The substitution effect or how technology can destroy wealth

Substitution for better products

Remember when you bought your first smartphone. Let’s say it cost you € 300. The smartphone suddenly replaced:

  • Your old mobile.
  • Your radio.
  • Your stereo or your i-pod.
  • Your watch. Your alarm clock.
  • Your road maps or your TomTom.
  • Your camera.
  • An encyclopedia
  • An agenda
  • Books
  • The daily newspaper

Your purchase contributed to the country’s GDP, say, about € 300. If there had been no smartphone to buy, you would probably have bought the aforementioned products sooner or later for, say, around € 1,000. In other words, the contribution to GDP would have been much higher.

Smartphones are only one example among others of how innovation replaces services and reduces invoices globally.

Replacement by software and robots

There is a lot of talk about artificial intelligence and robotics as job destroyers. In some cases it is obvious. Just compare a Ford T manufacturing plant at the beginning of the 20th century, full of human activity, and compare it with a modern factory, where a handful of workers supervise hundreds of robots and automatons. In other cases it is more difficult to see. How many jobs does good engineering software eliminate? And accounting software?

In any case, more and more often, a product is directly replacing employees. The exponential increase in computing capacity (Moore’s law) plays in favour of this trend and no longer just low-skilled jobs are lost, but also expert middle managers.
At the same or lower cost, an increase in production and a much lower final price are achieved. This benefits the end consumer, who will pay less for the product.

This can be good or bad, depending on what happens next:

  1. The lower price allows many more people to buy the product. The robotic company invoices the same as before or even more. Profits are reinvested in new products. Employees are relocated to new lines or find work at other companies. Everybody wins.
  2. Although the price is lower, there really is no more market. The company sells with the same margin but globally invoices less. There is a lower contribution to GDP; the state receives fewer taxes. Workers get unemployed and consume less overall. They are no longer consumers of this product, neither of many others. The company may benefit from reducing labour contingencies, and their (fewer) consumers will enjoy better prices, but everyone else loses.

Cases in which technology destroys wealth

As long as the first case prevails in the economy, things improve. This has been the case mostly since the industrial revolution. But in the last twenty years, I have the impression we are increasingly encountering the second case. A wicked effect has taken place: the decrease of turnover and the layoffs outweigh the reduction of prices and production improvement.

Money in circulation always goes into someone’s pocket. If a company has less turnover, it means that it puts less money into circulation and, therefore, less money goes to people’s pockets.

Why don’t these innovative companies sell more, even though their product is now cheaper? First, because if this happens to many companies at a time, in general, there will be less money for salaries. Fewer or lower wages, fewer consumers.
Second, because certain markets are already saturated. After forty years of relative well-being, we have almost everything we need, and the demand is small, except for new needs.
And so we come to the third reason: there are not many new needs because radical innovations are missing. The famous initials R + D + i (research, development and innovation) really deceive: the small i for innovation is the one that takes the lion’s share, while investments in research are small. We are very good at improving present processes, but we are not making the effort we should in the basic research to trigger real quantum leaps in knowledge.

Summing up, the substitution effect causes technological improvement to reduce costs and improve benefits. As the system cannot assimilate the surplus-labour, it reduces the capacity to consume and impoverishes the economy. Necessarily? No, central banks and governments have tools that could compensate, but we’ll talk about that in another chapter.