Innovation theory as a criticism of neoclassical theory

Innovation theory as a criticism of neoclassical theory

Criticisms of the neoclassical model of the firm:• Impressively rigorous but how relevant in practice?

Maximization under clearly defined (and known in advance) constraints; assumptions that simplify mathematics

• Firm tends to remain a black box; more interest in markets than in firms

• Technology is given exogenously• Rational and fully informed actors• Self-interested behaviour; everybody in the firm acts

in the firm's interest (firm is like a person)

Attempts to get things more realistic (at the expense of rigour?)

Explicit recognition of risks and uncertainties: • Risk: A probability distribution is known

• Uncertainty: You are unable to attach probabilities to future outcomes from an action (strong uncertainty: you do not know what you do not know)

• Incomplete information: In many cases it is rational not to be fully informed! Why?

→Think of the neo-classical rule of profit maximization (MR=MC). Assume that getting informed is an economic activity with marginal costs (MC) and marginal revenues (MR) … Moreover, the value of information to be collected can be assessed only once the information costs are incurred (uncertainty about MR!)

Instrumental rationality versus bounded rationality:

Instrumental rationality:• The choice of the best means to specified ends.

Bounded rationality (Herbert Simon):• Decision-making is influenced by the limited

cognitive capacity of actors. Firms are unable to maximise; they are 'satisficing'; they stop searching for better solutions once they have found a satisfactory solution.

Routines in evolutionary theory:

• Definition: A routine is a regular and predictable behaviour pattern

• Business decision making is skilled behaviour, comparable to driving a car. It involves large amounts of learned skills, as well as limited amounts of immediate calculation.

• Management involves "internalized skills"; skilful behaviour has become "automatic", routed in the firm's history, culture and social milieu.

Danger of routines:

• Managers may display response patterns, drawing on internalized knowledge and skills, after the environment for which they were appropriate has changed.

Note that history matters:• Cultures, experiences and "how we do things here"

develop in time and constrain the present. They cause path dependency: past experience determines what the firm "is good at"; it shapes ways of decision-making and closes off options. Firms may be trapped into inefficient behaviour by long-past influences and decisions.

Technological change

Angus Maddison's estimates of total World production of goods and services:During 320 years preceding 1820 → Increase by a factor 3During 180 years after 1820 → Increase by a factor 60

New questions:

Why has industrial capitalism been so successful?

Which factors drive or hamper innovation?

Are some types of capitalism (e.g. the corporatist 'Rhineland' model) better than others (e.g. the Anglo-Saxon 'free market' model)?

The neo-classical approach to growth accounting:

A classical article by Robert Solow (1957): About 80% of growth in the period 1909-1949 in the US cannot be explained by growth of labour or capital; it must be due to "technical change" ...

… but "technical change" remained a "black box"!

Critique:• "Technical change" is what is unexplained (i.e. the

"residual" or the "coefficient of ignorance")

Criticism on Solow:

• No account of education and training of labour force• No account of differences in the quality of capital• Solow ignored economies of scale: Cost reduction

from producing at a larger scale• Solow ignored economies of scope: Cost reduction

due to savings on R&D by producing technically related products

• Solow ignored 'learning-by-doing': Cost reduction due to experience

• Solow assumes that all firms operate at the technological frontier; they can tap into the stock of knowledge and use whichever technology they choose (perfect knowledge).

Change of focus in economics:

From the neo-classical question: • "Given available technologies, how can we allocate

resources most efficiently?" (static efficiency)

… to the evolutionary question:

• "How can we achieve fast technological progress?" (dynamic efficiency)

Towards a "direct" investigation of technical change: David S. Landes (The unbound Prometheus)

Key conclusions:

• At the heart of the industrial revolution is substitution of mechanical devices for human skills

• Substitution of inanimate power (steam) for human and animal strength

• Marked improvement in raw materials production and use

• Key factor: Introduction of machines, leading to unprecedented productivity growth

Towards a "direct" investigation of technical change (1):

• Innovations "came in a sequence of challenge and response, in which the speed-up of one stage of the manufacturing process placed a heavy strain on the factors of production in one or more other stages and called forth innovations to correct the imbalance' (David S. Landes: The unbound Prometheus, CUP, p. 84). Innovations create new bottlenecks and new opportunities elsewhere.

