The Significance of Innovation

Abstract

Innovation is fundamental to economic growth. This chapter provides an introduction and overview of innovation and its relationship to economic growth. Firms, industries and countries compete on the basis of innovation. A critical issue is the nature of the relationship between investments in resources, like R&D and realized innovative output and how innovation subsequently affects performance in terms of economic growth. This chapter frames these issues, provides definitions of the various types of innovation and show how innovation and its economic impact is measured. Drawing on recent advances in the literature, the chapter provides an introduction to how economists study innovation, setting the stage for subsequent chapters.

Full text

The Significance of Innovation
July 10, 2004
Maryann Feldman
Rotman School of Management
University of Toronto
Toronto, Canada M4R 1L1
416 485 7609
email: maryann.feldman@rotman.utoronto.ca
Abstract: Innovation is fundamental to economic growth. This chapter provides an
introduction and overview of innovation and its relationship to economic growth. Firms,
industries and countries compete on the basis of innovation. A critical issue is the nature
of the relationship between investments in resources, like R&D and realized innovative
output and how innovation subsequently affects performance in terms of economic
growth. This chapter frames these issues, provides definitions of the various types of
innovation and show how innovation and its economic impact is measured. Drawing on
recent advances in the literature, the chapter provides an introduction to how economists
study innovation, setting the stage for subsequent chapters.
Prepared for the Swedish Institute for Growth Policy Studies
Acknowledgements: I would like to thank Anders Östhol for comments and
suggestions as this chapter developed. This paper has benefited from discussions
with Pontus Braunerhjelm of SNS. I would like to thank Benny Borgman and
Connie Liu for research assistance. Comments are welcome.

Innovation is fundamental to economic growth and development. The ability to
create economic value by introducing new products to the market, redesigning production
processes, or reconfiguring organizational practices is critical to competitive advantage
and growth for firms, industries and countries. The question then becomes how to best
organize resources to create, diffuse and sustain innovation and, moreover, how to
leverage investments made in science and technology, research and development and
related capabilities with the ultimate goal of reaping rewards in terms of wealth creation
and increased standards of living.
The purpose of this chapter is to describe how economists think about and define
innovation and to clarify the role of innovation in economic growth and development.
Economic growth is the traditional purview of macroeconomists yet innovation is
fundamentally about microeconomics. Sound fiscal policy and stable macroeconomic
conditions are certainly important to economic growth but microeconomic concerns such
as the role of government to promote innovation relies on addressing market failures that
inhibit the accumulation of knowledge and aligning incentives for economic agents to
commercialize that knowledge and realize economic value.
Economic Growth and Innovation
Economic growth is most commonly measured using changes in the total value of
goods and services produced by a country’s economy or what is know as Gross Domestic
Product (GDP). Of course, since the size of countries varies this number is adjusted for
the size of the population which provides a crude measure of the average individual’s
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well-being. Figure 2.1 presents GDP per capita estimates for several countries for
comparison. GDP per capita is highest in the United States compared to any of the other
major industrial nations shown. The consensus is that these differences in levels and in
trends is driven by increased productivity that comes from innovation and technological
change.
The study of innovation and economic growth began in earnest in the late 1950s
with the work of Robert Solow (1959) for which he subsequently was awarded the Nobel
Prize. Of course, like any idea that gains currency the foundations had been provided by
earlier scholars, notably Joseph Schumpeter (1934, 1939, 1942). What was important
about Solow’s work was that he empirically demonstrated that 87% of economic growth
in the American economy from 1909 to 1949 was accounted for by an unspecified factor
or residual that he described as technological change. Other studies have refined these
estimates and provided more elegant theoretical models. Most importantly, as a point of
departure, the basic results hold and have been replicated for other countries: the largest
single factor explaining economic growth is not increases in factor inputs but the ability
to extract greater economic value from advances in science and technology. The ability
to extract economic growth from advances in knowledge is the essence of innovation.
Yet Solow’s models treated technological change as exogenous–something that
was outside of the model and thus not subject to economic forces. This is not very
satisfying [say what the models missed/ignored/could not account for] and since we
expect that economic growth should be a function of factors that we can describe,
enumerate and model. Ever since then, economists have focused on trying to understand
the underlying economic attributes of technological change, specifically innovation in
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new products, processes and organizational forms. While innovation is important to the
performance of countries harnessing the potential of innovation is the domain of
microeconomic and there is an increased acceptance of the need to understand innovation
as a processes that relies of individual agents, be they firms or individuals, who recognize
and respond to new opportunities, organize resources and add economic value and
increase productivity.
