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The Rise of the Digital Capital Economy

April 19, 2015

I just read an interesting article that was published last summer in Foreign AffairsNew World Order: Labor, Capital, and Ideas in the Power Law Economy.  The article was written by MIT professor Erik Brynjolfsson and MIT Principal Research Scientist Andy McAfee, who are also Director and Co-Director respectively of the Initiative on the Digital Economy; and by Michael Spence, professor in NYU’s Stern School of Business, professor and dean emeritus of the Stanford Graduate School of Business, and recipient of the 2001 Nobel Prize in economics.

A major transition is now taking place in our digital economy.  Over the past few decades, advances in technology, and the Internet in particular, have helped create an increasingly global marketplace for labor and capital.  A highly connected, global economy has been rising all around us, whose magnitude and implications were brought to light by NY Times columnist Tom Friedman in his 2005 bestseller The World is Flat: A Brief History of the Globalized World in the Twenty-first Century.

Another bestseller, The Second Machine Age, published last year by Brynjolfsson and McAfee, is now helping to explain our new era of data science, AI and advanced automation.  These second age machines are being increasingly applied to activities requiring intelligence and cognitive capabilities that not long ago were viewed as the exclusive domain of humans, while enabling us to process vast amounts of information and tackle ever more complex problems.

These advanced machines are ushering a new kind of digital capital economy, quite different from the flat-world economy of only a decade ago.  The winners are no longer those able to compete solely based on cheap labor or ordinary capital, both of which are being squeezed by automation.

“Fortune will instead favor a third group: those who can innovate and create new products, services, and business models,” says the article.  “So in the future, ideas will be the real scarce inputs in the world – scarcer than both labor and capital – and the few who provide good ideas will reap huge rewards.  Assuring an acceptable standard of living for the rest and building inclusive economies and societies will become increasingly important challenges in the years to come.”

Internet-based Globalization

The industrial economy that prevailed through much of the 20th century saw the rise of major corporations like IBM, GM, GE, P&G and Kodak. Their capital assets – including plants and equipment, sales and distribution, and finance – enabled them to achieve the necessary scale to compete across the country and around the world.  Their management skills enabled them to effectively organize and deploy the necessary large labor force.

Late in the 20th century, the digital technology revolution began to radically change the business environment.  Capital assets and a large labor force were no longer the keys to success, and in fact were often viewed as a noose around legacy companies, making it harder to compete against lean startups in the fast changing digital economy.  Given dramatically lower communications and transaction costs, companies disaggregated their various processes, kept some in-house and outsourced others to supply chain partners around the world in order to optimize the overall costs of their products and services.  As the Foreign Affairsarticle notes, this globalization era is succinctly characterized by these 8 words that you’ll find in the back of iPhones, iPads, and other Apple products: “Designed by Apple in California. Assembled in China.”

“All of this creates opportunities for not only greater efficiencies and profits but also enormous dislocations,” it adds.  “If a worker in China or India can do the same work as one in the United States, then the laws of economics dictate that they will end up earning similar wages (adjusted for some other differences in national productivity).  That’s good news for overall economic efficiency, for consumers, and for workers in developing countries – but not for workers in developed countries who now face low-cost competition.”

Automation-based Globalization 

But the economy has since evolved.  “Even as the globalization story continues, however, an even bigger one is starting to unfold: the story of automation, including artificial intelligence, robotics, 3-D printing, and so on.  And this second story is surpassing the first, with some of its greatest effects destined to hit relatively unskilled workers in developing nations…  As intelligent machines become cheaper and more capable, they will increasingly replace human labor, especially in relatively structured environments such as factories and especially for the most routine and repetitive tasks.  To put it another way, offshoring is often only a way station on the road to automation… In more and more domains, the most cost-effective source of labor is becoming intelligent and flexible machines as opposed to low-wage humans in other countries.”

The article points out that the share of labor in the US economy averaged 64.3% between 1947 to 2000, and has been declining ever since, falling to 57.8% in 2010.  Similar declines in the labor share have been documented in many ofter countries, including China, India and Mexico.  Capital is now a larger share of overall production, and capital-based technologies are rising in importance, including physical assets like computers, robots, and IoT-based smart products of all kinds, as well as intangible assets like software, patents, copyrights and brand value.

But, despite the higher share and importance of capital in the economy, higher earnings are not necessarily accruing to the general investors in those companies.  In a free market, the biggest returns are earned by the scarcest and hence most valuable resources in the economy.  A major portion of capital is now digital capital,including software and hardware technologies, both of which are increasingly ubiquitous and inexpensive.  Software can be replicated and distributed at marginal costs. And the digital technologies that go into computers, robots and smart equipment keep getting cheaper and more powerful over time.

Continue reading the full blog post from April 14, here.