• Important are not only the major breakthroughs but also the innumerable adjustments and improvements that follow them.

Towards a "direct" investigation of technical change (2)

• Historical path dependencies count: Accumulation of knowledge requires (time-consuming) learning and R&D investment; what a firm is "good at" depends on its past learning through product and process development; a firm's historically grown knowledge base determines (and limits) successful future choices for innovative investment → knowledge is not freely available to perfectly informed agents.

• There are from time to time "pervasive" (general purpose) technologies that become relevant not just for one sector, but also for several others or even to the entire economy (steam, electricity, new materials). Progress in one sector is crucial for progress in others.


• Many firms are (far) distant from the best-practice-frontier (Production possibility curve): There are significant differences in productivity between firms in the same industries

• "Tacit" knowledge can be crucial. Tacit knowledge is ill-documented, ill-codified, implicit (in the finger tops of people), based on personal experience. Its tacit character limits the transfer of knowledge across geographical distance.


• It is unrealistic assuming perfect knowledge. Innovations are expensive, time-consuming and uncertain; they involve trial and error, failures and dead ends. Technical and commercial uncertainty can lead to under-investment in innovation. There is no 'linear' sequence: Basic research→ applied research→ invention→ development→ production→ marketing.

• Uncertainty can be aggravated by the "sunk costs" character of innovative investments: they are quite specific and often irreversible.


• Firms are not so free to choose; they can be 'locked-in' (in inferior technologies), due to 'sunk costs' due to past investments or standards.

• Markets tend towards under-investment in R&D since firms cannot fully appropriate innovation benefits (positive externalities). This is due to the 'public goods' character of technological knowledge (non-rival, non-excludable).

• R&D projects involve indivisibilities: High fixed costs, negligible marginal costs (strong economies of scale)→ imperfect markets!


• Innovations are rarely an isolated episode but are embedded in a 'technological trajectory'. Major technological breakthroughs can be followed by numerous incremental product and process improvements.

• Successful innovation in one industry often depends on progress in other industries, requiring interaction with other parties (suppliers, clients, public research institutions)

Why does not everybody innovate?

• 'Sailing ship' effect? (Power of vested interests: emergence of the steam ship triggered improvements in sailing ships)

• Technological opportunity (Sector-specific factors)

• Firm-specific knowledge/competencies (Path dependency due to accumulated 'tacit' knowledge)

• Economic inducements (Bottlenecks, local demand, input prices, competitive rivalry)

Appropriation of innovation benefits:

• Secrecy: Never perfect; more efficient for process than for product innovation

• Accumulated tacit knowledge = Un-codified, ill-documented, idiosyncratic knowledge, based on personal experience (keep your qualified personnel!)

• Lead times on competitors• Establish brand loyalty and credibility; exploit

customer feedback for improvements; • The learning curve (learning-by-doing)• Complementary assets, e.g. marketing and after-

sales-services• Standards, e.g. IBM vs. Apple• Patent protection: More efficient for product than for

process innovation

The economics of the patent system (I)

Advantages of a patent system:

• Well-defined and protected property rights

• A database on the current state of knowledge

• Monopoly profits give an incentive for further development, but also for 'inventing around' by others

• Facilitates financing of developments and of large-scale investment

The economics of the patent system (II)

Disadvantages of a patent system:

• Monopolies lead to welfare losses

• De facto cartels through (cross) licensing

• Waste due to 'inventing around', notably in cases of 'fencing in' technology by means of numerous fringe patents

• Large firms can 'squeeze' small firms in protracted lawsuits

• Other means of protection may be more efficient (time-lead, secrecy, tacit knowledge)

Why selling licenses on patents?

• Reduce costs and risks of production and distribution

• Reach a larger market

• Exploit in other applications

• Establish standards

• Gain access to complementary technology

• Block competing developments: Convert a competitor into a defender of your product

Five major technological trajectories:

• Supplier-dominated innovators

• Scale-intensive innovators

• Science-based innovators

• Information-intensive innovators

• Specialized suppliers

→ These five types of innovators differ substantially

Supplier-dominated innovators:

Typical sectors: • Agriculture, traditional manufacturing and services

Main sources of technology: • Little R&D (rather process-oriented than product-

related R&D); equipment bought from suppliers; production learning

Main tasks of technology strategy: • Exploit non-technological advantages; adopt IT and

other equipment offered by suppliers; respond flexibly to user needs.

