Too unimportant to fail? Innovation and competitive selection in markets

26 February 2007

 

TOO UNIMPORTANT TO FAIL? INNOVATION AND COMPETITIVE SELECTION IN MARKETS

 

Professor Michael Mainelli

 

Good evening Ladies and Gentlemen.  It's my privilege to welcome you to Gresham College tonight.  I'm pleased so many of you found tonight's lecture topic innovative enough to attend, or perhaps less flattering, that there's a particularly weak competitive selection of other things to do in London tonight. 

 

[SLIDE: OUTLINE]

 

As you know, it wouldn't be a Commerce lecture without a commercial, so I'm glad to announce that the next Commerce lecture will continue our theme of better choice - 'Does Society Risk My Life Through Safety? The Perils Of Too Much Risk-Aversion' - here at Barnard's Inn Hall on Monday, 19 March at 18:00.

 

An aside to Securities and Investment Institute, Association of Chartered Certified Accountants and other Continuing Professional Development attendees, please be sure to see Geoff or Dawn at the end of the lecture to record your CPD points or obtain a Certificate of Attendance from Gresham College.

 

Well, as we say in Commerce - 'To Business'.

 

 

Survival of the Wittest

 

What can you say that's new about innovation?  We might start by noting that 'life is fast in the tough lane.'  This lecture is about the theory of evolution and how it might apply to firms and markets.  Joseph Schumpeter initiated evolutionary economics in 1942 with his concept of 'creative destruction'.  Creative destruction means simply that markets create new things through innovation that must displace existing things.  To Schumpeter, entrepreneurial innovation sustained long-term economic growth, while simultaneously destroying the value of established companies that enjoyed some degree of monopoly power. 

 

[SLIDE: SURVIVAL OF THE WITTEST]

 

It's a jungle out there; it's a shark pool.  I have a personal interest in tonight's talk.  I noted in my inaugural lecture that the theory of evolution and competitive selection acting at the level of families, firms, societies and governments forms part of an over-arching theory of Commerce, competitive capitalism.  In addition, as a child, I, like many in tonight's audience I suspect, worshipped innovators such as scientists and inventors - Thomas Alva Edison, Lord Kelvin, Alexander Graham Bell, Alexander Fleming, Samuel Morse, Michael Faraday, Charles Goodyear, George Eastman, George Washington Carver, Charles Richard Drew, William Shockley and Enrico Fermi, just to get started.  I fancied myself as a great inventor.  Ultimately, I did go on to help develop some minor innovations in aerospace, laser line-following digitisers and pattern recognition, but found the subject of innovation most vital when trying to commercialise the UK's defence technologies in the 1990's.  I began to realise that we know both too little about fostering innovation. 

 

Innovation is crucial to economic development.  As you have gathered from the likes of Adam Smith as well as from mere Gresham College Commerce Professors, competition is essential to markets, but without innovation, we have no new competition.  In the words of Michael E Porter, 'Innovation is the central issue in economic prosperity'.  So tonight I'd like to explore the links between evolutionary theory and innovation.

 

 

Niche Job, If You Can Get It

 

There are numerous comparisons to be made between Commerce and evolution.  Darwin's theory applies in many circumstances where there are individuals in a population, offspring who 'inherit' a mix of characteristics, a randomisation of characteristics and a Grim Reaper.

 

[SLIDE: DEATH IN VENTURES]

 

 'Genetic algorithm' is a description for many automated problem-solving approaches which attempt to develop methods that 'evolve' from partial solutions towards a satisficing answer.  Genetic algorithms use evolution as a metaphor for their approach.  Genetic algorithms evolve a population by assessing individuals' fitness for a task or function.  Successful organisms survive to become parents of the next generation using breeding processes that promote crossover, and possibly mutation. 

 

The idea of evolving business strategies is appealing as a means of both generating novel ideas and as a means of optimisation.  'The emergence of biological novelties and the creation of mental novelties are processes which show certain analogies' [Koestler, 1967, page 168].  The algorithmic cycle can be summarised as:

 

1.                    create initial population with characteristics;

2.                    evaluate each individual for 'fitness';

3.                    select parents;

4.                    breed new individuals and incorporate mutation;

5.                    replace some or all of parents with new individuals;

6.                    [if end condition not satisfied,] then repeat from step 2, evaluate 'fitness'.

 

Dawkins [Dawkins, 1976] and many other writers describe applications for genetic algorithms ranging from automated musical scores to designing buildings to finance [see Deboeck, 1994, pages 133-173].  For instance, in developing an ideal lifting crane for a particular problem (load, centre of gravity) a genetic algorithm might start with an initial set of parameters for cranes (e.g.  wood:steel, long arm:medium arm:short arm, steam:electric) that will be combined in an initial round to create new combinations.  At the end of the round the cranes are evaluated according to a 'fitness' algorithm based on their ability to solve the problem and the most successful cranes pass on more of their characteristics to the next set of combinations in the next round of simulation.  Over many rounds, genetic algorithms can evolve to reasonable solutions, e.g., an acceptable crane specification for the problem at hand.  However, 'reasonable' solutions may be local optima and not the desired solutions at all.  Contrasting genetic algorithms with evolution in nature is fairly direct.

 

[SLIDE: NICHE JOB, IF YOU CAN GET IT]

 

The attraction of genetic algorithms lies in the recognition that complex organisms arise, not from chance or design but, from the accumulation of small changes that assure survival of the fittest.  - 'the evolution of life is a game played according to fixed rules which limit its possibilities but leave sufficient scope for a limitless number of variations.  The rules are inherent in the basic structure of living matter; the variations derive from adaptive strategies' [Koestler, 1967, page 148].  On the other hand, fitness varies.  Genetic algorithm techniques might produce an 'ideal' result, but only for a particular time or a particular use.  Genetic algorithms also have problems with niches, both showing how niches emerge in environments, as well as how niches grow to subsume the total environment.  Yet, if we could apply genetic algorithms to modelling the evolution of firms, then we gain valuable insights. 

