Notes on innovation
Sanjeev Sabhlok
Preliminary Draft21March 2014
Happy to receive input at
Work in progress.This is a preliminary set of ideas/research on innovation.
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Contents
1.Three ways to create value
1.1Method 1: Trade
1.2Method 2: Imitation
1.3Method 3: Innovation
2.Salient aspects of innovation
2.1Types of innovation
2.2Innovation is hard: Knowledge is growing expontentially, but innovation (value add) is barely keeping pace
2.3Difference between innovation and entrepreneurship
2.4Entrepreneurs don’t get richer, mostly go broke
2.5More entrepreneurs is not necessarily a great policy
2.6Key implications
2.6.1We are only interested in ideas that create new value
2.6.2We are not interested in “best” ideas
2.6.3Innovation must be distinguished from waste
3.Market failure theory of innovation
3.1Intellectual theory (Francis Bacon): Knowledge drives innovation
3.2Market Failure Economists
3.3Kenneth Arrow (IPA paper)
3.4Richard Romano (IPA paper)
3.5Romer (Kealey)
3.6Baumol (Kealey)
4.Competition theory of innovation
4.1Adam Smith’s theory
4.2Schumpeter’s theory
4.3Endogenous growth theory
4.3.1Romer’s theory
4.3.2Innovation can occur in research labs, but mostly ‘on the shop floor’
4.4Testing the two theories
4.4.1Whether innovators are highly qualified
4.4.2Anecdotes
4.4.3Inventions
4.4.4Competition as a key driver
4.4.5Signalling by the price system
4.5Planned innovation
4.5.1Continuous improvement/ business R&D
4.5.2Discontinuous (significantly new) innovation
4.6Limitations of planning
4.7Scientists do not innovate; innovators pose questions for science
4.8Science was largely privately funded in the past, and through philanthropic efforts
4.8.1Western governments have funded science only since 1940s
4.9Basic science may be a public good, but commercial R&D is not
4.10Government R&D usually displaces private R&D
4.10.1Paul David and Bronwyn Hall, 2000
4.10.2Paul David, Bronwyn Hall and Andrew Toole, 2000
4.10.3OECD 2003
5.Institutional frameworks
5.1Liberty and dignity (egalitarianism)
5.2Stable, predictatble institutional environment
5.3Property rights
5.4Free market competition: Say’s law (Walrasian market equilibrium)
5.5Profit
5.5.1Do not fix prices!
5.5.2EIU innovation environment index
6.Enablers: Cultural factors
6.1Social rewards and respect for wealth generation
6.2Absence of “tall poppy syndrome”
7.Key ingredient 1: Entrepreneur
7.1Academic courses in entrepreneurship and innovation
7.1.1The University of Swinburne
7.1.2
7.1.3Teaching lateral thinking and innovation in schools and universtities
7.1.4Lean startup (Eric Ries)
7.1.5Learning organisation (John Seddon/Peter Senge) (double loop learning/ system thinking)
7.1.6Wall St. Journal debate
7.2Incentives for academics to innovate
8.Key ingredient 2: Risk taking and venture capital
8.1Entrepreneur must always risk his own capital
8.2Institutions of risk capital
8.2.1Market based options if you HAVE to fund
8.3Venture capital and angel investors
8.3.1The Indus Entrepreneurs
9.Enablers: individual factors
9.1Drive
9.2Number of people
9.3Quality/capability of the individual
9.3.1Immigration matters, but only high-end brainpower
9.4Knowledge and specialisation
9.4.1Adam Smith’s theory of innovation: specialization and competition
9.5Ability to take risks
10.What are governments doing?
10.1Commonwealth: innovation.gov.au
10.1.1Seven innovation priorities
10.1.2Funding startups
10.1.3Tax breaks for R&D
10.2Western Australia: Vouchers
11.Role of government: arguments in favour
11.1R&D
11.2Information gaps?
11.3Coordination?
11.4Protection of intellectual property
11.5Risk?
11.6Successful examples
11.7Preventing brain drain?
11.8Moral hazard
11.9Displacement or crowding out of private research
11.10Public choice question: how can bureacurats without any capacity to innovate support innovation?
