Archived — Occasional Paper Number 25: The Economic Determinants of Innovation

by Randall Morck, University of Alberta, and Bernard Yeung, New York University, 2001

Executive Summary

This paper describes what economists know, suspect, and guess about the underlying determinants of innovation. It evaluates the evidence and points out areas where further work is urgently needed. In many cases, no solid conclusions can be drawn. Though the reader may find this frustrating, knowing "what we don't know" is the beginning of wisdom, and also a guide to avoiding public policy gaffes.

A few general facts about innovation are relatively clear. Countries that show more evidence of innovation are richer and grow faster. Companies that show more evidence of innovation post better financial performance and have higher share prices. These broad findings seem quite robust, and justify the current focus of both public policy-makers and corporate decision-makers on fostering innovation.

In a knowledge-based economy, the primary competition is competition to innovate first, not competition to cut prices as standard economics posits. Because sole ownership of an innovation bestows monopoly power, the economic laws of perfect competition do not govern innovators. Their monopolies reward their investment in innovation. But unlike monopolies in standard economic theory, innovation-based monopolies are temporary, for they last only until another innovator makes yesterday's innovation obsolete.

Intellectual property rights prolong innovators' monopolies. Do they encourage more innovation by increasing the economic rewards to successful innovators? Or do they slow innovation by letting yesterday's winners rest on their laurels? Economic theorists have generally assumed the former view, but recent empirical studies seem more consistent with the latter.

Larger firms clearly have an advantage in some types of innovations where large amounts of equipment are required. In general, such capital-intensive research is found in work aimed at modifying, extending, or refining previous innovations. Radical innovations are associated with smaller firms.

Since large firms are required to mobilize the capital needed for much innovation, monopoly problems become an issue. This is one reason why liberalized international trade and capital flows are required in an innovation-based economy. Global markets make monopolies more difficult to establish and maintain, but also allow firms to achieve economies of scale in research funding.

Small firms appear to be at an advantage in producing breakthrough, radical innovations. This raises the issue of whether state support for small firms might encourage such innovations. The evidence does not support this. Industrial policies of this sort seem prone to failure because they invite "rent-seeking" and so end up fostering and subsidizing losers. Firms rationally become innovative at extracting money from governments because that is where the highest return is. Government policy in this area must take care to keep corporations' returns to political lobbying lower than their returns to real innovation.

In general, this means subsidizing firms makes much less sense than subsidizing infrastructure or education, though government failure problems must be kept in check regardless. One consistent finding is that innovation raises the demand for high-skill workers and drives up their wages. Governments should also realize that lower taxes, both personal and corporate, are the simplest and most direct way to subsidize winners rather than losers.

There is a large literature on the tendency of innovative firms to spontaneously form geographical clusters. Although a number of high-profile theories have been proposed to explain this, the data seem most consistent with concentrations of skilled workers attracting the firms that need them, and with those firms attracting more skilled workers, in a positive feedback loop. If so, concentrated pools of skilled labour would seem to underlie cluster formation.

One theory of this ilk, due to Jacobs (1969), appears most strongly supported by the data. It stresses the importance of the cross-industry transfer of ideas, and implies that one-industry clusters like Silicon Valley and Detroit are less stable than more diversified clusters, like Boston, New York, or London. This suggests that highly focused "centers of excellence" might produce only limited innovation.

Corporate governance also seems to matter. Many of the classical capital budgeting tools used by corporate managers work poorly in assessing the returns to innovation. Newer techniques that might be more appropriate are being developed, but are not applied in Canada to any significant extent.

Incentive schemes and corporate intellectual property rights systems that let innovative employees own stakes in their innovations appear to foster "basic research" within corporations. Presumably, corporate scientists know what basic work is needed to pursue financially rewarding applied research later. Promising people a high monetary reward for valuable innovations seems superior to having government committees or corporate managers screen and approve funding proposals for basic or applied research.

Excessive equality may thus be a problem. Studies of Sweden's current dramatic economic problems show clearly that high taxes and job security reduced worker productivity. High personal taxes also kept the pay of skilled workers low and so increased the demand for skilled workers. But the same low wages discouraged the next generation from acquiring skills. Sweden's productivity is low, its skill shortage serious and its economy faltering.

But excessive inequality is also a problem. Countries where established wealthy families control most firms have low rates of innovation. Established wealthy families are content with the status quo, and therefore are understandably unenthusiastic about innovation. Many traditional Canadian policies have the perhaps unintended effect of protecting inherited wealth. These include Canada's high income taxes (which deter the formation of rival concentrations of wealth), low taxes on inherited wealth (which preserve existing wealth concentrations), and a tradition of protectionism (which protects established firms from competition).

Culture also matters. Tradition-bound, class-conscious societies with hierarchical revealed religions are statistically associated with serious economic problems. In such cultures, the elite views business laws that protect entrepreneurs with suspicion. Economic relationships are often confined to relatives and close friends because no legal or cultural penalties enforce business contracts with strangers. Outsiders defeating established power is part of the American cultural mythology. Perhaps government should subsidize American culture and its mythic ideal of "enterprise".

Finally, financial development clearly matters. A competitive financial system helps innovative small players grow quickly and displace established wealth. Large, independent and scientifically sophisticated venture capital funds seem critical in this context.

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