements in economic life. These measures overstate price growth because they may not capture quality changes; they measure the price of goods and services but do not capture the change in efficiency of these goods and services; and they do not capture the enormous change in the efficiency of delivery of goods and services when new products are introduced.

Nordhaus estimates that 37 per cent of output is in tectonically shifting sectors. In these sectors, such as medical care, household appliances, electronics, communications, and transportation, change in production and consumption is so vast that price indices do not attempt to capture qualitative changes. An additional 36 per cent of output is in seismically active sectors, such as housing, where there have been major changes but goods and services are still r