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Joe Kennedy: Demand Innovation

By Joe Kennedy November 1, 2013

The demand for better and cheaper services exerts constant pressure on providers to speed up technological and process innovations.

Many of America’s economic difficulties would be solved by higher productivity. Producing more with less would create better jobs, reduce the debt-to-GDP ratio, and increase national income. Great effort has gone into studying how to increase the supply of innovation. Common suggestions include increasing tax incentives for private investment, spending more on research and development, and increasing the number of skilled workers. Yet, little effort has gone into studying the demand for innovation; however, this is where some of the most promising answers lie, for with relatively easy policy changes, we can speed the introduction of an emerging wave of new technology.

The concept behind “demand innovation,” at its simplest, is consumer demand for constantly cheaper and better products.  For example, when you walk into an electronics store you expect that, if you walk out and return a year from now, the televisions will be both cheaper and better. This expectation affects your decision on whether to buy now and what to pay. More importantly, it also affects the company’s expectations about what it needs to do in order to stay competitive. Executives may not know exactly how they will improve both quality and price, but they do know that, unless they find a way, they are likely to lose market share to those that do. Interestingly, this price deflation does not cause consumers to put off buying televisions forever. Instead, they upgrade their sets long before they wear out. They also buy one for the kitchen, bedroom and den.

This demand for constantly cheaper and better products and services applies to every market. The problem is that in major sectors of our economy, including health care, education, government services, construction, transportation, and energy, , and most professional service industries, this demand for innovation does not create constant pressure for productivity improvements. The reason is not that these sectors are somehow different because they involve services rather than manufacturing. At some level, all workers are performing a service, whether it is examining a patient or bolting a seat onto a car. The difference is that the policies surrounding these industries strongly resist the kind of structural changes necessary for higher productivity.

One reason is that customers are often insulated from paying the full cost of what they receive. This “cost veil” reduces their power to choose between suppliers and their incentive to press for lower prices. Another reason is that government policy frequently makes it costly for new providers to enter the market. Although justified as protecting the consumer, these restrictions mainly protect existing providers from competition. Not only has this prevented cheaper and better delivery, but in many cases performance has fallen even though total spending has increased.

Yet change is happening. In every one of the industries mentioned above a new wave of technologies is just beginning to arrive on the market. Much of this innovation is based on information technology. Uber and Lyft are giving riders an alternative to taxi cabs. Massively open online courses threaten to dramatically lower the cost of higher education. Some of these changes are built around material sciences: improvements in photovoltaics and batteries are growing the market for distributed generation. Still others allow consumers to talk to each other and compare quality and prices: ZocDoc allow patients to find and compare doctors while patientslikeme.com lets them communicate and learn from each other.

Slowly, but surely, these innovations will fundamentally disrupt the existing markets. The legal profession is far along this process: applications are down, law schools are firing tenured faculty, firms are under greater price pressure, software is replacing many functions, and people are talking about shortening law school from three years to two. Each of these changes faces resistance.

Productivity would increase much faster in these markets if the innate customer demand for innovation forced producers to innovate faster. This would require giving individuals much more control and information regarding the services government is willing to provide on their behalf. It will also require significant changes from producers. In most cases, companies have to fundamentally restructure their organization and processes in order to take full advantage of new innovations. So far society has refused to allow these changes, hence low productivity. Incumbents worry about surviving and observers fret about the macroeconomic impact of technology replacing more and more jobs.

It is natural to worry. Yet the history of technology tells us that its benefits far outweigh its costs. As the Information Technology and Innovation Foundation has shown, while technology clearly displaces some workers, it generates higher living standards, which in turn create the demand for higher value goods and services as people try to satisfy their higher needs. More importantly, it equalizes incomes by making it possible for virtually everyone to afford multiple clothes, good food, appliances, and a portable phone. Imagine the social effect of innovations that reduced the cost of health care and education while at the same time improving quality.

Past policy has generated tremendous waste. Americans throw away approximately 40 percent of all food produced. The outgoing head of the Centers for Medicare and Medicaid Services recently estimated that 20-30 percent of health spending delivers no benefit to the patient. A recent study of over two thousand college students found that, after four years, 36 percent showed no improvement in critical thinking, complex reasoning, or writing skills.

Restructuring markets so that the demand for better and cheaper services exerts constant pressure on providers will speed the integration of technological and process innovations. It will create great disruption but even greater social benefit. We should begin demanding it.

Joseph V. Kennedy is a Senior Fellow at the Information Technology and Innovation Foundation and President of Kennedy Research, LLC.