The last few decades have featured exceptional technological progress.  Many economic activities that used to be performed with rudimentary tools, such as landline phones and pencils, are now performed with powerful computers connected through fast communication networks. Other activities previously performed by humans are now performed by robots or artificial intelligence. Economic output, however, did not keep pace with this fast and unprecedented technological revolution. Many reasons have been proposed for this decoupling between economic growth and technological progress. A surprising missing explanation is the impact of technology on “rent-seeking” behaviors, that is, behaviors that aim to increase one person’s or firm’s wealth at the expense of others’. While technological improvements make inputs more productive, they also make them better at appropriating the higher production of others. As technologies improve, they disproportionally prompt more rent extraction, decoupling production from technology.

The dual use of technology for production and rent seeking is not a new phenomenon but a fundamental characteristic of technological progress. Gunpowder was critical to clearing land and building infrastructure, as well as colonial conquest. The telegraph revolutionized not only communication but also military strategy. The steam engine and railroads were fundamental for trade, but also for extracting colonial resources by imperial powers. 

While most would argue that these dual effects of technological progress are at play in all economic sectors, they have shown up perhaps most clearly in the financial industry. For example, financial institutions specialized in matching buyers and sellers of securities (an activity commonly referred to as “market making”) are now being continuously updated about their customers’ needs using electronic platforms that track investors’ desired trades instead of having to (cold) call customers on landline telephones and write down their trading wishes on notepads.  Moreover, trading that used to happen verbally or manually in a centralized physical location, like the New York Stock Exchange, now happens digitally through a network of interconnected and automated trading venues. Computing improvements and communication advances sped up the generation, routing, and execution of trade orders: some trades are now implemented within less than a millisecond, while the blink of an eye takes about 400 milliseconds. The technological advancements that facilitated financial market making have benefited society by improving households’ ability to diversify financial portfolios and access liquidity.

Yet, not all technological investments made by financial institutions and traders in the last few decades have been for the benefit of society. For instance, the broad technological advancements that facilitated financial market making were also exploited by high-frequency trading (HFT) firms to take advantage of clients looking to buy and sell securities. High-frequency trading firms hired thousands of highly skilled scientists, purchased the most powerful computers, dug tunnels through mountains, and erected radio towers, all to trade faster than other investors.  While gaining a few milliseconds of trading speed allowed these firms to boost their profits, the economic benefits for society may have been limited. When an HFT firm uses its speed to purchase the security that a pension fund is slowly trying to obtain and then resells it to this same pension fund now at a higher price, the profits generated by the HFT firm’s speed come at the expense of the pension fund.  This is what economists call a “zero-sum game.”  High-frequency trading firms gain from investments that boost their trading profits by reducing the profits of pension funds and other similar institutions. While, in principle, this may seem like a game that simply transfers profits across financial parties, it also affects total output, as those investments detract from alternative activities that would benefit society. The sophisticated trading firm in the example above could have used its human capital and computing power to help the pension fund better fulfill its beneficiaries’ retirement saving goals—rather than trying to appropriate their savings. Put simply, using technological improvements for rent-seeking purposes not only affects how the pie is sliced, but also prevents the pie from reaching its full size!

Empirical studies have recently shown that technological advances in high frequency did promote socially productive activities, such as liquidity in financial markets. Still, they also resulted in an increase in rent-seeking activities, such as opportunistic trading by sophisticated firms that exploit the predictable trading patterns of large institutions, such as pension funds. Therefore, how good these technological advances are for society depends on how financial firms allocate their resources between productive activities like financial market making and socially wasteful rent-seeking activities like predatory trading.

Unfortunately for society, firms’ resource reallocation will likely favor rent seeking. When technological progress facilitates rent-seeking activities, even disproportionately less than they facilitate productive activities, firms will tend to invest a relatively larger portion of their resources in socially wasteful rent seeking.  Why is that? Let’s take the HFT context as an example and assume communication and computing technologies make traders employed to match buyers and sellers 10% more productive and make traders employed to identify predatory trading patterns aimed at extracting profits from other financial institutions 1% more productive. If these technological improvements only affect one firm, it is evident that this one firm will respond to this progress by using more traders for market making. When these technological improvements affect all firms in the industry, the boost in traders’ productivity in extracting profits is now magnified by the fact that other firms make higher profits. Thus, an HFT firm would like other firms to become more profitable by expanding market-making and focusing its own resources on extracting these firms’ now higher profits. In equilibrium, however, all firms allocate more resources to extract resources from other firms and to defend themselves from other firms’ rent-seeking efforts. These are just socially wasteful activities. All firms have a higher incentive to extract profits, and all spend resources to end up in the same place. They would use resources more productively and increase output if they could coordinate, but instead, they waste resources in fighting over a pie that could be larger. 

Once we account for this reallocation of resources within firms, we realize that the social benefits of technological advancements in computing and communication might be lower than we think.  If HFT firms hire many highly skilled workers and purchase the most powerful computers in the world, there might not be enough resources left to find a cure for cancer or to create innovative solutions to society’s important problems. 

Altogether, this implies that one unintended consequence of technological advancements that improve economic productivity is that it makes it more attractive for nefarious agents to try to appropriate the economy’s larger output. Put in layman’s terms, as technological progress allows some people to get richer, it also makes it more attractive for others to try to extract resources from such rich people.  Since technological progress tends to make it disproportionately more appealing for young, intelligent people to become hackers instead of doctors, over time, society might end up dominated by socially wasteful activities aimed at appropriating the profits created by others’ efforts and resources. 

The figures below show how these different forces can interact in an economic model in which firms strategically respond to technological advancements by reallocating their resources between socially beneficial and wasteful activities.

Figure 1 shows that as technological productivity increases (plotted on the x-axis), a larger fraction of firms’ resources is invested in socially wasteful activities (orange line) relative to socially beneficial activities (blue line). 

Figure 1: Resource Allocation

Figure 2 shows that this overinvestment in socially wasteful activities (e.g., predatory trading) inflates the price firms are willing to pay for resources (e.g., talented workers and fast computers) above the social value of these resources (orange line vs. blue line, respectively).

Figure 2: Price of Resources

Figure 3 shows the decoupling between economic output and technology: society’s aggregate output (orange line) falls below its potential (blue line) once we account for firms’ wasteful rent seeking.  In fact, by zooming in on the right side of the figure, we see that technological progress might worsen society once the economy is sufficiently technologically advanced.

Figure 3: Economic Output

To understand the link between technology and economic output, it is important to acknowledge that technological progress affects the incentives of firms and agents to appropriate other parties’ profits. When an economy becomes wealthier, rent-seeking incentives increase and induce a reallocation of resources towards appropriating and defending profits that would be socially more beneficially obtained from productive activities. Regrettably, rent seeking decouples technology and production as technology improves.