 

[SLIDE: DARWIN-SCHUMPETER CROSS-OVER]

 

A business analogy for evolution, linking Darwin and Schumpeter, seems straightforward; death is bankruptcy; survival is based on profit; the next generation are spin-offs, mergers or derivative organisations; etc.  Real-world data is readily available for simulation, e.g.  corporate accounts.  However, what constitutes the corporate genome?  Profit and loss would only evolve to show a trite result that high revenues and low costs were desirable.  Balance sheets and cashflow would likewise produce banal results linking fitness with assets and cash.  One attractive proposition is that the corporate genomes might be the set of risks and rewards that businesses accept.  While attractive, this is problematic.  There is a paucity of data even for a single company on what constitutes the set of risks and rewards.  For instance, a reward might be the flexibility and commitment gained from hiring solely graduates (a policy pursued quite strongly by many firms) and the consequent risk might be graduates? relative inexperience or higher likelihood of departing.  Most risks and rewards are subjective assessments, perceptions, not ab initio facts.  Comparing risks and rewards among firms quantitatively seems next to impossible.

 

In the 1980's, I was desperate to use genetic algorithms to generate business strategies, a 'tool in search of an application'.  Ultimately, I never used genetic algorithms successfully to evolve novel organisations, but the desire to do so forced the issue of what might constitute the 'genome' of an organisation.  As George Box concluded, 'All models are wrong, but some are useful.'  The idea that the corporate genome is a set of risks and rewards that could be swapped, mutated, eliminated or enhanced in successive generations still attracts me, if it could be measured.

 

I'll end this section on a cautionary note against taking biological analogies too far:

 

'Social organizations are not natural like mechanical or biological systems; they are contrived.  They have structure, but the structure of events rather than of physical components, and it cannot be separated from the processes of the system.  The fact that social organizations are contrived by human beings suggests that they can be established for an infinite variety of objectives and do not follow the same life-cycle pattern of birth, maturity, and death as biological systems.' [Kast and Rosenzweig,1981, page 50]

 

 

Innovation - Definitionally Indefinite

 

[SLIDE: DEFINITIONALLY INDEFINITE]

 

Numerous people distinguish invention from innovation.  'Consider, for example, Chester Carlson's breakthrough in his flat in Queens, New York, where his smelly experiments provoked complaints from the neighbours.  His invention of xerography would never have become the hugely profitable Xerox photocopying business were it not for what Charles Ellis calls the 'extreme entrepreneurship' of Joe Wilson.' [The Economist, 'Innovation and Entrepreneurship: No Fear of Flying', 18 November 2006, page 98-99]

 

Invention is having a great idea that might be practical; innovation is introducing it to the world.  Albert Einstein pointed out that: 'Innovation is not the product of logical thought, although the result is tied to logical structure.'  The philosopher Robert Scruton distinguishes:

 

' ...between innovation and originality.  The second [originality], unlike the first [innovation], can never break with what preceded it: to be original, an artist must also belong to the tradition from which he departs.  To put it another way, he must violate the expectations of his audience, but he must also, in countless ways, uphold and endorse them.'

 

Of course, we then find ourselves having to distinguish between unique innovations, virtually unique innovation (sic), revolutionary innovations, virtually revolutionary innovations and just bog-standard improvements.

 

Which reminds me of two economists walking down the street who notice two men yelling across the street at each other.  'Of course they will never come to agreement', states the first economist. 'And why is that, inquires his companion.  'Why, of course, because they are arguing from different premises.'

 

Schumpeter tried to define innovation:

¨        the introduction of a new good - that is one with which consumers are not yet familiar - or of a new quality of a good.

¨        the introduction of a new method of production, which need by no means be founded upon a discovery scientifically new, and can also exist in a new way of handling a commodity commercially.

¨        the opening of a new market, that is a market into which the particular branch of manufacture of the country in question has not previously entered, whether or not this market has existed before.

¨        the conquest of a new source of supply of raw materials or half-manufactured goods, again irrespective of whether this source already exists or whether it has first to be created.

¨        the carrying out of the new organization of any industry, like the creation of a monopoly position (for example through trustification) or the breaking up of a monopoly position.

 

The OECD also attempts in its many comparisons of nations to define and measure innovation.  Its standard guideline on measuring innovation is the Oslo Manual.  First introduced in 1992, then updated in 1997 and re-updated in 2005, it defines innovation as:

 

'Technological product and process (TPP) innovations comprise implemented technologically new products and processes and significant technological improvements in products and processes.  A TPP innovation has been implemented if it has been introduced on the market (product innovation) or used within a production process (process innovation).  TPP innovations involve a series of scientific, technological, organisational, financial and commercial activities.  The TPP innovating firm is one that has implemented technologically new or significantly technologically improved products or processes during the period under review.'

 

[SLIDE: ANDO <> EDISON]

 

For the OECD, nothing is an innovation until people buy it - innovation is about making a difference in the marketplace.  Of course the next problem is that everything is an innovation.  Every novel wrapper for a burger, every new phone-answering phrase, every inventive internet click function, every new fashion accessory.  Momofuku Ando, inventor of instant noodles, is as important as Thomas Edison.  Further, if everyone can use a new process immediately, how innovative is it?  Are entrepreneurs just another stage of the paradigm shifts Thomas Kuhn pointed out in The Structure of Scientific Revolutions in 1962.

 

Recent texts have dwelt on the link between entrepreneurs and their customers.  Patricia Seybold has written a book, Outside Innovation: How Your Customers Will Co-Design Your Company's Future [HarperBusiness, 2006], stating, in effect, that we are all innovators.  Let's have a show of hand for those who have connected to the internet in the last 10 years, since 1997?  You've struggled with computers, with internet service providers, with awkward, stupid software, all so you could be novel in your relationships with colleagues, friends and family.  Now you send mail around the world, with photographs, and expect instant replies.  You have innovated.  'User innovation' is increasingly recognised as a key source of economic transformation.  User use products and services differently from what designers anticipate.  Yet because the users see value, the innovation is lasting.

