Economics Of Innovation - Essay Example

ECONOMICS OF INNOVATION Innovation is the lifeblood of a market economy. It extends the range of products available to consumers. It lowers the prices that consumers have to pay. It creates wealth and rewards risk-taking. It alters the compositions of industries by setting growing dynamic firms apart from declining ones. It improves the ways in which firms combine capital and labor, allowing them to produce goods and services more efficiently. Innovation embodies the entrepreneurial spirit. The essence of innovation is commercialized change. Its commercial nature warrants special emphasis, in that innovation pertains directly and exclusively, to observable market activities and outcomes – to the scope of good and services that are offered to consumers, or to technological and organizational advances that facilitates the flow of these goods and services. Innovation is about more than ideas, it is about how the economic system transforms ideas into outcomes, outcomes that continually shapes its evolution. Considerable economic research has been devoted to establishing whether small and large firms differ with regard to the rate of innovation or their R & D activity. In the recent literature on industrial innovation, the main issue is not whether small or large firms are more innovative, but the role each plays in the innovation process. The growth in the number of small firms during the 1980s is not seen as an independent process, but is attributed to the decentralization strategies of large firms (Albert and Patrick, 1992).The outsourcing of entrepreneurial functions by larger firms ha increased their flexibility, allowing them to react more quickly to changing market conditions. Small firms are a major source for new product and processes, but due to their limited financial resources they are often confined to the first phase of the innovation process. Large firms, on the other hand, tend to be engaged in gradual technological changes, imitation and defusion, often adopting the incomplete innovations of small firms and bringing them to the market. They make incremental innovation and carry out more process-oriented research and development than smaller firms (David 1995).Mass production enables larger firms to achieve learning effects, but also leads to path dependence and tends to bind them to technological trajectory, impeding flexibility. While innovation strategies in large firms often focus on activities that benefit from small economies ( for example particular form of research and development), small firm pursue innovation strategies that emphasize specialization, customization and product flexibility, characteristics that depend on the continual interactions between firms and their customers. These innovation strategies often draw on informal learning networks – networks in which small firms learn how to absorb, adapt, improve and tailor new technologies to meet specific market needs. Engineering skills, product know-how and understanding customer requirements are all major sources of incremental innovations in small firms. Considering all the research activities, the relationship between firm size and the intensity and the kind of innovative activity undertaken can be summarized as follows : There is ample evidence that small firms are not per se more innovative than larger firms, although small firms that perform R&D tend to be more innovative than large firms and also generate a large number of innovations per unit of R&D input. The number of firms that do not innovate or that are not engaged in R&D is relatively high among small firms and decline with its size. Large firms are more innovative with respect to the share of firms with R & D. An optimal firm size for innovation does not exist. Innovation varies between firms, between sectors and between markets. Innovation activities depends on the risk aversion of firms, their absorptive capacity, knowledge base, their competencies in organizing innovation processes, their learning abilities and information channels and their access to and handle ability of external knowledge. Small and large firms play different roles in the innovation process. Small firms are the engine of new technological development, but are often unable to complete innovations because of limited resources R & D activity in large firms is more directed towards incremental innovations and process developments, since the budget for process R & D rises somewhat more with size than the budget for product R & D. These finding emphasizes the different roles played by large and small firms in the innovation process. It is of course not merely the size which makes the distinction between the activities and behavior of firms. However, firms with similar structural characteristics tend to group around a particular size. Large and small innovators do, however, rely on different sources of ideas for innovation. Ideas of innovation comes form a number of sources – R &D, customers, the marketing or sales department, the production division or suppliers. Large firms use R&D much more frequently than do small firms. Large firms are also more likely to rely on an external research network, through relationship with a related firm, or to engage in collaborative research with other firms. On the other hand, small firms rely relatively less on an R&D department and relatively more on the technical capabilities of their production departments than do large firms. Small firms also depend on networks – but these networks rely more heavily on customers and their marketing departments for innovations (Cristiano, 2006). These differences in the sources of ideas, when taken together, suggest that the information and transmission processes vary considerably across size classes. Large firms rely more on tacit, noncodifiable information that is developed within the firm, either in their own R&D laboratories or in the R&D laboratories of related firms. Some smaller firms do the same, but this group as a whole does not do so with the same frequency. The rest of the small-firm group relies on information that is more easily codifiable and transmitted from customers and suppliers. The information networks of small firms differ from those of large firms. Despite the importance of R&D for innovation, there are other areas where small firms indicate that they are more likely to face impediments to innovation, and, therefore, where public policy might develop special policies for small firms. Small firms perceive that externalities are relatively important in the area of information about technologies, market potential