Clarifying Terms
When an issue is significant the popular discussion may easily become muddled,
terms may be used interchangeably and without precision and as a result the debate
becomes superficial. To avoid this, a series of definitions that discriminate between the
components of innovation will be provided in order to advance the discussion and enrich
the choice of policy options.
In daily conversation, terms like invention and innovation as well as science and
technology, among others, are often used interchangeably. However, for academics and
policymakers there are important distinctions between these terms and these distinctions
give each term a unique meaning and enrich discussion. Invention is about discovery and
the creation of something novel that did not previously exist. Innovation, on the other
hand, carries invention further with the commercial realization of the value of the
invention or the receipt of an economic return. This is a subtle but important distinction.
Thus, patents, the legal protection of an idea reveals an invention while, for example, the
marketing and consumer acceptance of a new drug is evidence of an innovation.
Commercialization is the process that turns an invention into an innovation and
involves defining a concept around who is willing to pay for the new idea, what attributes
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they value and how much they are willing to pay for the added value. Through
commercialization economic value is realized from new ideas and inventions. The
economic profits earned are the rewards. Figure 2.2 demonstrates the weak relationship
between economic growth and patenting for the same countries previously considered in
Figure 2.1. While patenting measures invention, ccommercialization requires the
additional steps of translating inventions into consumer needs and product markets. At
its earliest stages, before applications are easily described or generally appreciated,
realizing the potential of an invention requires a sophisticated understanding of consumer
needs, existing markets for product innovation and factor inputs. Commercialization,
even when ideas are abundant, may not be completed because outcomes are highly
uncertain and risk aversion may cause projects to be delayed or abandoned. Policy
mechanisms such as R&D tax credits or stock options decrease costs and may mitigate
the inherent risk of innovation. Venture capital investment, where the investors are
knowledgeable about the science and the potential market may also serve to reduce
uncertainty.
Realizing the commercial benefit of innovation relies on a variety of inputs. The
most notable knowledge input is embodied in skilled human capital, scientists, engineers
and managers who appreciate and can implement new ideas. Entrepreneurs are the
individuals who organize resources to create value from commercialization (see Thurik,
Chapter 3). Entrepreneurs are typically associated with new firm start-ups, and
individuals who work in large firms are sometimes known as intrapreneur, people who
work in the public sector or in non-profit organizations are often referred to as 'social
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entrepreneurs'. Whatever the nomenclature, these terms demonstrate the ways
individuals act as agents of change in economic systems.
Science, in a broad sense, is the unfettered search for knowledge for the sake of
understanding. That search is based on observed facts that may be replicated through
experimentation or theory. Thus, science begins with conventional preliminary
conditions and searches for some unknown results to address fundamental questions
related to hypothesis about the world. The process of investigation is known broadly as
research and research may be basic with the intention of advancing science or applied
with the orientation towards some practical end. These are two ends of a continuum of
problem solving as basic research suggests avenues of inquiry that are advanced by
applied research. Likewise, research is enriched, made more complex and significant as
applied work creates the need for more theoretical work and suggests new avenues for
further basic research. In addition, and most critically, while science is classified by
disciplines that define traditions of inquiry, and scientists are trained within these specific
traditions, applied problem-solving frequently creates the need for multidisciplinary
teams or even creates new disciplines to colonize the frontiers of knowledge. Examples
would be the rapidly evolving fields of biochemistry and biomedical engineering or the
emerging field of nanotechnology.
In contrast, industrial Research and Development (R&D) is the systematic
augmentation or deepening of knowledge by applying it to some practical problem or
new context with the idea of generating a commercial return. While science is typically
conducted by universities and institutes of higher learning, R&D is typically conducted
by private firms. An important distinction is that private firms have a responsibility to
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earn returns for their shareholders. In general, the more basic the science involved in a
research project the more difficult it is to appropriate the resulting returns. This is due to
particular characteristics of the knowledge that research creates. A variety of government
incentives and public-private partnership programs have evolved over time from
government’s desire to steer private investment towards more basic types of scientific
activity and to stimulate the development of new technologies that private firms would
not consider attractive investments in the absence of some incentives such as direct
grants, R&D subsidies or other programs that encourage firms to conduct projects with
universities or government laboratories (see Henrekson, this volume).