 

[SLIDE: DISRUPTIVE EVOLUTION]

 

The definitional problem is deep, and circular.  New inventions that aren't commercialised aren't innovation.  If a new invention is commercialised, but unsuccessfully, it isn't a lasting innovation.  If one company is superior to its competitors, that's because it is innovative.  If a company fails, that's because it wasn't innovative enough.  As The Economist supposedly analysed recently [Survey: European Business, 'Tomorrow The World', 8 February 2007], contrasting European absorption strategies with American agility, '...many European businesses are able to soldier on thanks to their bulk and solidity rather than their capacity for innovation'.  However, perhaps their absorption strategies are innovative?  Even worse is the notion of 'disruptive technology', i.e. technological innovation that overturns the dominant technology or product in the market, e.g. steamships for sailing ships or microcomputer for mainframes.  Of course this disruption is unpredictable.  But there are still sailing ships and mainframes, so when is evolution truly disrupted.

 

Innovation has become synonymous with success, confusing us further.  This conflation of innovation with success is especially surprising as it has long been recognised that failure is an important part of learning and innovating.  George Chapman (1559-1634) noted in the 16th century that 'Pure innovation is more gross than error.'  While in the past century, Woody Allen quipped that 'If you're not failing every now and again, it's a sign you're not doing anything very innovative.'  More subtly, I rather like Herman Melville's (1819-1891) observation that:

 

'He who has never failed somewhere, that man can not be great.  Failure is the true test of greatness.  And if it be said, that continual success is a proof that a man wisely knows his powers - it is only to be added, that, in that case, he knows them to be small.'

 

If you have to fail so many times to be innovative, then why do we confuse innovation with success?  Given the all-encompassing definition of innovation, that innovation is the successful bringing to market of novelty, the confusion of innovation with success is not surprising.  Innovation is simultaneously noble failure and unexpected success.

 

 

[SLIDE: CLOSED BELIEFS - PARTIALLY INNOVATIVE]

 

I am reminded of Koestler's closed belief systems. 'Closed systems' have three main peculiarities.  First, they claim to represent a truth of universal validity which explains everything.  Second, the system 'cannot be refuted by the evidence, because all potentially damaging data are automatically processed and reinterpreted to make them fit the expected pattern'.  Third, criticism is invalidated by shifting the argument to the motivation of the critic.  Koestler provides an example of a closed system from the orthodox Freudian school of pyschoanalysis. '...if you argued that for such and such reasons you doubted the existence of the so-called castration complex, the Freudian's prompt answer was that your argument betrayed an unconscious resistance indicating that you yourself have a castration complex; you were caught in a vicious circle' [Koestler, 1967, pages 263-264]

 

Innovation as discussed today fulfills the first peculiarity of a closed system; it explains everything about capitalist change.  Superior performance is, at least partially, due to superior innovation while failure is due to inferior innovation.  Innovation fulfills the second peculiarity of a closed system; it cannot be refuted by the evidence.  All change is innovation and all non-change is a failure to achieve true innovation.  To meet the third peculiarity of a closed system, we invalidate criticism by shifting the argument to the motivation of the critic.  If your great efforts at innovation had no great result, perhaps you didn't really believe in radical innovation.  The solution?  More, and better, innovation.

 

We can't define innovation, so we wind up mimicking Justice Byron White on pornography, 'we know it when we see it'.  And clearly, given the focus on innovation by government, the media and business, we want more of it.  In many ways, innovation has hallmarks of religious fervour.  If your faith in innovation is strong enough, you will prevail.  Though Edmund Burke (1729-1797), writing about the French Revolution, was not exactly a fan of wanton innovation: 'A spirit of innovation is generally the result of a selfish temper and confined views.  People will not look forward to posterity, who never look backward to their ancestors.'  Of course, as Coco Chanel criticised, innovation isn't everything: 'Innovation! One cannot be forever innovating.  I want to create classics.'

 

 

Innovation - Deterministically Random

 

[SLIDE: FONT OF NEW IDEAS]

 

Evolutionary analogies with business can be problematic in other ways.  In the case of species evolution, we know that there is randomness due to mutations of the genome.  While serious biological debate continues on the subject of punctuated or gradual mutation, we can posit that the equivalent random element for business is 'innovation'.  What is the source or font of innovation?  Many economists would prefer to ignore this awkward question.  To quote The Economist on Robert Solow's two seminal papers on growth in 1956 and 1957, 'invention, innovation and ingenuity were all 'exogenous' influences to [technological progress]' [The Economist, Economics Focus: 'The Growth Of Growth Theory', 20 May 2006, page 96].

 

Aside from some economists, everyone else is desperate to find the fountain of innovation.  There are a number of views on where this source might be found, yet attempts to create fountains of innovation have almost always petered out.  Consider the statistics of new technology commercialisation by structured organisations.  It takes about 100 research ideas to generate about 10 development projects of which two will usually make it through to commercialisation.  Only one will actually make money when launched.  In Britain and America, around half of companies? development money is spent on projects which never reach the market.    Government R&D productivity is far worse.  At the same time, investors value 'intangible assets' such as talent more and more.  'Accenture, a management consultancy, calculates that intangible assets have shot up from 20% of the the value of companies in the S&P 500 in 1980 to around 70% today' [The Economist, Survey: Talent, 'The Battle For Brainpower', 7 October 2006].

 

[SLIDE: IT'S RAINING MEMES! HALLELUJAH!]