and technical services (Grant, 2005). They also perceive that there are significant barriers to inter firm cooperation. This is a particularly serious problem since this is the method that they use more frequently for developing new ideas for innovation. Small firms may also face barriers on the intellectual property front. They are less likely to make use of the intellectual property rights that are meant to facilitate the protection of intellectual ideas, and when they do so, to emphasize different forms of intellectual property protection. Over 60% of large firms protect themselves with any one of the statutory rights; less than 30% of those with fewer than 100 employees do so. Part, but not all, of this difference is accounted for by different tendencies to innovate. But even when these differences are taken into account, small innovative firms make less use of the statutory forms of protection than do large firms. When they do make use of intellectual property rights, small firms use trade secrets more frequently, relative to patents, then do large firms. When other differences between small and large firms such as innovatiness, nationality, and industry of activity are considered, size has the greatest impact on patent and trademark use. Financing also presents different problems to small firms. Small firms are more likely to have to finance their innovation investments exclusively from internal sources. Of those firms that receive outside funding, small firms are more likely to receive government funding. But smaller investors are less likely to make use of government tax credits for R & D. According to some studies, small firms are responsible for a disproportionate share of innovations in terms of innovations per employee. While small firms clearly are an important component of R & D infrastructure, it is inaccurate to say that they are necessarily more innovative in general than are large firms. In some respects small firms enjoy advantages over large firms in innovations, while in other respects large firms have the advantages. The Small Business Administration (SBA) notes that for small firms “the incentives are greater: small firms may have the potential to create or capture an entire industry, while large firms are more often protecting a market positions”. Small firms also can be more flexible than large firms, allowing them to change quickly the direction of their research when necessary. Large firms have other advantages in innovation : they can more easily overcome the fixed costs associated with conducting research; can more easily appropriate the returns to an innovation; and, in the case of a monopolist, may have an incentive to innovate to discourage new competitors. Rationale for Government Support Technological innovation is a key to economic growth, but economics suggests that firms of all sizes will invest less than the socially optional amount in R&D. Two main factors are responsible for this under-investment. First, firma are unable to appropriate all of the returns to their investments as others use and extend research results. Second, firms may not have sufficient access to capital because they may be reluctant or unable to provide financiers with enough information to evaluate the potential success of a research project, and because R&D investments cannot be collateralized, unlike investments in machines or buildings. Many empirical studies have documented that these market failures are more than simply theoretical. Recent work confirms that cash flow is an important determinant of R&D investment, suggesting that capital markets are not perfect, while other studies commonly find that the social returns to innovations are far higher than their private returns, implying that market failures do lead to significant R&D under-investment. The market failures leading to R&D under- investment may be exacerbated for small firms. Small firms may have more trouble appropriating the returns to an innovation, and may have worse access to capital markets, in general, than do large firms. Since financiers have less information with which to evaluate the prospects of a small, new firm than they have about a large, established firm, they will demand a premium to provide capital to smaller firms. Capital market imperfections mean that opportunity cost of internal funds may be lower than that of external funds, leading the firm to prefer cash flow for financing investment. While small firms can face difficulties obtaining funds, markets almost certainly do respond to investment opportunities afforded by small firms. In addition, the venture capital market is an important source of finance for young firms and its activities have increased dramatically in the past few years. Nonetheless, evidence of market failures specific to small firm suggests that government has a useful role to play with policies to help small firms perform a more socially optimal level of R&D. CONCLUSION: The relative advantages enjoyed by small and large firms suggest that small firms may be more innovative group under some market structures, while large firms may be the more innovative group under other market structures. Indeed, empirical work confirms that in some industries small firms are responsible for a disproportionately large share of innovations, while in other industries they are responsible for none at all. REFERENCES :  Acs Zoltan J, 1999: Are Small Firms Important? : Their Role and Impact, Springer.  Acs, Zoltan J., and David B. Audretsch, "Innovation in Large and Small Firms: An Empirical Analysis," American Economic Review, September 1988, 78: 678-690  Antonelli Cristiano, 2006 : The Economics of Innovation, New Technologies and Structural Change , Routledge (UK)  Arora, Ashish, Andrea Fosfuri and Alfonso Gambardella (2001), Markets for Technology: The Economics of Innovation and Corporate Strategy, Cambridge, MA: MIT Press  Audretsch David B, 1995 : Innovation and Industry Evolution, MIT Press  Baldwin John R, 2004 : Innovation Strategies and Performance in Small Firms, Edward Elgar Publsihing  Bishop, Kal, 2007: "Creativity and Innovation - Large Firms Versus Small Firms." EzineArticles 17 June 2005.  Black Grant, 2005 : The Geography of Small Firm Innovation, MIT Press  Leyden Patrick & Link Albert, 1992 : Government’s Role in Innovation, Springer  Peters T. (ed.) 1997 : The Circle of Innovation, Springer  Scotchmer Suzanne, 2004 : Innovation and Incentives, MIT Press  Symeonidis, G, 1996 : Innovation, Firm Size and Market Structure: Schumpeterian Hypotheses and Some New Themes?, OECD Economics Department Working Papers N° 161, Paris. Read More