One of the most common responses to my post on middle class incomes was to point out the role of technological progress. If the average American family went back in time to 1989, I wrote, they’d make just as much money but work longer hours to do it. But, some responded, they wouldn’t have iPhones. That isn’t meant to sound trivial, and as someone optimistic about technology I don’t consider it to be. Improvements in technology are an important piece of any conversation about progress. But do they change the story about middle class incomes?
Yes and no.
Short version: All of the data I included adjusted for inflation, which accounts for certain kinds of technological progress but not others. Some new technologies – like the iPhone – aren’t currently captured in that data. Others are. If new technological inventions like the iPhone were able to be included in common inflation measures, the incomes of the middle class would indeed look at least a bit higher.
Here’s the long version, starting with a short overview of inflation.
Measures of inflation track the price of goods over time, and although it’s technically an oversimplification, you can think of such measures – like the Consumer Price Index (CPI) – as a proxy for the cost of living. If the stuff you need to get by costs, in total, $100 per week today, but next year that same stuff costs $200 per week, you’d need to be making twice as much money just to be keeping up. So if you hadn’t gotten any raise over the course of that year, an inflation-adjusted (“real”) accounting of your income would say that your income dropped 50%. Inflation-adjusted income measures account for how much stuff costs.
Prices don’t all change together of course, so the CPI uses a bunch of “baskets” of goods. Food is one part of that. Let’s say the price apples goes up, but the price of bananas goes down. If those changes average out, from the CPI’s perspective, “prices” haven’t changed. (If this happened, you might choose to buy only bananas for a while, in order to take advantage of the low prices. So this is an example of when the CPI starts to diverge from cost-of-living. That’s called the substitution effect and it’s one of the big challenges to measuring inflation, but it’s a bit outside the scope of this post.)
In theory, technological improvements should be captured in measures inflation. Say one of the things most people do is to send letters, documents, and other information to each other. It used to require going to Staples, buying envelopes, paying to print, then paying for postage, etc. Now you can just email them from a relatively inexpensive computer in your home. The price of sending all this stuff, one of your regular life activities, just got cheaper. Inflation is about measuring prices, so a measure of inflation should capture this price decrease. If the inflation measure captures it, it would mean that inflation-adjusted income (like I used in my previous post) would capture the impact of tech.
But in practice, measures of inflation have a really hard time capturing new technologies. To see when inflation does and doesn’t capture technology, let’s go back to the food example.
The kind of technological change that inflation is relatively well set up to track is the kind that results in decreased prices for an existing good. Say a farmer comes up with a new way to grow apples and the result is that the exact same kind of apple you’re used to buying suddenly costs half as much as it used to. The CPI will capture that decrease, and so inflation-adjusted income will reflect the improvement.
But say an agricultural scientist invents some new health shake, unlike any food out there on the market, which provides all your daily calories and nutrients. This counts as a “new good” and inflation measures don’t really have any way to account for it. In practice, if a bunch of people start buying the health shake, after a while the Bureau of Labor Statistics will decide to add it to the CPI and start tracking changes to its price going forward, but this misses the value of the new invention in two respects.
The first, and simpler, problem is that the BLS only updates the CPI’s “baskets” every four years. And for some technologies, prices can drop a lot over that amount of time. So imagine the health shake debuts at $100 per serving, but four years later, by the time the BLS gets around to counting it, it’s going for $20 per serving. That price decrease will be missed.
The second issue is a trickier. The very act of invention, if the new product is novel enough, is simply not accounted for at all in inflation statistics. Here’s how a report from The National Academies puts it:
Without an explicit decision to change the list of goods to be priced, standard indexing procedures will not pick up any of the effect of such newly introduced items on consumers’ living standards or costs…
…If significant numbers of new goods are continually invented and successfully marketed, an upward bias will be imparted to the overall price index, relative to an unqualified [Cost of Living Index]…
…Proponents of more traditional price index methodologies argue that it is a perversion of the language to argue that the effect of, say, the introduction of cell phones or the birth control pill is to reduce the price level, a result that comes from confusing the concept of a price level with that of the cost of living. Their position is tempered somewhat by the realization that, outside of price measurement, there is nowhere else in the national accounts for such product quality improvements to be included and, as Nordhaus (1998) and others have argued, real growth in the economy is thereby understated.
How would the introduction of a brand new good be translated into a change in price? The idea here is that sometimes a new good comes to market at a price lower than some consumers would have been willing to pay. Our magic shake example comes to market at $100 per serving; but perhaps some consumers would have been willing to pay $200 per serving for it, but just never got the chance because the technologies that make it possible hadn’t yet been invented. This difference represents value that inflation measures won’t catch. (An interesting note for innovation econ nerds: this is less likely to be a problem to the extent you see technological innovation as a demand or “pull” driven process. It’s really supply shocks that will cause big problems for inflation measures.) There are econometric techniques that some experts believe could be used to capture this value, but they are complex, controversial, and not yet in use.
To sum up, here’s how to think about it: when Amazon uses better software to make retail more efficient and therefore makes a bunch of consumer products cheaper, that’s captured in our most common measure of inflation. But when a radically new consumer product — like the iPhone — is introduced, some portion of the new value will go uncounted. If the iPhone gets cheaper over the first few years before it is incorporated into the CPI, that value will be lost. But once it is included, improvements in technology that make the iPhone cheaper will be captured.
The result is that inflation-adjusted income measures do fail to account for certain kinds of technological progress. How big is that bias? Best I can tell, we don’t really know. Some have suggested it is sizable, but there is no consensus.
So as for the response — sure, middle class incomes were the same a decade or two ago, for fewer hours worked, but now we have iPhones — it is on to something. It’s perfectly reasonable to point out that certain new tech products are available now and weren’t then, and that income data doesn’t fully capture that. But be careful with this argument. It’s not all new tech that goes un-captured. Lots of the behind-the-scenes increases in efficiency due to tech that result in lower consumer prices are captured, as is at least a portion of the continuing decreases in price for consumer tech products once they’ve been in the market for a while.
So it’s a good point, but a nuanced one.
UPDATE 2/5/14: Martin Wolf at FT nicely captures this in two sentences: “Its price was infinite. The fall from an infinite to a definite price is not reflected in the price indices.”