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Thursday, January 10, 2008

Innovation sparks

Jan 4, 2008
Innovation's bright sparks
By Lam Chuan Leong, For The Straits Times

INNOVATION is now accepted by economists as essential to economic growth. But how does innovation drive markets and vice-versa? What conditions favour innovation?
Innovation consists of two phases: a generative phase and an extrapolative phase.

Because extrapolative innovation is about increasing order and knowledge, I shall refer to it as O-type innovation. O-type innovation is at the heart of most initiatives undertaken by businesses and governments. It uses expert knowledge and processes to identify and solve problems. For example, what the customer needs.

O-type innovation needs a constant supply of new ideas. This is the role of generative innovation. I call the introduction of these ideas V-type innovation to stress their role in increasing variety.

V-type innovation requires an ability to take advantage of unexpected opportunities, and relies on the ability to 'connect' existing ideas that have not previously been linked. These are characteristics usually associated with entrepreneurship.

V-type innovation may be compared to a furnace that supplies the energy to power the O-type, or extrapolative, phase of innovation. These two types work in tandem to create the 'Innovation Cycle', which is the engine of long- term economic growth.

Four factors favour V-type innovation:

1. Free Flow and Spread of Information

First, the free flow and diffusion of information. This is critical to both types of innovation. Without the knowledge of previous generations, even geniuses would have to re-invent the wheel.

Historically, economic growth and prosperity are strongest during those periods when there is a surge of new ideas and inventions brought about by V-type innovation. For example, the growth cycles following the invention of the steam engine, the motor car, electricity and the railroads.

This idea is consistent with neo-classical growth theory, which suggests that technical progress is the key to long-term growth. In other words, it allows us to escape the tyranny of diminishing returns from the traditional inputs of labour and capital.

2. Make it Easy - Free Market Entry and Exit

Second, free market entry and exit. Economies that make it easy for people to start new businesses have a better chance to produce innovation. This is especially so for radically new ideas, which rarely find rapid acceptance. Inventors must find a way to develop a prototype. So it is important that innovators can set up businesses easily to commercialise their ideas.

India claims to have a market- based system, but suffers a lower rate of growth because it has an onerous licensing regime that makes it difficult to set up a business. China did not allow for private business startups during its central planning days. In such circumstances, V-type innovation was not possible. Only O-type innovation - which takes advantage of existing processes to solve problems - was possible.

Besides the ease of market entry, other market characteristics that assist innovation include:

3. The Large Market

Breadth and size: Larger markets tend to have more people willing to use new technologies, thus helping to build up a critical mass of demand for the new product to be commercially viable.

A lack of market distortions, arising from restrictions and control either by governments or from monopolistic practices.

4. Rule of Law and Openess

Transparency and the rule of law: This is especially true with respect to property rights, including intellectual property rights.

Capital markets able to limit, transfer or spread risks: The invention of the limited liability company in particular is crucial because it limits the risks involved in commercialising an invention.
The third factor favouring V-type innovation is a suitable 'selection system'. The free market as we know it today does a good job as a 'selection system'. It is certainly better than a system in which innovations are selected by a planning committee.

With a panel of independent experts, there is always the danger that expert opinion will fail to re-cognise the potential of a new idea. History is full of such mistaken prognoses.

Free market selection can be described as an ex-poste system. New products and services are introduced. They compete with one another and the market chooses the winner. Submitting a novel idea to a panel, however, is an example of ex-ante selection because the choice is made before the production stage is reached.

The broader, deeper, more developed and diversified a market is, the greater the chance that the innovation will take root. It is not surprising that so many radically new innovations take place in the United States, which is the largest and most varied consumer market in the world.

Advanced capital markets tend to do a good job because they use ex-poste selection. Venture capital funds that seek emergent innovations and are prepared to take higher risks play a bridging role. But traditional loan financing from banks is less conducive to V-type innovation because it relies on ex-ante selection, in this case the banker responsible for approving the loan.