Scale-intensive innovators:

Typical sectors: • Bulk materials; consumer durables; automobiles;

civil engineering

Main sources of technology:• Production engineering; Production learning;

suppliers; design offices

Main tasks of technology strategy:• Managing safe and complex products and processes• Managing incremental improvements; adopt best

practices

Science-based innovators:

Typical sectors:• Electronics, chemicals

Main sources of technology:• R&D, basic research

Main tasks of technology strategy:• Exploit economies of scope• Exploit basic science; collaborate with universities

Information-intensive innovators:

Typical sectors:• Finance, Retail, Publishing, Travel

Main sources of technology:• Software and systems departments; suppliers

Main tasks of technology strategy:• New products and services; design and operation of

complex information processing systems; match IT-based opportunities with user needs

Specialized suppliers:

Typical sectors:• Mechanical engineering; instruments; software

Main sources of technology:• Design; advanced users

Main tasks of technology strategy:• Monitor users and maintain strong links with lead

users; match technologies to user needs;

Ignoring uncertainty: Rationalist school (Victor Ansoff)

Analogy with military strategy: (1) Describe, understand and analyze environment(2) Determine course of action(3) Carry out action

Corporate equivalent: →SWOT: Analysis of corporate strengths and

weaknesses in the light of external opportunities and threats.

→Weak in a complex, fast changing environment and under imperfect information

The difficulty with "strategic" thinking:

• The war in Vietnam is going well and will succeed (R. McNamara, 1963)

• I think there is a world market for about five computers (T. Watson, 1948)

• Prediction is very difficult, especially about the future (N. Bohr)

• I cannot conceive of any vital disaster happening to this vessel (Captain of Titanic, 1912)

Alternative: An Incrementalist Strategy (1)

Make deliberate steps – measure and evaluate – adjust objectives (if necessary) and decide on next steps

Design – development – test – adjust design – retest – operate

Incrementalist Strategy (2)

Implications for corporate strategy:

(1) Corporatist strategy should be seen as a form of corporate learning, from analyses and experience, how to cope more effectively with complexity and change

(1) Successful management practice is never fully reproducible

Incrementalist Strategy (3)

Implications for strategy formation:• Explore implications of a range of possible

(but uncertain) future trends• Ensure broad participation and informal

channels of communication• Use multiple sources of information, debate

and scepticism• Expect to change strategies in the light of new

(often unexpected) evidence

Michael Porter (1)

Five forces driving industry competition:

• Relations with suppliers• Relations with buyers• New entrants • Substitute products• Rivalry amongst established firms

Threats and opportunities in Porter’s analysis (1)

Potential entrants and substitute products:

• Threat is increased by poor economies of scale and / or poor learning effects; and by substitute products

• Threat is decreased by ‘lock-in’ to technological standards or through patent protection


Power of suppliers and buyers:

• Increases with the dependence on innovations that are essential to your inputs

• Decreases by innovations that reduce technological dependence on suppliers


Rivalry amongst established firms:

• Market power can be established by innovation, but it can also be destroyed by imitation

Porter’s generic technology strategies (1)

Choose between “Cost leadership” and “Differentiation” strategy


“Cost leadership” (minimize costs):• Lower material inputs• Ease of manufacture• Improve logistics• Minimum features• Exploit economies of scale• Exploit learning-by-doing


“Differentiation” strategy:• Enhance quality and features (niche

markets)• Deliverability• Precision and quality control• Response time


(1) Choose between cost leadership and differentiation

(2) Also choose between “Innovation Leadership” and “Innovation Followership”


“Innovation Leadership”

Strong commitment to: Creativity, risk-taking and R&D Close linkages with major sources of new

knowledge and Needs and responses of customers


“Innovation Followership”

Strong commitment to: Competitor analysis and intelligence Reverse engineering Cost cutting and production learning


Weaknesses of Porter’s theory: Too close to ‘rationalist’ school: underestimates

uncertainty (unexpected new technologies that change the rules of the game)

