Disruptive Deflationary Technology

Disruptive technological innovations lead to out-sized financial returns, resulting in lower prices and higher quality products for consumers.  According to Professor Christensen from the Harvard Business School, “An innovation that is disruptive allows a whole new population of consumers access to a product or service that was historically only accessible to consumers with a lot of money or a lot of skill”.  While most new firms that enter the market have no chance in unseating incumbents because the performance gap is too wide, a few startups are able to capture new customers by offering a similar product at a lower price, thus gaining the market segment that could not previously afford to buy the product at what was offered by incumbents.  The market becomes expanded by having a new, lower price point entrant, and as the entrant gains more business, the quality of its product also increases.  As such new firms that launch disruptive technologies are able to rise to dominance in the industry.  What is interesting is that these technological innovations have a deflationary force on the economy: a sustained decrease in aggregate price level.

The smartphone for example, is essentially the combination of a mobile phone, a MP3 player, and internet connection at home, but is cheaper than buying all three of the functionalities separately.  Likewise, successful IT startups like Craigslist, Amazon, Google, and Skype have all disrupted and deflated parts of the economy by offering cheaper prices.  Craigslist took an industry where incumbents had charged users high fees and made such a service virtually free.  By providing free and cheap listings, Craigslist was able to build a critical mass of users, and today, remains as the most popular place for viewership and advertisements for free and “classified” types of posts. Likewise, Amazon was first able to increase its market size by undercutting the competition on price.  The online retailer capitalized on its cost advantage of not being subject to the limitations of physical retailers and physical floor space, and ruthlessly priced close to cost to increase sales volume. The Jeff Bezo aphorism soon became “Your margin is my opportunity”, so much so that Amazon now takes massive shipping losses (this reached an all-time high of nearly $7.2 billion in 2016).  But to Amazon this is a trade-off, as its strategy is focused on long-term growth and innovation rather than short term profitability.  Technology as a deflationary force is also evident in the energy industry. Horizontal fracking discovered by U.S. oil producers led to an increase in supply, a rise in competition, and a massive initial drop in crude oil prices (although as mentioned in a previous article, the price of oil is rebounding).

Of course this is not the case for all advances in technology.  As seen in many luxury automobile firms, premium prices are charged to capture early adopters through price discrimination and to continue to fund the firm’s investments in research and development.  But by and large, the effect that technological innovations have had on the economy is deflationary.   This also has implications on the predominating traditional thought that deflation is destructive.  Many economists and central banks including the U.S. Federal Reserve maintain that moderate levels of inflation are needed to drive consumption, push production, and fuel economic growth.  Keynes argued that some inflation was needed to prevent the Paradox of Thrift, where increase in individual savings lead to decrease in aggregate demand and thus a decrease in gross output.

However, in theory, the deflation driven by technology appears to be “benign”, as unlike “malign” deflation where prices fall due to deficient demand (as seen in countries like Spain and France in which reduced consumption, reduced output, and falling wages reinforce each other in a cycle of negative economic growth and high debts), technology deflation is caused by increased output and excess supply resulting from innovations that increase efficiency and reduce cost of goods.  This is illustrated in the figure below: AS shifts to the right, leading to a lower equilibrium point with lower price and greater gross output.

However, some experts do not feel that technology driven deflation is “benign”.  O’Connor argues that long term trends in the U.S. point to slower rates of credit growth and spending growth exacerbated by technology acting as a major source of deflation.  This can be seen in the U.S.’s interest rates, which have been declining for nearly four decades.  

Indeed, the sharing economy and the unprecedented transparency of information provided by the internet has only intensified competition among firms and continues to put downward pressure on price.  I wonder what the implications of this will be on the U.S. economy, and by extension the global economy at large.