Regional and national innovation systems and creative destruction

Business: National or Regional Innovation System

The subject of this review is the creation and administration of regional and national innovation systems. This paper will assume that the results of such systems, whether formal or informal, are key in determining their effectiveness. Since it is not possible to separate cultural from governmental or natural advantages, the primary focus of this paper is to find success and deconstruct it, wherever it occurs.

Innovation: Most oppose it, and it is Politically Difficult

As Schumpeter said, the primary driver behind innovation and entrepreneurship is "creative destruction (Schumpeter 1942)." His model was that capitalism is a method of economic change. It cannot be stationary. Thus Schumpeter would argue that destruction is necessary if new businesses are to thrive. In a similar fashion, John Dewey argued that government was a matter of accommodating change through the political structure, and that such change caused prima facie painful changes to the populace (Asen 2003).

By this definition, successful innovation can be threatening to governments. The more a government is concerned about the loss of jobs in existing industries, the more likely that government is to try to prop up old industries and their employment, and thus to penalize the rest of society with higher prices or restricted choice.

Thus a successful innovation replaces existing products, services and employers with new, uncertain products, services and employment. In Clayton Christensen's parlance, this is the "Innovator's Dilemma," that "old-line" companies are unable to innovate due to their focus on existing products and existing markets. it's along the "disruption line" that innovation -- and destruction -- occurs (Christensen 1995).

In the figure below, the incumbent companies -- market leaders and major employers all -- exploit current technology growth. It is unlikely that they will 'jump' to the new technology's 's-curve,' because the market and technology are unproven.

Incumbent companies stay with the old technology and fail to make the "leap" to new technology

According to the model, the incumbents in an industry would rather not invest in the new technology for three reasons:

The early investment in the emerging technology will not be profitable, nor does it bring sales growth during the early phases. In general, the new technology will have a lower price/performance ratio than the existing technology (for existing customers -- not for new customers: see point 2).

The new technology may have a different market. As an example, Christensen writes about the disk drive market. Those companies which succeeded in the 8-inch disk drive market did not foresee that the 5-1/4-inch disk drive would become dominant, primarily because their customers were minicomputer makers with no space limitations. The 5-1/4-inch disk drive makers didn't see the need to move to a 3-1/2-inch disk drive because their PC desktop customers didn't need the smaller size. In short, the customer group prevents incumbent companies from adopting innovation.

The old technology brings much more growth per dollar invested in R&D than the new technology -- at least until the old technology starts to mature, at which point additional investment in R&D results in diminished returns.

Put a different way, the market challenger (i.e. The innovator) is unlikely to compete directly with the market leader, but will, over time, overtake the leader -- including its jobs, tax base and customer base. The following graph shows how the incumbent manufacturer and the innovator compete for the "sweet spot," where growth and profit per unit produced are the highest:

Competing for market demand with old and new technologies

Thus the notion of a national or regional government supporting truly innovative change is likely to be so disruptive to existing employers, employees and customers, that it is unlikely to obtain the political support necessary to succeed. Direct support of new, innovative companies by local and regional companies can continue as long as the new companies do not infringe upon incumbent companies' sales or market share. As soon as they do, those companies take the case to politicians to allow the companies to compete on a level playing field.

Hostility to Innovation and Entrepreneurs

Most state-sponsored innovation programs which work through universities tend not to succeed because of innate disdain by academics for business and entrepreneurial people (Radosevic 2007). This is also true of political support, which is quite thin for entrepreneurs, particularly those who are yet developing their ideas or companies, cannot contribute time or money to politicians, and have the possibility of failure of their enterprise.

Part of the hostility of academics to entrepreneurs and innovators may relate to the fundamentally messy -- or in academic terms "heterogenous" nature of innovation and entrepreneurship. For this reason, there has been relatively little cohesive writing in the academic world, as this subject is not easily given to classification (Balzac 2007)

Once an entrepreneurial enterprise achieves a certain size, it is either accepted into the corporate structure by academicians and politicians, or ostracized for its effects on incumbent competitors. An example of the former is SAP or Oracle, both of which are accepted worldwide. Examples of the latter are Google and Microsoft; Google threatens entrenched publishing interests, while Microsoft threatens non-U.S. computer and software manufacturers.

State-Sponsored Innovation Support Efforts

Direct State Investment in Innovative Efforts

The state or regional government may choose to invest directly in venture capital, small business capital or state-subsidized loans. These investments can take one of several forms:

National investment support, such as the Small Business Administration in the United States. With 1,100 offices, the SBA covers every Congressional district in the country. While originally founded to help new small businesses, most SBA loans go to existing small businesses, generally retail establishments, which have already been running for several years.