Empirical evidence: ‘Stucking in the middle’ (between cost leadership and innovation) can be quite profitable

You cannot always choose a strategy (firm size; tacit knowledge due to established product base)

If innovation is only seen as … Strong R&D capability

… the result can be: Technology fails to meet user needs

Problems with partial views of innovation (1)

If innovation is only seen as … The province of specialists in R&D

laboratories

… the result can be: Lack of involvement and knowledge /

experience from others (e.g. clients, market research)


If innovation is only seen as … Understanding and meeting customer

needs

… the result can be: Lack of technical progression (users

demand what they know)


If innovation is only seen as … Technology advances

… the result can be: Producing products which customers

do not want; designing processes which fail to meet user needs


If innovation is only seen as … The province only of large firms

… the result can be: Weak small firms with too high a

dependence on large customers


If innovation is only seen as …

Only about “breakthrough” changes

… the result can be:

Neglect of potential of incremental innovation


If innovation is only seen as … Only associated with key individuals

… the result can be: Failure to utilize creativity of your

entire organization



Only internally generated


'Not invented here' effect



Only externally generated


Only externally generated

Little internal learning; dependence on others



Only concerning single firms


Neglect of networking


Uncertainty around R&D (1)

Planning and financial assessment of R&D projects is almost impossible, because:

• Project outcomes are uncertain• Different stages have different outcomes, requiring

different methods of evaluation• Many crucial variables depend on expert judgement

(there are no precise figures to be fitted into a formula)


Research by Edwin Mansfield shows that:• Managers and R&D workers can not predict

accurately the development costs, time periods, markets and profits of R&D projects

• Underestimation of time and costs: 140-280% for incremental improvements; 350-600% for major new products

• More than half of all projects (and about half of R&D expenditures) are on failed projects

• R&D scientists often are over-optimistic in their estimates.


How to deal with uncertainty?• Incrementalism: step-by-step modification of objectives and

resources in the light of new evidence• Use simple rules (transparency)• Criteria for stopping a project should be made explicit from the

beginning• Use sensitivity analysis (E.g. ‘What if costs double?’)• Try to reduce uncertainty before committing large sunk costs

(‘learning before doing’).• Recognize that different types of R&D require different

evaluation criteria


Three overlapping categories of R&D:• Knowledge building: Monitoring of technological

environment; inexpensive; questions: which options or threats emerge? Can we afford (not) to enter certain fields?

• Strategic positioning: Applied research and feasibility studies in order to reduce uncertainty and build in-house competence; live with high volatility of predictions and expectations; variety of evaluation methods that are more judgemental than rigorously quantitative.

• Business investment: Division-level decision about commitment of large resources (sunk costs!). Emphasis on user needs and marketing. Careful monitoring and control of progress. Tight control of external links (Joint Ventures, ownership).

Factors influencing diffusion (1)

• Relative advantage: e.g. financial payback, convenience, satisfaction, social prestige

• Compatibility: Consistency with values, experience, needs of potential adopters, their skills and practices, equipment, procedures and performance criteria; is it an 'all-or-nothing' option or can it be gradually implemented? How important are 'network externalities' and complementary innovations?

• Complexity: Is it hard to understand? Does it require additional skills and knowledge? ("absorptive capacity" of user?)

Factors influencing diffusion (2)

• Triability: Experiments may reduce uncertainty

• Observability: Epidemic model assumes spread by contact with other users

• Future improvement potential: If you expected a rapid speed of technological change: postpone adoption?

• External interests in diffusion: E.g. diffusion of medical technology crucially depends on doctors and hospitals; or insurance companies may insist on certain specifications

National differences in innovation patterns

Factors: Examples:

Local buyers tastes

Food and clothing in France and Italy

Reliable machinery in Germany

Private investment Automobile sector stimulating CAD and robots in Japan, Sweden and Germany

Public investment Railways in France

Medical instruments in Sweden

Input prices Labour-saving innovations in high-wage countries

Europe-US differences in automobile technology

Environmental technology in Scandinavia

Local natural resources

Innovations in oil and gas; mineral ores, food and agriculture

Innovation models: Schumpeter I and II

Schumpeter I model:

“Entrepreneurial model”: new firm foundation (e.g. in ICT, biotechnology); individual inventor-entrepreneur (“Garage business”).

