The Rise of the Digital Capital Economy

• By
 
• IRVING WLADAWSKY-BERGER

Guest Contributor

I just read an interesting article that was published last summer in Foreign Affairs, New 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.

SeongJoon Cho/Bloomberg News

Visitors are silhouetted while standing in front of the Samsung Electronics Co. logo in Seoul, South Korea, Jan. 27, 2015.

Another bestseller, The Second Machine Age, published last year by Mssrs. 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 IBM -1.51%, 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 Affairs article notes, this globalization era is succinctly characterized by these eight 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 U.S. 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 other 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 equipments keep getting cheaper and more powerful over time.

“Digital capital, in short, is abundant, has low marginal costs, and is increasingly important in almost every industry… If digital technologies create cheap substitutes for a growing set of jobs, then it is not a good time to be a laborer. But if digital technologies also increasingly substitute for capital, then all owners of capital should not expect to earn outsized returns, either.”

The scarcest and most valuable resource in this second machine age is neither ordinary labor or capital but highly talented, innovative people.  “Digital technologies increasingly make both ordinary labor and ordinary capital commodities, and so a greater share of the rewards from ideas will go to the creators, innovators, and entrepreneurs. People with ideas, not workers or investors, will be the scarcest resource.”

The Superstar-based Economy

This is giving rise to what the article calls superstar-based technical change, in which a small number of players reap a very large share of the rewards, upending the global economy with their outsize, winner-take-most returns. Whenever a product, service or process is captured in software and digitized, they become digital capital and the economics of abundance take over. They can now be perfectly replicated and transmitted almost instantaneously anywhere in the world at marginal costs. And network effects make them more valuable the more users they have.

The result is that a small number of companies become what this recent study referred to as category kings, dominating the rest of their competitors in their particular market, – the Facebooks, Twitters, Ubers and Instagrams. Category kings generally take over 70% of the total market value in their category, leaving everyone else to split the remaining 30%.  Winners are winning at almost triple the speed since 2000, while losers are losing faster than ever. A company destined to reach a $1 billion dollar valuation, will do so now in one-third the time that it would have taken it just a dozen years ago– 2.9 years in the 2009-2013 era versus 8.5 years in the 2000-2003 era.

Rising Inequality

“Globalization and technological change may increase the wealth and economic efficiency of nations and the world at large, but they will not work to everybody’s advantage, at least in the short to medium term,” note Mssrs. Brynjolfsson, McAfee and Spence in their concluding section. “Ordinary workers, in particular, will continue to bear the brunt of the changes, benefiting as consumers but not necessarily as producers. This means that without further intervention, economic inequality is likely to continue to increase, posing a variety of problems. Unequal incomes can lead to unequal opportunities, depriving nations of access to talent and undermining the social contract. Political power, meanwhile, often follows economic power, in this case undermining democracy.”

This is a very serious issue, as has been noted in a number of other recent articles. Public policy interventions are required to help address these New World Order challenges, including:

• Public provision of high-quality basic services, including education, health and retirement security.
• Public investments in basic research in health, science, technology and education.
• Infrastructure spending on roads, airports, public water and sanitation systems, and energy and communications grids.

“Should the digital revolution continue to be as powerful in the future as it has been in recent years, the structure of the modern economy and the role of work itself may need to be rethought,” they write. “As a group, our descendants may work fewer hours and live better – but both the work and the rewards could be spread even more unequally, with a variety of unpleasant consequences. Creating sustainable, equitable, and inclusive growth will require more than business as usual. The place to start is with a proper understanding of just how fast and far things are evolving.”