Knowledge has characteristics such as being nonrival and nonexcludable that
classify it as a public good. Nonrival, in the economists’ terminology, indicates that one
person’s use of knowledge does not impede another’s use of it. Consider the example of
a mathematical formula. Knowledge is created when the formula is first derived and
formal proofs are demonstrated. The result is most likely a scholarly publication which
would codify the knowledge, rendering it easy to diffuse and put into practice. Once the
formula is known, the fact that one scientist uses it does not diminish its usefulness or
utility to other scientists. In fact, the value of the formula may actually increase as a
result of its more diffuse use and acceptance. Thus, knowledge, once created, is nonrival
in that many economic actors may enjoy it simultaneously. Nonexcludability refers to the
fact that once knowledge is discovered it is difficult to contain or to prevent others from
using that knowledge. Once an idea is known it frequently seems obvious to others and
can be simply replicated at what is known as zero marginal cost.
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As a result of these two conditions, the social value of knowledge is greater than
the value that the creator may be able to capture, a classic case of an externality. Private
firms are likely to under-invest in knowledge production since the returns to the firm are
smaller than the returns to society. Patents and copyrights, which extend property rights
to knowledge and ideas, are one way, although imperfect, to create markets for the use of
new ideas.
Innovation is subtly different from technology, which is the embodiment of
knowledge into a physical form. Technological change is the rate at which new
knowledge is put into physical forms and diffused for use in the economy. Major
technological advances, such as the steam engine or microprocessors are known as
general purpose technology as they have broad applications and productivity-enhancing
effects in a number of different sectors. As a result, general purpose technologies induce
dramatic economic changes by creating innovation that rejuvenates existing sectors and,
in the process, create new industries and services. A historical example is the steam
engine, the Internet is a more recent example. The Dot-Com bubble notwithstanding, the
Internet has fundamentally changed the way business transactions take place, creating
efficiencies and productivity growth for existing firms as well as new opportunities for
entrepreneurs. Alan Greenspan attributes the expansion of the Information Technology
(IT) sector as accounting for at least one-third of the total growth of the United States’
economy since 1992. In 1999, the IT sector became the largest commercial sector in the
U.S., with job growth six times the average rate.
Yet it is important to remember that innovation also encompasses incremental
improvements to existing products or processes. Indeed, the vast majority of innovation
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may be attributed to minor improvements, adjustments and refinements to existing
products, manufacturing process and organizational practices. While not particularly
glamorous these activities add economic value and, in sum, provide a basis for sustained
competitive advantage. In addition, while science is important to innovation, new ideas
are frequently suggested by individuals who work on the shop floor, who use products
and who supply machinery or materials. Indeed, innovation spans the spectrum of
industrial activity. The view that innovation is limited to new science-based or so called
high technology industries is a myopic as it ignores the equally transformative nature of
innovation in existing mature industries that are already in place. Consider Proctor and
Gamble’s new product innovation, the Swiffer, which revolutionized household floor care
in the very mundane product category of brooms and mops. Within six months of
introduction, Swiffer had captured one-quarter of the market, the total size of which was
estimated at $436.5 million in 2002. Thus, innovation may be profitable in mature
industries.
As mentioned earlier, economic growth is, most simply, increases in wealth as
measured by indicators such as Gross National Product (GNP) or Gross Domestic
Product (GDP) for countries. For sub-national or local jurisdictions, increases in
employment or in the tax base are a measure of growth. The corollary for firms is output
measures such as sales or profits or market share. In contrast, economic development, in
the case of a country, is associated with structural evolution such as the development of
industries that create higher value-added activities. An example of structural transition
for a country is the evolution from an economy dependent on agriculture to one with
substantial manufacturing and presumably a large share for export. Most critically,
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causality between economic growth and economic development is uni-directional: while
economic development likely leads to economic growth, continued economic growth
does not necessarily imply economic development. What is needed for economic
development is the addition of new infrastructure and complementary human capital.
While new ideas and innovation may guide industry evolution, government as an agent of
collective action guides economic development.