 

But from where come the ideas on which innovation is founded?  I happen to like Richard Dawkin's concept of memes.  He talks about replicators, called memes.  'Examples of memes are tunes, ideas, catch-phrases, clothes fashions, ways of making pots or of building arches.  Just as genes propagate themselves in the gene pool by leaping from body to body via sperms or eggs, so memes propagate themselves in the same pool by leaping from brain to brain?' [Dawkins, 1976, page 192]

 

We can imagine memes as seeds of ideas showering down upon the earth, randomly distributed.  We can expect great ideas in small countries and large, roughly on a per capita basis.  We can expect more ideas in large organisations than small, because large organisations have more people.  Our job must be to nurture them.  To treat ideas like seeds that need the right soil, the right nutrients, the right sunlight and the right water to grow.

 

 

Government - Displacement

 

Governments have always liked to control births and deaths.  Governments like running the registries of births and deaths, even more would governments like to claim credit for turning this shower of ideas into economic improvement.  However, instead of focusing on the general condition of the soil for new ideas, governments tend to try and grab the innovation just as it germinates and incubate it in a separated, intensive hothouse.  We have government innovation laboratories, SMART programmes, Alvey, Esprit or Foresight, just to get going.  This doesn't mean innovation isn't discussed.  Far from it.  We have publications on creativity, talent, education, entrepreneurship, clusters and learning cycles.  But as Richard Thaler supposedly pointed out, 'when an economist says the evidence is 'mixed', he or she means that theory says one thing and data says the opposite.'

 

[SLIDE: NATIONAL INNOVATION SYSTEMS]

 

Somewhat problematically, in a world where being the global leader matters, we retreat from the conclusion that we can only be technologically excellent within smaller and smaller ranges of activities.  We lament declines in gross patent applications or other broad measures purporting to show technological virility.  Globalisation of technology leaves us feeling behind and therefore, 'somebody has to do something'.  It is no surprise, therefore, that since the 1940's people have become more and more convinced that government should play a direct role in innovation.  A recent European publication by Science Business, The Innovation Manifesto, wails over poor university licensing revenues in Europe, ineffective technology transfer offices, difficulties in raising money for start-ups or expensive patenting.  It concludes that more government support is needed.  We have developed some misleading slogans, such as 'the British invent, the Americans develop, the Japanese exploit'.  So let's look at our first of three Red Herrings.

 

Red Herring 1: R&D needs government subsidy

 

 

I was reminded at last week's Worshipful Company of World Traders' Tacitus lecture at the Guildhall by Antony Burgmans of Ronald Reagan's view of government: 'Government's view of the economy could be summed up in a few short phrases: If it moves, tax it.  If it keeps moving, regulate it.  And if it stops moving, subsidize it.'  We should smirk when we observe R&D - clearly governments and voters already presume it needs subsidising, so it must have stopped moving.

 

[SLIDE: DIAMOND CLUSTERS]

 

In 1987, Freeman first explicitly expressed the concept of a 'National Innovation System' as ' ...the network of institutions in the public and private sectors whose activities and interactions initiate, import, modify and diffuse new technologies.'  Michael Porter has been influential in directing government attention to regional innovation clusters driving national innovation systems, particularly in his 1990 book, The Competitive Advantage of Nations, where he introduced the notion of a interlinked 'diamond' cluster consisting of demand conditions, factor conditions, firm rivalry and supporting industries.

 

Unfortunately, the implication of diamond clusters rather unglamorously directs government to getting the conditions right, making sure the soil for innovation is fertile.  If governments had focused on the soil conditions we would never have had Alvey, Esprit, Foresight or EU Framework Programmes For Research And Technological Development, Numbers 1 To 7.  The UK has fervently funded electronics and aerospace since the war to the point that there is no global UK electronics firm and one significant aerospace firm.  With not just a little Schadenfreude, I remember 1982 when the Japanese Ministry of International Trade and Industry made computing its priority.  Europeans, and to a lesser degree Americans, were a-twitter.  The Japanese were spending $1 billion (when $1 billion was a lot of money) on their Fifth Generation Computer project.  The Fifth Generation Computer Project aimed to create an 'epoch-making computer' with supercomputer-like performance and usable artificial intelligence capabilities.  All that money and more disappeared into what is widely regarded as a failure.  Where is the Japanese Google or Microsoft?  It is amusing, and saddening, to work out that government-funded research efforts tend to result in the demise of the industry concerned, whether it is European, Asian or American. 

 

[SLIDE: KEALEY'S ECONOMIC LAWS OF CIVIL R&D]

 

But we must try to move, in the spirit of scientific analysis, from anecdotes of great inventors or frustrated nationals or failed programmes to looking at research where possible.  Much research questions public policies on subsidies - it is tricky to ensure you realise benefits; or encouraging cooperative R&D - overall R&D spending often shrinks. [Beath et al, 1988]  Terence Kealey, now Vice Chancellor of the University of Buckingham, conducted extensive statistical research into the economic laws of scientific research.  Kealey set out three economic laws of funding Civil R&D [Kealey, 1996, pages 245-250].

 

1.        The percentage of national GDP spent increases with national GDP per capita.

2.        Public and private funding displace each other.

3.        Public funds displace more than they do themselves provide.

 

Despite a grounding in statistics, common sense goes a long way to explaining Kealey's premise.  Imagine two aerospace firms, Adam's and Zöe's.  Zöe wins some government R&D project for something big and novel for aircraft, say actually building aircraft parts from the same indestructible material used to make the black boxes.  Adam, believing he can't compete, abandons aircraft parts and moves into fast food.  But Zöe's troubles have only begun.  Of course the government oversight committee restricts her to researching things they all agree on, rather than innovative ideas.  Zöe's R&D slows down as she awaits oversight from government committees, cashflow problems emerge as government funds arrive late with huge bureaucratic overheads and, when all is finished, her intellectual property leaks out through committee members and the government publishing a number of trade secrets for public relations purposes.  So the whole process costs more, takes longer and results in a single, weakened, government-subsidised aerospace firm instead of two vibrant competitors, let alone a culture where political lobbying skills matter as much as technological capability.