The SBA created the SBIC structure, which is the "Small Business Incentive Corporation." SBIC invests in venture funds as a limited partner, matching other limited partners up to a 2:1 ratio with low-interest subordinated debt, up to a certain limit. In general, the limit of SBIC investment in any fund is $75 million, which can match $37.5 million in other limited partners' funds. This approach has drawn criticism, as many of the SBIC investments have proven uneconomic, and congressional and local interests have misused the system, while Congress has added additional restrictions. A few years ago, Congress created a set-aside SBIC called the MESBIC, which is the "Minority Enterprise Small Business Incentive Corporation," intended to further the cause of minority- and women-owned venture capital funds. MESBIC's have been singularly unsuccessful, and have been deemphasized in recent years.

Related to this are: State-sponsored venture capital investments. Countries and regions invest in venture capital funds as Limited Partners, meaning that they have the same or similar financial returns as all other investors in a Fund. In many cases, such state investments require some conditions on the privately-run venture fund. The most popular conditions include:

fixed percentage threshold of investment in the region or country, or certain number of jobs to be generated by their investments, or Attracting a certain multiple of investment from outside the state or region into the fund, or Limiting the venture investments to the types of technologies and industries which are of greatest interest to that state or region.

Examples of the above can include the Indiana Futures Fund, in which the State of Indiana invested $100 million in several venture funds. Among their conditions, 70% of the venture investment must be made in the State of Indiana. In addition, each of the venture funds must open an office in the State. Finally, the investments of interest to the IFF were biotech and high technology industries.

The neighboring state of Michigan created a $2 billion "fund of funds" in 2006 with similar conditions, including requiring the investee venture funds to open an office in the state (or be headquartered there) and to invest in "favored" industries, including pharmaceuticals, medical devices and automobile technology.

The general record of such state funds has been poor. The State of Ohio closed down its fund-of-funds investments after several scandals. The State of New Mexico, which had intended to invest over $200 million of state pension money, closed down its effort with an outside fund-of-funds manager due to differences between the managers (who wanted to focus on financial returns) and employees of the state (who wanted to direct money to political favorites).

Direct regional investment: Several states in Germany have created funds which are funded primarily by bonds or tax revenues in order to invest directly in small, innovative businesses. The primary argument used for the establishment of these funds is that the venture capital infrastructure in Germany is insufficient, and banks are too conservative to underwrite such financing. The states of Baden-Wuerttemburg and Bavaria have the most active programs, with Bavaria concentrating on biopharma investments, and the state of Baden-Wuerttemburg focusing more on high-tech, particularly related to machine tools and the auto industry. Since the primary goal is to support new companies, there is little or no reporting of the financial returns of these investments.

This model has been pursued in a number of other countries in Europe, particularly France, Spain and Italy. The UK, Netherlands and Scandinavian countries have been more laissez-faire about such companies, perhaps because each of these countries has a more active and focused local venture capital infrastructure.

In general, the argument that venture capital is underdeveloped in most European countries is true. The key factors blamed for this dearth of start-up investors include:

High capital gains and income taxes, which make it difficult for venture capital partners to maximize their personal returns on investment.

Few exits, due to a relatively underdeveloped IPO, or public stock market, access. In Germany, for example, the Neuer Markt was an abject failure on the Frankfurt Stock Exchange, which pushed many young companies to the London AIM market (for early-stage companies) or the Swiss SWX exchange.

High barriers to company formation, hiring and other bureaucratic barriers. Those countries in "old Europe" suffer particularly from the difficulty of forming new corporations.

High cultural cost of bankruptcy. Since bankruptcy is an important part of new company formation experiences, the high cultural stigma

Definition of Successful Innovation

The primary creator of value is market valuation, whether through profit creation, stock market capitalization, or acquisition for a set value. The benchmark used for the success or failure of such systems in this paper, therefore, is the measure of the actual value created.

Most regional and national governments may add two additional conditions: employment growth and tax base. Such job creation is helpful on a political basis, but may ignore the other effects of wealth creation: entrepreneurs, banks, investors, venture capitalists and shareholders may all benefit from the increase in value created by innovators and innovative companies.

Whither Innovation and National or Regional Systems?

There is a lot of money and ink, in addition to time and treasure, on developing "innovation systems." This paper has attempted to illustrate that such efforts are doomed to failure. The difference in culture between governmental and academic groups, on the one hand, and entrepreneurial and innovative groups, on the other, is too great. The reward systems, organization, cultural status and attitudes towards risk are at polar opposites between the two groups.

Does the above mean that there is no role for regions and nations to encourage innovation? The best policy is to embrace creative destruction, a la Schumpeter, and trust in the market to create more jobs in the creation process than are destroyed in the destruction process.