The corollary to economic development for firms is the evolution of the product
line towards more sophisticated, higher value added products as, for example, Intel
became a microprocessor firm instead of a semiconductor manufacturer. Andy Groves,
in a book provocatively entitled Only the Paranoid Survive, describes how Intel
recognized that it couldn’t compete with Asian firms in the DRAM market and instead
strategically moved into the more knowledge intensive and profitable product line of
integrated circuits. To succeed at such a transition requires a firm to recognize new
opportunities and develop new capabilities. Many firms do not make this transition in
what has become widely popularized through Clayton Christensen (1992) as the
Innovator’s Dilemma–where successful firms become captive to their customers and
existing markets and fail to recognize that radically new disruptive technologies are
changing market opportunities.
In simplest terms, a country’s economy is the sum of the collection of firms
located there. The fortune of the firms and their respective industries will determine the
growth and development of the country’s economy. Firms will innovate when there is a
profit incentive to do so, but government has a significant role in both providing
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incentives and correcting market failures. Our emphasis on policy underscores the role of
government in promoting commercialization.
The Role of Government in Innovation
Like firms, governments are socially constructed entities that can raise funds,
organize resources and live on in perpetuity or at least do these things better than
individuals can. Following this logic, government is a legitimate tool by which
individuals can further their shared interests by acting in common. Certainly,
governments have more complex objective functions overall than do firms. However
when we think about economic growth and development specifically within the context
of innovation and industrial competitiveness, the analogy is instructive. For firms, the
overarching goal is to gain and maintain competitive advantage, which translates into
above average returns for shareholders. For government, the shareholders are citizens.
For firms, the way to achieve competitive advantage is to create a competitive
strategy that is consistent with trends in the firm’s industry and appropriate to the firm’s
resources and capabilities (Porter 1996). Feldman and Martin (2004) argue that
governments may engage in a similar exercise that considers the unique and not easily
replicated assets, resources and skill set contained in a jurisdiction and the position of the
jurisdiction relative to the hierarchy of cities in the regional, national and world economy.
At the national level, it will be increasingly important to understand the role of
individual cities or regions in constructing competitive advantage and economic growth
(see Scott this volume). If a nation is comprised of individual jurisdictions that each
attempt to attract the currently fashionable industries (e.g. biotechnology or
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nanotechnology) and compete against one another, then the overall nations’ prosperity
potential may be diminished. Just as there is multiplicity of outcomes of corporate
strategy, there are likely to be many different models that emerge with respect to how
government and firms may work together to foster innovation and economic growth.
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References
Christensen, C. 2003. The Innovator’s Dilemm. New York: HarpersBusiness.
Feldman, M.P. and R. Martin. 2004. “Jurisdictional Advantage” National Bureau of
Economic Research (NBER) working paper.
Freeman, C. and L. Soete 1997. The Economics of Industrial Innovation. Cambridge,
MA: MIT Press.
Porter, M. E. 1996. What is strategy? Harvard Business Review. 74(6): 61.
Schumpeter, J.A. 1934. Theory of Economic Development (1911, in German; tr. 1934).
Cambridge, MA: Harvard University Press.
Schumpeter, J.A. 1939. Business Cycles: a Theoretical, Historical and Statistical
Analysis of the Capitalist Process. 2 volumes. New York: McGraw-Hill.
Schumpeter, J. A. 1942. Capitalism, Socialism, and Democracy. New York: Harper &
Row 1976 edition.
Solow, Robert M. “Technical Change and the Aggregate Production Function,” Review of
Economics and Statistics, 1957, pp. 312-320.
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Table 2.1: Real GDP per Capita for Selected Countries, 1970-2001
(PPPs of 1995 USD)
Source: OECD, Statistical Compendium via Internet 2003-10-09 (National Accounts Vol. 1) and
Statistical Compe ndium via Internet 2003-10-09 (OECD Economic Outlook).
0
5
10
15
20
25
30
35
1970
1972
Real GD
Franc
United States
d Kingdom
Unite
en
Japan
Swed
Germany
e
P
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
Year
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Figure 2.2
¾ Source: Patent Application: OECD.org, Science, Technology and Patents
Database 2004-02-23. Additional Calculations by Benny Borgman, SNS (Center
for Business and Policy Studies)
Correlation between Real GDP/Cap and Patent Applications/Cap. 1981 - 2001.
R2 = 0,0629
Rea l GDP/Ca p
Pate nt Applications/C ap
14