 

[SLIDE: NATIONAL CHAMPIONS - DISPLACEMENT]

 

Government and professional commentators are also particularly bad at spotting winners.  Sherden, in his delightful 1998 book, The Fortune Sellers, tears apart any structured ability of government or private 'futurologists' to spot winners in science or technology.  I have a particular soft spot for a certain blue-blooded consultancy's brazen approach.  The consultancy walks into every industry analysis with a number.  If there are 50 major players in the industry, it predicts that in 10 years there will be only 20; if there are 10 major players, it predicts that in five years there will be only five; if there are five major players, it predicts that in three years there will be only three.  Almost inevitably these numbers support the idea of national or regional champions.  Strangely, as governments and investment managers drive firms towards these mesmerizing numerological simplicities, managers are powerless to resist these predictions.  These consultancy prophecies are self-fulfilling.  Meanwhile, innovation is driven out of these industries while the consolidation proceeds.  Too frequently the winners are those firms who ignore the fateful numbers and continue to innovate and transform themselves, though post facto  the consultancy claims that they differentiated or specialised to the point that they were no longer in the industry in question.

 

I would add Ashby's Law of Requisite Variety to the analysis.  Ashby's Law, originally from cybernetics, states that the amount of appropriate selection that can be performed is limited by the amount of information available; and that for appropriate regulation the variety in the regulator must be equal to or greater than the variety in the system being regulated. Or, the greater the variety within a system, the more regulation will reduce its variety.  Significant government direction of R&D inevitably reduces the essential variety behind true innovation thus, as innovation is about variety, government direction of R&D is necessarily inferior to no direction.

 

So can large private sector firms do better than governments?

 

 

Large Organisations - Processed Out

 

[SLIDE: CORPORATE FUNNELS]

 

All large corporates would like to be called 'innovative'.  Steve Jobs said that 'innovation distinguishes between a leader and a follower.'  It is easy to find articles stating that the job of organisations is to innovate.  There are two religious sects for corporate leaders, both stark and unforgiving - and you can't compromise - top-down versus bottom-up.  In the top-down sect, policy and planning lead to new innovations.  In the bottom-up sect, of wild markets and innovation, you have no idea from where the next big idea will come.  Sadly, large numbers of stories show that large companies are not that good at 'hard', measurable innovation of the top-down variety.  But bottom-up innovation means corporate headquarters has no idea where the next big idea will emerge to justify being a large corporate, a very uncomfortable situation, so naturally large corporates want to buy innovation consultancy snake oil.  I quote an email from the strategist, Jabir Walji:

 

'Picture the systematic study of over two million of the world's most successful innovations and every available example of good business practices in every business function from HR to operations.  Now visualize the construction of a problem solving method, which combines these excellent business solutions into a whole, which strips away all boundaries between different industries.  Now imagine that it exists.  What you are seeing is Systematic Innovation!!!!'

 

One of my colleagues, Stephen Martin tells a story of a former boss, Frank Lynn.  Frank Lynn was part of a think tank put together by Jimmy Carter to answer the question 'if the USA is so good at inventing new things - how come we don't launch that many new products'.  Frank concluded that by the time a company has grown enough to invest in R&D, its channels to market have matured to the point where they are no longer suitable for launching and selling the output of R&D.

 

Let's look at a second red herring [from Mainelli and Pumphrey, 2002].

 

Red Herring 2: Large organisations need to be more innovative[Notes 2 to 7]

 

'Innovation culture' dominated the R&D management literature in the 1980's at, for instance, 3M, DuPont and GE. Unfortunately, by 2000, a more common comment was 'who needs a research lab?' 'This explains why, increasingly, development and growth of a business is taking place not inside the corporation itself but through partnerships, joint ventures, alliances, minority participation and know-how agreements with institutions in different industries and with different technologies'.  Further, neither state-funded research nor government aid help innovation for either large or small firms.

 

[SLIDE: PROCESS = FAILURE]

 

Despite this, signs of measurable behavioural change are scarce. Seventeen of the top 20 global R&D spending organisations [in 2002] would have been recognised 50 years ago (the exceptions being Cisco - 10th, Intel - 14th, Microsoft - 17th). Perhaps the balance of large, corporate R&D is moving from research towards development or evaluation, but evidence is scanty and anecdotal.  Further, there is little correlation between R&D and sales growth.

 

I particularly like this marketing blurb for the book 'Weird Ideas That Work: 11½  Ways For Promoting, Managing and Sustaining Innovation', which points out why innovation is subversion in large firms:

 

'There are massive rewards for original thinking, but an innovative company is - and has to be - a pretty weird place.  Convinced that their ideas will work, creative people deceive their managers and disobey direct orders.  They are sneaky, vindictive and misguided to the point of lunacy.  They try ridiculous things and dismiss the advice of experts.  Not only are true creatives messy and noisy, they're almost always wrong. And that's if you're doing it right.'

 

No wonder these unruly, disobedient innovators find few corporate homes.  Large organisations don't need innovation, they need to be able to absorb smaller innovative organisations either directly or indirectly through alliances or purchasing.  I would pick out the oil industry, pharmaceutical industry, computer industry or global mining industry, as industries where larger firms are working hard at absorbing smaller, more innovative firms rather than being innovative themselves.  This makes sense.  Large firms cannot be innovative because their existence requires structure and process.  But large firms can identify smaller firms with valuable technologies or techniques.  The pharmaceutical industry consists of a few mega-corporations feeding off smaller innovators.  We have over 3,000 bio-technology firms when two decades ago we had virtually none.  On the other hand, no wonder corporate lawyers burgeon in growing technical industries.  It's one thing to defend intellectual property grown in-house - keep it a secret.  However, when you pay hard cash for intellectual property it requires sophisticated teams of bright lawyers to protect the intellectual property you bought.

 

 

Entrepreneurs - Cultural Diversity

 

[SLIDE: BREEDING INNOVATION]

 

Let's look at a third red herring [from Mainelli and Pumphrey, 2002].

