Business: National or Regional Innovation

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

Science Parks, Incentives to move Manufacturing

There are some measures that local and regional economic development authorities will take which do prove politically popular. These are, for the most part, not related directly to innovation:

Tax, education and other subsidies in order to move factories to a new site. These practices are particularly popular in mature industries with a lot of employees. Thus Tennessee, Kentucky, South Carolina and Alabama competed in a 'subsidy war' to attract green-field factories from BMW, Honda, Daimler-Benz, Nissan and others to their state. While the jobs attracted prove politically popular, the costs in foregone tax revenues or direct subsidies can sometimes pose a political problem.

Erection of "innovation centers," usually buildings and real estate with subsidized prices for qualifying renters, who meet certain criteria as 'innovation company.' These can specialize in specific technological areas, such as semiconductors, telephony or life sciences/biotech. The screening committee is usually a panel of amateurs from the community, and the success rate is rather low.

Innovation centers attached to universities. For the most part, these are profit-making real estate ventures, in many cases owned and managed by a university. In some cases, the university may receive additional support for management and building from a regional or national government. The intention is usually to form a venue for the successful 'spin-out' of technology from the university's labs into a company in which the university may receive a portion. A prominent example of this is Stanford University, which, among its sponsored ventures, loaned 10 desks to Google in 1998 as it was starting. The stock that Stanford received in return was sold for $250 million in Google's IPO.

As proof of the above, only 71 of the 500 companies in the Fortune 500 were present in 2004 that were also present in the list in 1955 (Colvin 2004). The illusion of permanence is reassuring to employers and employees alike, but innovation can overtake even the biggest company.

Nearly all new jobs -- 80%-- are created by small businesses in the U.S. (small businesses are those employing fewer than 100 people) (Birch 1987). Politicians, on the other hand, focus on large companies -- precisely the ones which continually lose employment.

The U.S., by and large, accepts this logic of creative destruction. There are certainly exceptions, such as Chrysler and Lockheed in the 1980's, and the steel industry (through tariff barriers and direct subvention) in the last three decades. European governments are less willing to let go of their "strategically important" businesses, and as a result spend billions of Euros per year propping up businesses that will eventually fail.

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.