Schumpeter II model:

“Routinized innovation model”: Incremental, stepwise innovations based on continuous accumulation of (tacit) knowledge; professionalized R&D labs in larger firms.

Rhineland model versus Anglo-Saxon model

Characteristics Anglo-Saxon Nippon-Rhineland

OwnershipIndividuals, pension funds, insurers

Individuals, companies, banks

Control Dispersed; arm’s lengthConcentrated, close and direct

ManagementBusiness Schools; accountants

Engineers with business training

Evaluation of R&D Published information Insider knowledge

Strengths

Responsive to radically new technological opportunities;

Efficient use of capital

Higher priority to R&D than to dividends for share-holders;

Remedial investment in failing firms

WeaknessesShort-termism;

Inability to evaluate firm-specific assets

Slow to deal with poor investment choices;

Slow to exploit radically new technologies

Factors behind sources and directions of technological change (1)

Firm size:

Typically big in chemicals, road vehicles, materials processing, aircraft and electronic products; typically small in machinery, instruments and software

Type of product:

Price sensitive in bulk materials and consumer products; performance sensitive in ethical drugs and machinery

Objectives of innovation:

Typically product innovation in ethical drugs and machinery; process innovation in steel; both in automobiles

Factors behind sources and directions of technological change (2)

Sources of innovation:

Suppliers of equipment in agriculture and traditional industries; customers in instruments, machinery and software; in-house R&D in chemicals, electronics, transport, machinery, instruments and software; basic research in ethical drugs

Locus of own innovation: R&D labs in chemicals and electronics, production engineering departments in automobiles and bulk materials, design offices in machine building; systems depart-ments in service industries (banking, supermarkets).

Locating R&D: Corporate or divisional?

Corporate level: Long time horizons; slow feedback loops; weak internal

linkages; strong linkages to external knowledge sources; projects are relatively cheap

Business unit level: Short time horizons; fast learning feedback loops; strong

internal linkages with production and marketing; projects are relatively expensive

Locating R&D: Corporate or divisional?

Rules of thumb: R&D supporting existing businesses should be located in

established divisions R&D supporting new businesses should initially be located

in central labs, then transferred to divisions for exploitation R&D supporting foreign production should be located close

to foreign production (adaptation of products to local conditions).

Distinction between physical location and funding unit!

Location and funding of R&D:Corporate or divisional?

Corporate-level per-formance: Interfaces with advances in generic S&T

Divisional-level per-formance: Interfaces with production, custo-mers and suppliers

Quadrant 1 Quadrant 2

Corporate-level funding: Benefits are corporate-wide

Scanning external research; Assimilating and assessing radical new technologies

Commercializing radical new technologies; Exploiting inter-divisional synergies

Quadrant 3 Quadrant 4

Divisional-level funding: Benefits are division-specific

Exploratory development of radical new technologies; Contract research for specific division problems

Mainstream product & process development;

Incremental improve-ments

Criteria for centralized versus divisionalised R&D

A firm’s main technological trajectory. Is the critical interface:• Between basic science and technology? (pharmaceuticals,

chemistry) ⇛ Central lab + cooperation with universities• Between R&D (and design) and production? (automobiles,

aircraft) ⇛ Division

How young is the field?• New fields like biotechnology, need to be sheltered for

some time against the pressure of immediate valorisation ⇛ Central lab + cooperation with universities

Corporate style: • Short-run profit maximization (‘market-led strategy’) leads

to emphasis on divisionalised R&D ⇛ Division

R&D: global versus local

Evidence from the World’s 359 largest firms:

• On average, they perform about 12% of their innovative activities outside their home country (equivalent share of production: 25%)

• Shares of foreign innovative activity are explained by shares of foreign production

• Firms from smaller countries tend to have higher shares of foreign innovative activities

• Foreign production tends to be less innovation-intensive than home production

• Most of foreign innovative activities are performed in the USA and Europe (in fact: Germany). They are not globalised

• Since the late 1980s, European firms (esp. from F, D and CH) have increasing shares of innovative activities in the US (⇛ tap into local skills and knowledge in IT and biotechnology)

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Innovation theory as a criticism of neoclassical theory