 

Red Herring 3: Small companies need to be more virtual and more networked

 

Supposedly, 'the fundamental building blocks of the economy will one day be 'virtual firms', ever-changing networks of subcontractors and freelancers, managed by a core of people with a good idea'. An attractive corollary to intense virtualism is that the firm is 'sticking to its knitting', 'focusing on core value-added'. Or as John Chambers, CEO of Cisco says, '[In a virtual network organization] you [a company or government agency] do only what adds sustainable value'. [USA Today 'Cisco Chief: Future May Lie in Virtual Networks' (interview), 12 November 2001]

 

However, Phil Agre, a professor of information studies at the University of California at Los Angeles, says, 'such predictions [of firm size] are often based on a one-sided interpretation of the ideas of Ronald Coase, a Nobel-prize-winning economist. True, technologies that speed up the flow of information bring down transaction costs. That should induce companies to do less themselves and outsource more. However, Mr Coase also argued that organising costs (which technology tends to lower) determine the size of the firm. So, the real-time enterprise might end up being larger than its less nimble predecessors.' [The Economist, Survey: The Real-Time Economy, 'Re-engineering in Real Time', 31 January 2002]

 

This leads us back to the most fertile ground for innovation memes being the allotments of sole entrepreneurs or very small teams who organize, manage and assume the risks of a business or enterprise.  Peter Drucker believed that 'innovation is the specific instrument of entrepreneurship.  The act that endows resources with a new capacity to create wealth.' But if the large corporate track record is two out of 100, small entrepreneurs may have worse odds.  'Of 1,091 Canadian inventions surveyed in 2003 by Thomas Astebro, of the University of Toronto, only 75 reached the market.  Six of these earned returns above 1,400%, but 45 lost money.  A rational manager will balk at such odds.  But the entrepreneur answers to his own dreams and demons.' [The Economist, Economics Focus: 'Searching For The Invisible Man', 11 March 2006, page 86]  Worse, much research has shown that successful entrepreneurs vary so wildly, from the meek to the wild, from the octogenarian to the child, that it is hard to distinguish entrepreneurs in advance from the general population.  The memes fall randomly on different people in different fields.  Entrepreneurial nature wins over entrepreneurial nurture.

 

So if governments can't directly fund innovation and large firms are bad at it, and entrepreneurs are our only salvation, how can policy-makers increase innovation? The key policies are to increase sensible risk-taking and make the ground more fertile.  Sensible risk-taking is increased through better information, lower costs of failure, e.g. bankruptcy, and greater rewards, e.g. through lower taxes.  More fertile ground means getting the basic clusters right - strong rivalry, emerging from equal-handed legal systems and strong anti-monopoly conditions; demanding customers, developed through strong consumer rights legislation and open borders; support, via a continuous and open flow of information and ideas; good factor conditions, created by good infrastructure, education and open capital markets.

 

One of my problems with advising entrepreneurs in the 1980's and 1990's is that I had to advise them to go where the action was.  For information, computing and telecoms entrepreneurs that was definitely the USA, Silicon Valley, Route 128 or Texas.  In these places they would find support networks, role models, suppliers who understood risk and financiers.  Moreover, as a professional financial advisor, if they told me that, contrary to the odds, they were virtually certain to succeed, I had an obligation to advise them to go to a lower tax jurisdiction, such as America, because their guaranteed success meant that they would pay far more tax in Europe.  Tax take is a crucial element in risk/reward calculations.

 

[SLIDE: TAX SQUEEZE SPIN]

 

It is at this point that I must raise a depressing Tax Squeeze Spin.  Over the years, a number of European trade and industry officials have wondered why Europeans develop fewer entrepreneurial businesses.  There are certainly at least two contrary effects at work - better lifetime security in large organisations and risk-money displacement.  Most rational Europeans, and most of us are, should stay in jobs with large private or public organisations till we are eligible for pensions.  Why take risks with our long-term family incomes?  Likewise, European tax rates are typically at an effective 50% level for most middle-income families when all taxes are taken into account.  After paying more tax and when I've made my extra pension provisions because I can't rely on the state, bought private health insurance to queue-jump the poor public health system and paid extra for my children's education to give them an edge in a weak educational system, it's little surprise that I don't fund my brother-or-sister-in-law starting up a new business in his or her attic.  My brother in the USA has an effective 35% tax level when all taxes are taken into account.  It's no surprise that Americans can take more entrepreneurial risks funding their brothers-or-sisters-in-law starting up in their garages.  They can afford to lose more.  High rates of taxation lead to Tax Squeeze Spins.

 

The answer to Tax Squeeze Spin is lower tax rates.  But of course it garners more votes to pledge more money to government R&D, to spend more money on innovation awareness campaigns, to subsidise private sector R&D and to try and develop more networks of business and academia.  But all this effort costs money and increases tax rates making Tax Squeeze Spin worse.  Policy-makers don't like the answer that less policy and less tax could make Europe far more innovative.

 

[The next two paragraphs are heavily cribbed from Swann, 2000, pages 24-29, coming in turn from DTI Economics Paper Number 12]

[SLIDE: INNOVATION TREES]

Finally, we turn to the role of government policy in standards.  Standards, formal, informal or purchasing, by government play an enormous role in innovation.  This diagram's vertical axis represents vertical product differentiation, i.e. the higher up the diagram the greater the performance or functionality.  The horizontal axis represents horizontal product differentiation: points along a horizontal line in this diagram represent products of different design and configuration but of roughly comparable functionality.  Product and service innovations can fill this space.  A bio-diverse innovation process can be measured by the size and richness of the 'tree' canopy.  The starting point is (a), a key innovation opens up a new area of technological space, so new and revolutionary that people can only find horizontal differentiation for the moment (colours and shapes).  In (b) two subsequent innovations, drawing on the basic standard, develop in two orthogonal directions.  In (c) each of these innovations spawns two further innovations. The forces of product innovation build a canopy of competing products and services of differing technological characteristics leading to (d). 