12.Role of government: arguments against
12.1Businesses are the “smartest” in their field
12.2No skin in the game
12.3Picking winners is a bad idea: Solyndra
13.List of investions
1
1.Three ways to create value
1.1Method 1: Trade
Economic models of competitive general equilibrium (e.g. Edgeworth box), or Walrasian equilibrium, are based on exchange.
Schumpeter called this the “circular flow”. The circular flow does not drive long term growth. If there was no innovation, it would merely opitimise existing value.
Schumpeter showed that the circular flow has its limitations. He therefore identified a key role for the entrepreneur who identifies new opportunities. The availability of profits signals where money should be invested.
Standard growth models (e.g. Solow’s model) are based on the idea that growth is based on capital accumulation. Dierdre McCloskey has shown that exchange (‘shuffling’) and capital accumulation can modestly increase prosperity but can’t drive the growth mankind has seen in the past few centuries. That requires breaking out of the capital accumulation phase into innovation. No amount of collecting gold will help if there are no new ways to create value.
She calls the entire capitalistic system ‘innovation’, to distinguish it from capital accumulation, which was a common characteristic of pre-captialistic societies.
1.2Method 2: Imitation
Imitating those who are successful can increase wealth. This can be considered to be a low level of innovation, in which existing technology and methods are copied and value created. This is a crucial part of the growth. Every society needs to imitate (“technology transfer”).
Imitation is driven by the availability of information about existing methods. However, profit-seeking activity will usually motivate such transfer of technology
Is there a role for government in helping businesses imitate?There might be a role for the government to ensure that information is widely available, subject to intellectual property right constraints. In this highly globalised world, it is unlikely that many opportunities to imitate are left lying on the roadside.
There is a cost to systematic attempts to innovate. Businesses in Victoria can grow either through innovation or by imitation.
It can be rational to not innovate but to copy. Australian companies prefer to bring technology from abroad and modify to suit Australian conditions.
1.3Method 3: Innovation
Innovation is the process of generating new value by creating and adopting new or significantly improved ways of doing things.
Marx realised this when he noted that “The bourgeoisie cannot exist without constantly revolutionizing the instruments of production” (Communist Manifesto).
As indicated above, Schumpeter showed that entrepreneurs breakes out of the competitive equilibrium by either deploying own capital or other’s capital (profits) towards new forms of production. Society must generate profits before it begins to innovate.
2.Salient aspects of innovation
2.1Types of innovation
According to Schumpeter, there are 5 types of innovation:
(1) The introduction of a new good – or a new quality of a good.
(2) The introduction of a new method of production.
(3) The opening of a new market.
(4) The conquest of a new source of supply of raw-materials or half-manufactured goods.
(5) The carrying out of a new organization.[1]
Four types of innovation: goods and services, organisational process, operational process, and marketing.
Innovation refers to the use of a novel idea or method to create value. Invention refers only to the the idea or method.
2.2Innovation is hard: Knowledge is growing expontentially, but innovation (value add) is barely keeping pace
There is no doubt that “the rate of technical progress amongst humans has been exponentially increasing”[2]. E.g. scientific knowledge doubles every 15 years, or quicker (see figure below). [ Moore's Law is perhaps the most prominent of these examples.[3] If productivity had advanced at this pace, the world would have been wealthier by many orders of magnitude. The rapid advances in education technology, robotics, 3D printing, solar cell technology, and many others, point to rapidly increasing knowedge.
[Figure:
However, the West has been growing quite modestly, compared to the growth in knowledge.
Why?
Growth theory suggests the catch-up hypothesis, that (subject to ability to absorb new technology, attract capital and participate in global markets[4]) countries farthest from the PPF will grow quicker, and others, slower. Those closest to PPD have to innovate, and innovation is hard. Innovation (conversion of ideas into value) is much harder than increasing knowledge.
It is made particularly because of competition, and changes in people’s expectations. People are not willing to pay for outdated technology. The value of ‘outdated’ technology drops to zero quickly. This is the process of creative destruction.
2.3Difference between innovation and entrepreneurship
Entrepeneurship is a complex commercial skill, including people management, finance, technology, marketing, etc.