Finally, the reward system. Having used time and resources to develop an innovation, the innovator expects a financial return. The economy must provide the means to reward him. This is only possible if assets and intellectual property are protected.

Taxation affects rewards. Overly high income taxation has the effect of expropriating the innovator's return. A tax regime that is non-transparent or often changed raises the risk that the innovator will not be rewarded.

Singapore's case

SINGAPORE scores well in all the areas except in market size. With rare exceptions (mainly on social grounds), information and knowledge flow freely. Foreign companies are able to bring in their technology, skills and people without restriction. Companies can be established easily and at low cost. Both legislation and government policy prevent the development of restrictive market practices.

The selection system is based on a free market. Property rights are enforced, and stability of that protection is ensured. There are no confiscatory tax policies or arbitrary changes in tax laws.

But the economy does not have the size, breadth or depth of markets (physical and financial) to sustain a high rate of V-type innovation. The introduction of totally new ideas is a function of diversity, which is proportional to size. Improved education, skills and knowledge can multiply the effectiveness of O-type innovation, but do little for V-type innovation.

That explains why the state has intervened by giving grants to companies and research centres. This is a good move, but the danger of ex-ante planning, even with the best of intentions, is real.

This state intervention is probably why Singapore's economy is classified as a form of state-guided capitalism in the book Good Capitalism, Bad Capitalism, by William J. Baumol, Robert E. Litan, Carl J. Schramm (Yale University Press, 2007).

This book describes four types of capitalism: state-guided, oligarchic, big-firm and entrepreneurial. The authors argue that entrepreneurial capitalism is best for long-term growth.

State-guided capitalism is not necessarily optimal for sustained high growth, particularly when the country already has a fairly advanced level of development.

Why then does Singapore exhibit such high rates of growth? Is it because the time-frame of measurement is too short? Or are there extenuating circumstances?

In theory, the Singapore economy should show lower growth because it lacks a large, sophisticated market and does not have sufficient size to sustain the Innovation Cycle by itself. But Singapore's economy is not limited to its political boundaries.

This was recognised even in the early 1960s. Singapore was founded as an entrepot to serve the region. The initial economic strategy was to become part of the Malaysian market. When this failed, Singapore did what could now be considered an example of brilliant V-type innovation.

It opened up its economy, welcomed MNCs, and leap-frogged the region by becoming plugged into the global economy and in particular the US economy. This approach was certainly contrary to the conventional economic wisdom of the 1960s.

By plugging into the global economy, Singapore has become part of a larger system. Its growth is powered by an innovation cycle that operates on a transnational basis, even though some of the benefits are diluted as a result of being thousands of miles from the product and financial markets of the developed countries.

The importance of being close to large, diverse markets is underlined by Mr Bill Gates' comment that Microsoft intends to set up research centres only in places with a population of a billion or more, that is, China, India and Europe.

Becoming part of this global cycle of innovation means more than just engaging in trade. It involves actively encouraging foreign companies to bring their technology (O-type innovation) and research activities (V-type innovation) to Singapore. In doing so, they bring with them their knowledge and access to markets.

These companies thus perform the task of bridging the innovation cycle in the Singapore economy with that of other markets. They act like 'transport agents' in this innovation and information exchange in addition to their production and trading activities.

The huge importing power of the American market has given rise to the saying that when the US economy sneezes, the rest of the world catches a cold. But it is not just that importing power that matters. The US provides large, sophisticated markets that allow the innovation cycle to work. The process of free trade and cross-border investments spreads the resulting innovation and production gains to other countries.

Conversely, innovation is needed to drive and sustain economic growth and hence markets. This then is the symbiotic relationship between markets and innovation.

Innovation needs markets as much as markets need innovation. Since innovation is so crucial to long economic growth and is so symbiotically linked to markets, it behoves policymakers to re-examine their own markets and investment policies when formulating economic policy.

The writer is chairman of the Competition Commission of Singapore. This article is extracted from a paper to be presented at a Nanyang Technological University seminar in March.

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