Why We Need Innovation

If innovation is so great, why don’t more companies do it?

While gurus proclaim “Innovate or die,” the truth is many companies get along fine without it and still others do their best to avoid it.  Innovation isn’t always profitable. If it were, corporations would always pursue it, which they clearly do not.

However, innovation is important for the rest of us, which is why we need to encourage and protect it.

Supply, Demand and Economic Rents

Every child in school learns that supply and demand determine prices.  If prices are too high, firms come into the industry and prices will fall.  If prices are too low, some firms will leave and prices can rise again.  Every company will seek to get the highest price it can but will be constrained by competitors.

The problem with this view is that it assumes an absence of profits when supply and demand are in balance (technically, profits would not exceed the cost of capital).  Why would anybody want to risk investing equity in a business when the best they can hope for in the long run is the same they could earn by investing passively?

David Ricardo, a contemporary of Adam Smith, theorized that one way of earning a profit is to seek economic rents.  Since all resources aren’t equal, for instance there are better and worse grades of land,  some will get the best resources and then be able to make extra profit.

In this view, profits are possible, but only for a lucky few.

The Problems of Rent Seeking

If profits are only for those who can grab the best resources, capitalism is an ugly system.  It’s in the interest of those in power to grab the best resources and most people have to subsist on scraps.

In the 19^th century, there was much to support this view.  Colonialism did subjugate whole populations to veritable slave labor.  Wars were fought over resource rich colonies.  Even in economically developed countries, low skilled factory workers lived on subsistence wages while “robber barons” accumulated wealth unseen in earlier ages.

Critics of capitalism predicted that this “contradiction” would lead to its demise.  As the rich and powerful would seek a greater hold over precious resources, there would ultimately be a backlash and capitalism would perish.

Despite the apparent strength of the argument, events seemed to conspire against it.  Over the past few centuries, it is the free-market democratic societies that have proven more stable.  This trend has persisted as trade becomes freer and the economy has become more globalized.  In Eastern Europe, as an example, the societies that moved quickly to a free enterprise system have been the most stable.

Moreover, within free enterprise countries capital invested in equity has outperformed capital invested in debt, even when the greater risk is factored in.  Obviously a piece of the puzzle was missing.

Creative Destruction

Joseph Schumpeter, managed to shed some light on the riddle in the middle of the 20^th Century.  He pointed out that control over resources wasn’t the only way to earn economic rents.  Creating better products and processes through innovation also produces excess profits.

Furthermore, he made the distinction between a capitalist and an entrepreneur.  While entrenched capitalists seek to earn economic rents based on their market power, entrepreneurs need to create something demonstrably better in order to overcome the barriers to entry that big companies erect to defend themselves.

Moreover, all corporations have to innovate just enough to stave off new market entries by entrepreneurs.  In effect, established companies will try to find an optimal mix between rent seeking and innovation.

Therefore, free capitalist societies would have a distinct advantage by creating a fertile ground for entrepreneurs (although Schumpeter believed that sociological tendencies toward a welfare state would constrain this).

Modern Day Rent Seeking

Even in our hyperkinetic digital age, rent seeking is alive and well. There are three main rent seeking options for today’s corporations.

Patent Protection: This is a rent seeking behavior that is mostly condoned and encouraged.  People who create something new are given protection for a period of time in which they can recoup their investment in research and development through excess profits.

In some cases, like with pharmaceutical companies who withhold life saving drugs from third world countries, it has come under fire.  However, patent protection is generally considered to be a positive thing and with good reason.  It encourages innovation.

Brands: A strong brand is another way to earn excess profits.  Companies like Nike are able to earn far more on their wares than any difference in product performance would explain.  Generally brands play a positive role as well, which is why I argued that brands will become even more important in the digital age.

Brands keep companies out of dark alleys.  When poor work conditions threatened to tarnish Nike’s brand, they deemed it more profitable to improve the plight of third world labor than to make their products cheaper.  Tainted Coca Cola in Belgium, a relatively small market, sent the company scrambling to implement quality control measures worldwide.

Regulation: Despite progress, the Robber Barons of centuries past haven’t disappeared.  In 2004, federal lobbying in the US was a $2 billion industry.  That’s an artificially small number that might even be surpassed by state and local lobbying.

Surely, corporations wouldn’t be spending that kind of money if they didn’t expect to earn a healthy return on their investment.  Moreover, they wouldn’t spend anything at all unless they felt that lobbying was a more efficient way to create profits than innovating.

As I pointed out in an earlier post about Rupert Murdoch, many free market advocates would often prefer to whine about “unfair competition” by upstarts rather than adapt to a new reality.

Every businessman is a free-marketeer until they think it will cost them money.

When Companies don’t Innovate, We Pay the Rent

It is clear by the behavior of profit seeking companies that innovation isn’t the only path to success.  Companies like News Corp, Microsoft and even Apple choose a mix of innovative and rent seeking activity.  While corporate mavens might pay lip service to innovation, in fact they will do what is most profitable.

It shouldn’t be surprising that many companies would choose not to innovate if they could.  Innovation is hard, expensive and risky.

However, while argument for innovation within businesses is highly situational, it is not for societies.   As Francis Fukuyama pointed out in his book the End of History, countries that encourage innovation outperform those that don’t and enjoy increased power on the world stage.

When governments protect corporations, they do so at the peril of everybody else.  Companies that are unable to innovate or build strong brands look for profits through protection by regulation.

So, despite what management gurus say, innovation isn’t always great for companies, but is for societies.  Therefore, we should be all the more suspicious when corporate moguls seek consideration in the name of “ideals.”

The rent that they seek will inevitably be paid by the rest of us.

– Greg.