"Arguing in My Spare Time," No. 5.04
by Arnold Kling
February 17, 2002
Half this game is 90 percent mental--Yogi Berra
About 25 percent of income in the United States goes to capital, and about 75 percent of income goes to labor. One might say that the U.S. economy is 25 percent physical (as represented by plant and equipment) and 75 percent mental (as represented by human labor). I think that this notion that economic performance is 75 percent mental amounts to a general rule of thumb that applies whether you are trying to start a company, accumulate more weath than your neighbor, or help a country achieve faster economic development.
To launch a company, you need to build infrastructure and to convince people to use your product or service. After observing a number of start-ups, I have come to believe that about 25 percent of the cost of launching a company consists of building the infrastructure and about 75 percent of the cost consists of overcoming customer resistance to the company's offering.
If it is a product company, the infrastructure consists of the first version of the product and any facilities needed for manufacturing and distribution. The cost of overcoming resistance to the product is the cost of marketing and sales. The 75% rule says that in order to achieve a successful product launch, for every dollar that you spend on product development, you will have to spend three dollars on marketing and sales.
When engineers form a company, their instinct is to put all of their budget into product development. However, the world does not beat a path to their door. The problem is that most new products are not as easy to explain or to justify as a better mousetrap. The process of explaining and justifying a new product to consumers is time-consuming and difficult. That is why a substantial budget needs to be allocated to overcoming customer resistance.
I believe that the 75 percent rule of thumb holds for new service companies, as well, but at a lower total cost of launching a company. Service companies typically have lower infrastructure costs, because they do not have to invest as much in developing a product prototype. Service companies also tend to have offerings that are easier to explain to potential customers than a new product. However, the ratio of marketing and sales costs to infrastructure costs probably still is about three to one. That is, if a service company has to spend $100,000 to get started, $25,000 will go toward developing infrastructure that is required to provide the service and $75,000 will go toward convincing initial customers to use the service.
Differences between individuals in wealth can be accounted for by two main factors. One is their differences in the propensity to save. The other is differences in ability to earn.
If you save a higher proportion of your income, then you will accumulate more assets. Ultimately, these assets are backed by physical capital. So savings represents the physical component of wealth.
Earnings capacity represents the other component of wealth. According to Danko and Stanley's The Millionaire Next Door, the highest earnings tend to accrue to people who are in business for themselves. Of course, even among people who work for others, there are substantial differences based on skills and field.
My conjecture would be that if you want to account for the differences in wealth across people, about 25 percent would be explained by differences in the propensity to save--that is, to accumulate ownership of physical assets. My guess is that 75 percent of the differences in wealth across people are accounted for by differences in the ability to earn by their efforts. That is, I suspect that wealth is 75 percent mental.
In his new Macroeconomics textbook, Brad DeLong treats output per worker as the key indicator of economic well-being. The determinants of output per worker are:
Capital per worker represents physical resources. The efficiency of labor represents mental resources. Mental resources include personal education, technological know-how, and cultural and institutional support for economic growth. Cultural and institutional support includes enforcement of contracts and property rights, openness to trade and competition, and the ability to overcome the resistance to new ideas.
There is a plausible argument that the 25%-75% relationship holds for these two determinants of output per worker. That is, economic growth is about 25 percent physical and 75 percent mental. The fact that about 25 percent of income goes to capital is consistent with a value of about .25 for what DeLong calls the "diminishing returns parameter" for capital. That is, if we increase the ratio of capital per worker by 1 percent, we will increase the ratio of output per worker by 0.25 percent. By the same token, a growth rate in the efficency of labor of 1 percent will increase output per worker by 0.75 percent.
The efficiency of labor is not a figure that is reported by government statistical agencies. The Department of Labor and the Department of Commerce attempt to measure, however imperfectly, the total hours that people work, the value of what is produced, and the value of the capital stock that is used in production. However, the efficiency of labor is something that an economist must impute in order to account for changes in output per worker.
DeLong says that our standard of living is between 14 and 25 times what it was one hundred years ago. This is the cumulative result of the average increase in output per worker of 3 percent per year. This is one percent higher than the official measures, which many economists believe are biased downward.
What accounts for this much higher standard of living? Again, about 25 percent of it can be explained by a higher ratio of capital to labor. The rest of it comes from higher efficiency of labor--the mental component, if you will.
One of the puzzles of economic development is that countries have failed to converge. Fifty years ago, most economists would have predicted faster growth in underdeveloped countries than in the developed world. Implicitly, they were assuming that growth is determined mostly by physical capital. Because there was much more room for physical capital to increase at a higher rate in percentage terms in underdeveloped countries than in developed countries, there should have been a trend toward convergence.
Instead, DeLong reports,
As development economist Lant Pritchett puts it, the dominant feature of world economic history is "divergence, big time." In terms of relative incomes and productivity levels, the world today is more unequal and more divergent than ever before...
--Macroeconomics, p. 132
If development only required physical capital, as economists tended to assume in the aftermath of World War II, then we would have seen convergence. However, it turns out that the availability of capital is not sufficient. As Parente and Prescott point out in Barriers to Riches, the ability of interest groups to thwart change accounts for much of the problem of underdevelopment. Thus, I believe that the divergence in development is one more illustration of the rule of thumb that differences in economic circumstances are 75 percent mental.
Our economic system is called capitalism, which suggests that capital accumulation is what is important. However, in many contexts, it seems that this physical component of wealth is not as important as the mental component that is represented by knowledge and cultural adaptability to change. As a rule of thumb, the game is 75 percent mental.