[SLIDE TRANSITION] Without standards the tree develops rather evenly across the canopy, but tremendous effort is expended to advance, opportunities for economies of scale are missed and innovation is duplicated.  No one innovation covers as much ground as would have been possible if the economies of scale had been realised. [SLIDE TRANSITION] Standards, and pseudo-standards such as patents, encourage more rapid functionality development, but at what cost and what missed opportunities?  Too early standardisation leaves the innovation space unexplored.  Too late standardisation leads to much wasted effort filling the space.  [SLIDE TRANSITION] With a de factostandard that approaches a monopoly, large areas of innovation space are unexplored.  Greater confidence in a standard or de facto standard by consumers and producers may lead to rapid advance, or monopoly rents and the greater critical mass of supporting items around the standard may hinder development.

Of course, as noted in last year's lecture, Gresham College - 'Standards Markets: The Free Market Response to Regulation?', 16 October 2006, this is why we also need open and competitive standards markets. 

 

Biodiversity

In another lecture at Gresham College about creativity on 8 November 2006, Professor Raj Persaud pointed out a hard truth - 'no matter how hard you're prepared to work, and I'm sure you're all very industrious individuals, there are millions of people in India and China willing to work harder than you for about a tenth of the pay, okay?  So as a national economy, for us to be competitive in the future in this world, we can't rely on resources, and we can't rely on hard work.  What are we going to rely on?  We're going to have to rely on innovation, being different, and being creative.'

[SLIDE: BIOLOGICALLY DIVERSE INNOVATION]

Early in the last century, Schumpeter argued that innovation and technological change comes from entrepreneurs, or wild spirits.  He created a German phrase Unternehmergeist, entrepreneurial-spirit.  But later, Schumpeter indicated that in the United States, big companies, which have the resources and capital to invest in research and development, are the real movers.  We need big and small.   We need biological diversity for an innovation economy.

We currently worship the entrepreneur.  'Unhappy is the land that has no heroes,' comments a character in Bertolt Brecht's Life of Galileo.  'No,' replies another, 'Unhappy is the land that needs heroes.'  Paradoxically though, if you believe both Thomas Edison, 'Genius is one per cent inspiration, ninety-nine per cent perspiration', and Truman Capote, 'Failure is the condiment that gives success its flavor', then we may be making role models of the wrong entrepreneurs, the success-only ones.  Further, with a different take on Edison's perspiration, we focus too much on bright ideas and not enough on rigorous execution. As Oscar Wilde said, 'Imagination is imitative - the real innovation lies in criticism.' 

So in a world where we must expect the unexpected, predict the unpredictable and think the unthinkable, as well as not think about elephants, we find that one of the most important unknown variables about innovation is 'what are the unknown variables?'  What policies can we develop within all this uncertainty?

[SLIDE: EXTINCTUISH THE RED HERRINGS]

Recent measures of European knowledge and skills, e.g. by the Lisbon Council and Deutschland Denken think-tanks in conjunction with Zeppelin University (sic) concur that a knowledge-based economy's four key areas are education, employment, productivity and demographics. [The Economist, 'Charlemagne: The Brain Business', 14 October 2006, page 52]

Perhaps the biggest innovation policy we can hold to is that of diversity.  Increased innovation means assuming increased risk in pursuit of higher reward.  If evolution applies to markets then, like other ecosystems, governments should pursue policies that encourage biodiversity.  Biodiversity means encouraging competition, so that one type of firm does not unnaturally predominate.  Biodiversity requires aggressive anti-monopolies enforcement.  Biodiversity means not leaping in too early with standards and regulations, and when we do making sure that they are founded within standards markets.  Biodiversity means lowering risk and increasing reward for entrepreneurs, such as lowering the stigma and effects of bankruptcy.  Biodiversity probably means lower tax rates so more rewards can be kept.  Improved biodiversity also means improved infrastructure quality, e.g. through universally improved education.

 

Make A Big Difference - Do Nothing Special But Everything Right

[SLIDE: GREAT CIRCLE OF COMMERCE]

Schumpeter gave us a construct, creative destruction, that is analogous to the Hindu view of Shiva - the creator and destroyer - or the 'Boethian Wheel'.  Boethius' 'Wheel of Fortune' was popular throughout the Middle Ages.   Men may rise from poverty and hunger to greatness, while those who are great may fall with the turn of the wheel - from dust to dust. 

Annual, global investment in technology is enormous.  Research & Development (R&D) alone is 1% to 3% of GDP in OECD countries, approximately £250 billion in the 1,250 largest multi-nationals and uncounted billions in small organisations.  Yet, while these firms will rise and fall, their advancements in technology transform lives for the better.  Without technological change, advancement in productivity and therefore GDP would be limited to increasing labour and material productivity, finite sources of improvement. 

The compelling argument that improving living standards requires improved technology has been augmented by increasing interest in technology investment.  There is more interest in, and funding aimed at, the exploitation of the science base.  Governments, universities, research establishments, think tanks and even trades unions talk confidently about turning nations into 'knowledge economies'.  Of course one great problem, contained in the title of this talk, 'Too Unimportant To Fail?', is that governments are particularly bad at dealing with lots of little firms when they think one big champion should do.  All the little unimportant firms that breed innovation need to be championed.  Of all the firms in the ecosystem, by far the ones that keep it going, as bacteria, fungi, beetles and worms do in biological ecosystems, it is the little folk that matter.

So, in conclusion, it is a combination of factors that makes innovation successful, not a single factor.  Jared Diamond derives an Anna Karenina Principle from the opening line of Tolstoy's novel: 'Happy families are all alike; every unhappy family is unhappy in its own way.' The Anna Karenina principle describes situations where a number of activities must be done correctly in order to achieve success, while failure can come from a single, poorly performed activity.  If we want successful innovation in our economies, paradoxically we should keep our feet on the ground and focus on just getting the basics right.

 

Thank you.