Type of firm / Type of innovation / Source of people / Source of funds / Issue/sNew startup (entrepreneurial) / Copying (e.g. a new café) / Existing firms / Bank / No role for government
Continuous improvement (e.g. a better café) / Existing firms / Bank / No role for government
Discontinuous improvement (e.g. Facebook) / Innovators/ researchers / Venture capital / Most discussion occurs in this space
Existing firm / Copying / Existing firms / Bank / No role for government
Continuous improvement / Existing firms / Bank / No role for government
Discontinuous improvement / Innovators/ researchers / Mostly bank, but some equity; private equity / No role for government
We note that a bulk of innovative activity occurs on its own momentum, in response to market forces. It is difficult, if not impossible, for a government to get involved in innovation or entrepeneurship.
2.4Entrepreneurs don’t get richer, mostly go broke
Shane's book reveals a bleak picture of entrepreneurship in the U.S. It shows the average new venture will fail within five years, and even successful founders usually earn 35% less over 10 years than they would working for others.At the individual level, the core fact here is the typical, median, right-smack-in-the-middle entrepreneur is a failure.[5]
2.5More entrepreneurs is not necessarily a great policy
You write that "encouraging startups is lousy public policy," based on the data you've examined. What would you propose as policy alternatives? The part that's lousy public policy is the idea that entrepreneurs, regardless of what kind, are good, and if we just have more of them, it's better. But what's a good public policy is if we picked certain kinds of startups, and we emphasized the increase in those. But the way the policies are set up, they don't encourage the specific high-potential startups. Most of the policies are: More entrepreneurs—just let's get volume. It's a very volume-oriented strategy. That's bad public policy.[6]
2.6Key implications
2.6.1We are only interested in ideas that create new value
We are not interested in invention for the sake of invention.
2.6.2We are not interested in “best” ideas
It is not necessary that the “best” product wins in a market (and thus adds value). Factors that make a product attractive to a market can include intangibles, being earliest in the marketplace, and many random factors.
2.6.3Innovation must be distinguished from waste
Innovation does not bear a direct relationship between the skill and effort put into the innovation.
Following innovative activities:
- research and development (R&D)
- product development and testing.
It is possible that some such activities might result in added value. However, by themselves there is no reason to expect that these create value.
3.Market failure theory of innovation
3.1Intellectual theory (Francis Bacon): Knowledge drives innovation
In 1620 Bacon wrote: ‘Printing, gunpowder and the magnet [compass] . . . have changed the whole face and state of things throughout the world.’ In his most famous quote, he said: ‘Knowledge is power.’it was by his study of the Portuguese historians that Bacon concluded that Spain had acquired its power and wealth by copying Henry the Navigator. And how had Henry made his great discoveries? By scientific research. From the chroniclers Bacon learned that in 1419 Henry had retreated to Sagres, an isolated promontory in Algarve in southwest Portugal where, leading a celibate life of austere study and research, he had collected a group of geographers and astronomers and cartographers and shipbuilders to plan a systematic programme of scientific exploration. Under his direction, Henry’s research group had improved the compass, developed the caravelle (a small, rakish ship with fore-and-aft sails and a large rudder that was especially manoeuvrable against the wind) and had constructed novel star maps and other navigational aids, including superior charts. Henry had created the science that had powered first the Portuguese and then the Spanish to global dominance.
Bacon thus concluded that Henry had confirmed that scientific research was the precondition for improvements in technology: ‘If any man think philosophy and universality [science] to be idle studies, he doth not consider that all professions [technology] are from thence served and supplied.’ (Second Book, p. 62.) It was therefore Bacon who first proposed the ‘linear model’ for economic growth:
science → technology → wealth
Bacon said that: ‘The benefits inventors confer extend to the whole human race’ – that is, inventors benefit the whole human race, not any particular individual. Consequently, no one will pay for its development because no one will pay for the development of a concept that cannot be monopolized but that will be used largely by others, including competitors, enemies and the unborn. So Bacon concluded (in an early claim of ‘market failure’) that for science ‘there is no ready money’, which was why governments had to pay for it. Bacon’s full linear model therefore was:
government money → science → technology → wealth
To propagate this idea Bacon in 1605 wrote The Advancement of Learning (which is still in print) to urge the British government to copy Henry the Navigator and to put money into university science.
[But Bacon was wrong]
[Henry] was not a scholar who maintained at Sagres an academic college of disinterested researchers; he was instead a professional soldier who employed technologists opportunistically, as cunning warriors do. And Henry’s involvement with dispassionate science was negligible. [H]e was instead a professional soldier who employed technologists opportunistically, as cunning warriors do.
