15 June 2011

Magic Wand Inflation

Speaking of the difficulty of measuring prices where technology is concerned:
The Great Ephemeralization | Timothy B Lee | Bottom-up:

If an economist at the BLS circa 1961 wanted to know how much the television industry was contributing to GDP, he simply added up the prices of all televisions sold to consumers.

Of course, economists aren’t only interested in measuring national output at a single point of time; they want to measure how the standard of living changes from year to year. If total spending on televisions falls, statisticians need to figure out whether this is because consumers are buying fewer televisions or because televisions are getting more affordable. The distinction is crucial because the former represents a decline in national output, while the latter amounts to an improvement in the standard of living. And of course, economists have to be careful about making apples-to-apples comparisons. For example, the switch from black-and-white to color pushed up average television prices, but it would have been a big mistake to record this as a sign of televisions in general getting more expensive.

There are many important subtleties to measuring changes in economic output, and official statistics have tended to overstate inflation (and hence understate growth rates) to some extent. But the important innovations of the industrial era had some common features that made such problems manageable. They came embodied in discrete physical objects with a fixed feature set. And the value of new innovations was roughly reflected by the prices consumers were willing to pay for them. If consumers were paying twice as much for a 60-inch television as a 40-inch one, it’s reasonable to infer that the former is twice as valuable.

Now imagine an alternate universe in which industrial products did not work this way. Suppose we lived in the world of Harry Potter, and one day in the late 1950s RCA hired a wizard to wave his magic wand and transform all of the world’s black and white sets into color sets. This would clearly represent a large increase in the standard of living—a larger increase, in fact, than the non-magical process whereby people have to buy new, more expensive, televisions. Yet the government in the alternate universe would almost certainly have recorded a smaller increase in GDP. Our own BLS would see consumers buying more expensive televisions while in the Harry Potter universe consumers would be happy with the old, cheap ones. Hence, consumers circa 1970 would be wealthier in that universe than in ours, but official GDP statistics would show just the opposite.

Ephemeralization offers an alternative explanation for the puzzling growth slowdown of the last decade. Every time the software industry displaces a special purpose device, our standard of living improves but measured GDP falls. If what you care about is government revenue, this point might not matter much—it’s hard to tax something if no one’s paying for it. But the real lesson here may not be that the American economy is stagnating, but rather that the government is bad at measuring improvements in our standard of living that come from the software industry.

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