 

[SLIDE: DISCUSSION]

 

 

Further Discussion

1.        Government can't direct R&D and government R&D subsidies displace private sector research.

2.        Management processes kill innovation.

3.        Government policy should focus on fair competition, low risk & high rewards for entrepreneurs and education.

 

 

Further Reading

1.        ASHBY, W.R. 'Self-regulation and Requisite Variety' in Emery, F.E. (ed) Systems Thinking, Penguin, 1983.

2.        ASTEBRO, Thomas B., 'The Return to Independent Invention: Evidence of Unrealistic Optimism, Risk Seeking or Skewness Loving?', The Economic Journal, Volume 113, pages 226-239, 2003.

3.        AYLWARD, David, 'Innovation Lock-In: Unlocking Research And Development Path Dependency In The Australian Wine Industry', Journal of Strategic Change, Volume 14, Number 7/8, 2006, pages 361-372, John Wiley & Sons.

4.        BEATH, John, KATSOULACOS, Yannis and ULPH, David, 'Strategic R&D Policy', Centre for Economic Policy Research, Discussion Paper 276, October 1988.

5.        DAWKINS, Richard, The Selfish Gene, Oxford University Press, 1976 (1989 ed).

6.        DEBOECK, Guido J. (ed), Trading on the Edge, John Wiley & Sons, 1994.

7.        DEPARTMENT OF TRADE AND INDUSTRY, 'The Empirical Economics of Standards', DTI Economics Paper Number 12, June 2005,http://www.dti.gov.uk/files/file9655.pdf.

8.        FREEMAN, C, Technology and Economic Performance: Lessons from Japan, Pinter, 1987.

9.        GRØNHAUG, Kjell and KAUFMANN, Geir (eds), Innovation: A Cross-Disciplinary Perspective, Norwegian University Press, 1988.

10.     KAST, F E and ROSENZWEIG, J E, 'The Modern View: A Systems Approach' in Systems Behaviour, Open Systems Group, 1981, pages 44-58.

11.     KEALEY, Terence, The Economic Laws Of Scientific Research, Macmillan Press Ltd, 1996.

12.     KOESTLER, Arthur, The Ghost in the Machine, Penguin Books Ltd, 1967.

13.     LINDER, Jane C, 'Does Innovation Drive Profitable Growth' New Metrics For A Complete Picture', Journal of Business Strategy, Volume 27, Number 5, 2006, pages 38-44, Emerald Group Publishing Limited.

14.     MAINELLI, Michael and PUMPHREY, Stephen, 'Optimising Risk/Reward in High Ratio Relationships: Jumbo Bonsai Meets Pocket Battleship', Journal of Change Management, Volume 2, Number 3, Henry Stewart Publications, August 2002.

15.     PORTER, Michael E, The Competitive Advantage of Nations, Free Press, 1990.

16.     SCHUMPETER, Joseph A, Capitalism, Socialism and Democracy, Social Science Classics Series, 1942.

17.     SCHUMPETER, Joseph A, The Theory of Economic Development, Social Science Classics Series, 1912.

18.     SHERDEN, William A, The Fortune Sellers, John Wiley & Sons, 1998.

19.     SWANN, G M P, 'The Economics of Standardisation', Final Report for Standards and Technical Regulations Directorate, Department of Trade and Industry, London, 2000, http://www.dti.gov.uk/files/file11312.pdf.

20.     SUTTON, Robert I., Weird Ideas That Work: 11½  Ways For Promoting, Managing and Sustaining Innovation, Free Press, 2001.

21.     The Economist, Survey: The Company, 26 January 2006.

22.     The Economist, Survey: Talent, 5 October 2006.

 

 

Further Surfing

¨        Innovation in general - http://en.wikipedia.org/wiki/Innovation

¨        OECD, 'Oslo Manual: Proposed Guidelines for Collecting and Interpreting Technological Innovation Data', 2nd Edition, 1997 -http://www.oecd.org/dataoecd/35/61/2367580.pdf

¨        BAUMOL, William J, 'Return of the Invisible Men: The Microeconomic Value Theory of Inventors and Entrepreneurs', 15 November 2005, presented at Annual Meeting of the Americal Economics Association 2006 -http://www.aeaweb.org/annual_mtg_papers/2006/0107_1015_0301.pdf

¨        Professor Michael Mainelli, 'Standards Markets: The Free Market Response to Regulation?', 16 October 2006 -http://www.gresham.ac.uk/event.asp?PageId=4&EventId=513

¨        Professor Raj Persaud, 'Creativity And Mental Illness - Do You Have To Be Mad To Be Creative?', 8 November 2006 -http://www.gresham.ac.uk/event.asp?PageId=45&EventId=561

¨        Science Business, 'The Innovation Manifesto' -http://www.sciencebusiness.net/pdf/Innovation_Manifesto.pdf

¨        DTI R&D Scoreboard -http://www.innovation.gov.uk/rd_scoreboard/

 

Notes

1.        COOPER, Robert, Winning at New Products, Kogan Page, 1989.

2.        OSBORN, T, 'The New Product Champions: How 3M Manages for Innovation', Marketing Communications, Volume 3, Number 11, pages 17-22, November/December 1988.

3.        WOLFF, M F, 'Overcoming Roadblocks to Commercialising Industrial R and D Projects', Research Management, Volume 29, Number 4, July/August 1986.

4.        BUSH, J B, 'Major Growth through Internal Development', Planning Review, Vol. 8, No. 6, pages 28-34, November 1980.

5.        DRUCKER, Peter, 'A Survey of the Near Future', The Economist, page 17, 3 November 2001.

6.        KEALEY, Terence, The Economic Laws of Scientific Research, Macmillan Press, 1996.

7.        Financial Times, 'State Aid not a Guarantee of Better Research, Says Brussels', 8 January 2002.

 

 

Thanks

My thanks for help with this lecture go to Kevin Parker and Stephen Pumphrey for directing me to interesting information on innovation, to Bill Joseph for additional research and to Stephen Martin for pointing out Frank Lynn's R&D development dilemma.