As for Bacon’s magic trio of gunpowder, the magnetic compass and printing, the first two had been developed in China by around the time of Christ, spreading to Europe via the Silk Road, while printing with movable type, though also developed by the Chinese, was independently invented in Europe by Johann Gutenberg, a goldsmith, around 1440. In none of these cases are the inventors believed to have been anything other than artisans or traders. They were not scholarly researchers.
The key point is that Bacon’s idea was a hypothesis, but that it was never tested. It continues to remain untested.
The opposition’s opening remarks Jul 24th 2012 | Terence KealeyIn his 1605 book "The Advancement of Learning", Francis Bacon described research as a public good: "The benefits derived from inventions may extend to mankind in general." But because private individuals will pay only for private goods, Bacon argued that it fell to governments to subsidise a public good like research.
People still agree with Bacon yet, oddly, their belief is not strongly supported by facts. As Paula Stephan, an economist, wrote in her 2012 book "How Economics Shapes Science": "The ratio of empirical evidence to theory is relatively low."
So, during the 18th and 19th centuries, the French and German governments subsidised science exhaustively, yet the two lead economies were successively those of Britain and America, whose governments barely funded any. The federal government in Washington started to support research significantly only in 1940, 50 years after America had become the richest country in the world, while the British government started to fund research significantly only in 1913, over a century after it had launched the Industrial Revolution.
The contemporary economic evidence is also ambiguous. In 2003 the Organisation for Economic Co-operation and Development (OECD) surveyed a large number of factors that might explain the different growth rates of the world's 21 leading economies between 1971 and 1998, and found that publicly funded research and development (R&D) was not one of them. Unlike privately funded science, publicly funded science does not create wealth.
Why not? One reason, as explained by Paul Romer, an American economist, is that research findings—particularly industrial research findings—can be held as reasonably private goods. A combination of corporate secrecy and patents can provide companies with some exclusivity over the results of their research, so to some degree they will fund it anyway, especially as surveys find a strong correlation between a company's investment in research and its subsequent profits.
Further, companies need not fear that others will easily copy them. When Edwin Mansfield, an economist, examined 48 products that, during the 1970s, had been copied by companies in the chemicals, drugs, electronics and machinery industries of New England, he found that the costs of copying were, on average, 65% of the costs of the original innovation.
Copying is expensive partly because it is hard to acquire the so-called "tacit" knowledge embedded in every innovation. No blueprint can convey all the subtleties of an innovation, which can therefore be copied by others only if they recapitulate the actual innovatory steps. Such recapitulation is expensive.
But there is a further cost to copying, which brings its full cost to 100%. The only people capable of copying innovations are active researchers, and they can remain active only if they produce their own research. Yet active researchers, even in industry, must publish if they are to benchmark their work. So the hidden cost of accessing the research of others is that you have to produce and share your own, which thus acts as the full fee of copying. The fee may be paid indirectly, in the form of knowledge shared with the scientific community at large, but it is so substantial that it pre-empts concerns that innovating companies are necessarily undercut by copying competitors.
Indeed, companies do research in part to trade it. In a 1983 international survey of 102 firms, Thomas Allen of MIT's Sloan School of Management found that no fewer than 23% of their important innovations came from swapping information with rivals: "Managers approached apparently competing firms in other countries directly and were provided with surprisingly free access to their technology."
We see therefore that industrial research is largely a private good (and thus attracts private money), the copying of which forces copiers to invest as fully in their own research. This is why the OECD has speculated that, when governments fund research, they might only displace or crowd out its private funding. Companies fund their own research, so, when governments fund it, companies may simply withdraw their own money.
Clearly there are non-economic reasons for governments to fund science: lung cancer research cannot be entrusted to tobacco companies, or public-health research to drug companies, or economic research to bankers. Defence research is, moreover, a special case, as is research into orphan diseases, climate change and so-called "big science", such as NASA's space science or CERN's Large Hadron Collider.
Yet even the purest of science might be funded by philanthropists if governments did not crowd them out (witness the private funding of Goddard's original space research or of the early cyclotrons, as well as the Gates Foundation's current support for rare diseases)—and, until we know more about crowding out, we should not assume that governments need fund any research.[7]
Full debate:
The myth that science comes prior to innovation is widespread, and shows no sign of abatement.