05/31/2010 05:12 am ET | Updated May 25, 2011

Innovation Poses Risks for Older Workers and Firms

Saying that innovation poses significant risks might seem rather counterintuitive. After all, innovation expands the productive capacity of the economy by increasing output, consumption, and wages. However, it also has a dark side that creates risks, particularly for older businesses and workers.

Older workers are often less able to adopt new technologies. Acquiring the skills and knowledge necessary to keep up with the technological frontier may be prohibitively difficult or economically unappealing after a certain age. As a result, following periods of above-average innovation activity, labor of older cohorts of workers may become less valuable as they have to compete with the newer generations of workers in the labor market. The same effect can be seen with older firms. Innovation brings competition, shrinking profit margins and adversely affecting the stock market value of older firms.

So while innovation is good for the overall economy, it does more good for some than others. New generations of entrepreneurs and workers benefit more from innovation activity than the older cohorts of households. My co-authors and I call this the "displacement effect." In our research, we've applied this concept to the measurement of risk in financial markets and found that the traditional way of measuring risk and financial returns -- using aggregate data -- is misleading because it fails to properly account for displacement risk. We need to measure consumption and wealth risk faced by the same cohort of households over time rather than relying on the average, aggregate numbers, which cover both the old and new cohorts of households.

To illustrate the displacement concept, and the measurement problems it creates, consider the following hypothetical example. Let's say that right now the average household consumption is $100,000 a year. But looking 10 years down the road, assuming that successful waves of innovation take place, there will be newer, more successful households on the scene with higher consumption, e.g., $200,000 a year. Consumption of the older households' from the original study may only have risen to $120,000 by that time. Assuming a four-to-one ratio of the older and newer households at the ten-year mark, this creates an average household consumption rate of $136,000 a year.

Looking at those numbers, it appears that the average consumption rate increased from $100,000 to $136,000 a year, a 36% gain, but that wasn't really the case. The consumption rate of the older households increased by 20%, much less than suggested by the aggregate numbers which factor in the newer households who have entered the economy during the 10-year period of the study. The critical piece missing from the study is the displacement effect. To take displacement and the risk it creates into account, we need to analyze the entire cross-section of households, their ages, and the cohort-specific effects in their consumption.

It turns out that the cross-sectional differences in household consumption are connected to the realized history of returns in financial markets. In particular, inter-cohort consumption differences are linked to the realized return differential between growth and value stocks. The same innovation shocks that create consumption heterogeneity among households have heterogeneous impact on firms, displacing an average growth firm less than an average value firm. Like we've seen with the labor market, the risks and benefits of innovation aren't distributed uniformly in the stock market.

Leonid Kogan holds the Nippon Telephone and Telegraph Chair in Finance at MIT's Sloan School of Management. His full article on this topic, coauthored with Nicolae Gârleanu of the University of California Berkeley and Stavros Panageas of the University of Chicago Booth School of Business, is: The Demographics of Innovation and Asset Returns.