The value of innovation – from a cup of tea to Facebook!
April 24, 2012
By Rachel Lund, PwC Economist
Innovation – the development of new products and processes – has a massive impact on the economy, raising living standards and supporting longer term growth. Innovation is also big business - just think of Facebook. An idea that started in a university bedroom has underpinned a business which is now being valued at around $100 billion.
However, innovation is risky – with no guarantee of success, whatever the level of investment of brainpower, money or media hype. For those wondering how valuable Facebook or similar headline- grabbing companies are, history offers some valuable and surprising lessons about which innovations are really valuable.
We can calculate how much an innovation has added to the economy by looking at both how profitable it is (the producer surplus) and how much better off it makes consumers (the consumer surplus). From a societal point of view the consumer surplus is more interesting and this is what economic historians tend to focus on. Consumer surplus measures the difference between what consumers would have been willing to pay for an item and the price they actually pay, which can be determined using historical data on consumer spending and prices. The results of some studies of the value to consumers of various innovations are shown in the table below.
Consumer surplus generated by a selection of innovations
Source: Hersch and Voth (2009), Leunig and Voth (2010)1 Goulsbee and Klenow (2006), Hausman (2006), Broda and Weinstein (2006)
Two things stand out. First, it appears that humble cups of tea and coffee (with sugar) added more proportionately to the economy than mobile phones and the ability to shop over the internet. These 17th century innovations generated a consumer surplus of somewhere between 8 and 17% of GDP. That is equivalent to £2-4,000 per person in the UK, at today’s prices. When tea was introduced to England in the 17th century it was a huge deal. It rapidly became a staple for even the poorest households, and occupied around 5% of the household budget in 1790 (Hersch and Voth, 2009)2 . Despite a period of severe economic difficulty and downward pressure on wages at the end of the 18th century, spending on tea did not really change. The fact is that when mobile phones were introduced we simply weren’t willing to give up the same proportion of income as our ancestors did for tea, coffee and sugar.
The second point of interest is that innovations which improve the process for making an already existing product have had just as much if not more impact than the invention of entirely new products. Both cotton spinning and the assembly line for cars added more consumer value (as % of GDP) than internet shopping and mobile phones. Process innovations have had big impacts because they make products cheaper and allow more people to buy them. Take Henry Ford’s assembly line for cars: The first cars improved the lives of their owners, but were very expensive and so relatively few people owned them, meaning that total consumer surplus was small. The assembly line made producing cars many times cheaper and enabled US car sales to increase from 64,000 in 1908 to 3.6m in 1923, creating huge benefits for American consumers.
There are a couple of important lessons here for prospective innovators and developers of new ideas like Facebook, for policy-makers looking to drive innovation and for investors trying to capitalize on the “next big thing”. First, life-changing products don’t have to be hi-tech. And second, making something that exists cheap enough for everyone to use it may be a much better investment of your resources than trying to invent something entirely new. Cuppa tea anyone?
1 Leunig, Timothy and Voth, Hans-Joachim, Spinning Welfare: The Gains from Process Innovation in Cotton and Car Production (November 18, 2011). CEP Discussion Paper No. 1050. Available at SSRN: http://ssrn.com/abstract=1961473 or http://dx.doi.org/10.2139/ssrn.1961473
2 Hersh, Jonathan and Voth, Hans-Joachim, Sweet Diversity: Colonial Goods and the Rise of European Living Standards after 1492 (July 17, 2009). Available at SSRN: http://ssrn.com/abstract=1402322 or http://dx.doi.org/10.2139/ssrn.1402322
Contact: Rachel Lund via email or +44 (0) 20 7213 3930