Government Support for Commercial Innovation Knowledge Economy Forum V Prague, 28 March 2006 Manuel Trajtenberg Tel Aviv

1. Government Support for Commercial InnovationKnowledge Economy Forum VPrague, 28 March 2006Manuel TrajtenbergTel Aviv University, NBER, CEPR

2. IntroductionR&D Policies: Prospects and Perils • We take it for granted that Governments should support Innovation and R&D, ride the wave of the Knowledge Economy. • “Official blessing” of such view in the Lisbon agenda: goal of 3% R&D/GDP • “Bandwagon effect” in the globalization of R&D; • Rush to mimic policies of presumed success stories (e.g. Finland, Israel, etc.), • Rush to attract/set-up Venture Capital funds, etc.

3. Intro - continued • In order to “do it right”, need to understand the fundamentals: • What is exactly the economic rationale for government intervention in the realm of Innovation and R&D? => • Appropriate policies should be derived from it! • How that varies across countries, given the tremendous heterogeneity in their institutions, stages of development, availability of appropriate inputs, etc.? • Not such as a thing as“one size fits all”!

4. Economic Growth and Innovation • The historical evidence: • Sustained growth always means widespread innovation throughout the economy, not “more of the same”. • Innovation takes many forms: • New/improved products and processes (“new” for the country/sector/firm); • Some “informal” (ingenuity at plant floor), some formal, i.e. patented innovations from R&D labs. • Institutional, organizational innovations.

5. Growth and Innovation – cont. 1 • Innovation entails a variety of processes: • Far reaching reallocation of resources (hence lots of entry and exit), • Upgrading the composition of skills and capital; climbing-up the tech ladder; • Changes in patters of trade. • E.g. see UK, US in 19th century; lately S. Korea, China, India, Ireland, Israel, etc. • => • In every country • continuous innovation sustained growth!

6. Growth and Innovation – cont. 2 • Historically, the cumulative effect of widely distributed “small” improvements as significant for growth as the impact of “major” innovations. • Innovations entail interdependencies, necessitating complementary investments and innovations to reap their full benefits. • Relevant “types” of innovation varies with stages of development, institutional setting, etc. • => • Growth-enhancing Innovation policies: • not only supporting formal R&D, strengthening IPR, • not only in the “high tech” sectors.

7. The Economic Rationale for Government Support of Innovation and R&D Endogenous growth theory: economic forces shaping R&D hence TFP R&D • Arrow (1962): Social returns >> private • Spillovers: Partial appropriability • Information asymmetries: funding gap • High risk, lumpiness, coordination failures K TFP Solow (1956): Total Factor Productivity (TFP) key to growth Growth Too little innovation => need Government intervention (e.g. subsidize R&D)

8. The Rationale for Government Support continued • So, clear-cut case for Government intervention to support innovation, i.e. • Even ina well-functioning market economy, there typically will be underinvestment in Innovation and R&D => Government support • However, many economies not “there” yet, need Government action to create institutional framework conducive to innovation. • Sequencing is important!

9. Spillovers: the basics • Innovations generate positive externalities (e.g. new ideas, new K) that benefit other would-be inventors; • Innovations confer benefits to purchasers of new products (consumers and producers) that often exceed sustainable increases in price; • => • social returns from innovations >> private returns • Spillovers channels: • local interactions, information diffusion, mobility, • International trade, FDI

10. Broadening the Scope of Spillovers,hence of policy • A single innovator may break the mold of stagnant, concentrated markets, and trigger a process of “spiraling innovations” – hence extra benefits. • “Demonstration effects”in diffusion: Early adopters positively impact later adopters: network externalities, informational effects, emulation, etc. • Policy implications: • encourage first-time innovators in stagnant markets; support early adopters, particularly of technologies that enhance productivity in wide range of sectors.

11. More on spillovers and “demonstration effects”:rent-creation vs. rent-seeking norms • J. Mokyr - precondition for Industrial Revolution (thus for growth): shift from rent-seeking to rent-creation, encouraged by the Enlightenment. • Shift yet to occur in some emerging economies: is it more attractive for entrepreneurs to search for innovative ways to further extract rents, or to develop new technologies? • Policy implications: • change cost-benefit of rent-seeking versus rent-creation, help market pioneers; need the local “Thomas Edison”, the local “Steven Jobs” to emulate.

12. Who really benefits from spillover flows in the global economy? • In very large economies such as the USA, spillovers benefit mainly the local economy: • - Large: high Prob. that other local agents will benefit; • - Relatively low [Ex+Im]/GDP: small risk of spillovers slipping out. • In “small” open economies (like ECA countries) : • - Fewer potential local recipients; • - Spillovers may easily spill out, benefiting foreign firms and consumers rather than local economy; • - But may be recipient of trade-mediated spillovers • => need “absorptive capacity”

13. Local vs. Global Spillovers some policy implications • Just promoting local innovation may not result in faster economy-wide growth. • Israel as case in point: extremely successful innovative ICT sector, but slow growth in rest of the economy. • Hence innovation policies should aim at increasing R&D in a way that, • incentivizes spillovers inflows rather than outflows; • develops “absorptive capacity”; • None of it can be taken for granted, certainly not in emerging countries.

14. Innovation and Growth in the context of“General Purpose Technologies” (GPTs) • GPTs as “engines of growth”, e.g. the steam engine, electricity, ICTs: • GPTs drive growth by spreading over a wide range of sectors, prompting them to innovate as well (i.e. “innovational complementarities”). • Progress in the adopting sectors feeds back into the GPT sector => further advances in the GPT itself, feeding a positive, self-sustained loop.

15. GPTs continued • Growth in the US, 1995-2000, due not just to “High Tech,” but to WalMart! TFP growth in retailing via massive adoption of ICT-based methods. • The GPT sector: small, cannot pull on its own the whole economy: if the rest of the economy fails to adopt the GPT, or to make complementary innovations, growth will not materialize. • Policy: focus not just on the prevailing GPT (such as ICT now), but on the potential “Walmarts”…

16. Guiding principles for growth enhancing innovation policies • Innovation should be widely distributed across sectors, and types of innovations. • Bottom up policies, not top down: provide enabling conditions and incentives => innovation should spring from widening cohorts of would-be entrepreneurs, not from gov labs or bureaucrats... • Alter the payoffs between innovations aim at rent creation versus ingenuity in rent extraction. • Main policy levers: • skills, incentives, information, finance

17. Policy levers: (i) Supply Skills • Wide spectrum of skills needed for innovation-based growth strategy, acquired via formal education, training, learning by doing. • Two-pronged strategy: • Supply broad-based, up-to-date skills, including math, ICT, English, management; upgrade often. • Ensure responsiveness (endogeneity) of academic institutions supplying vocational and advanced skills (Rosenberg: “Universities as Endogenous Institutions”).

18. Policy levers: (ii) Incentives • Crucial attractor: Expectation of large rewards to innovation, given risks, costs. • Traditional factor: appropriability, IPR. • Would-be innovators should have a stake in the firm, prospects of promotion, outward mobility. • Low “barriers to innovation” within markets (officially sanctioned regulations, tacit collusion) • Policies promoting, • inclusion(of potential innovators), • openness(of markets).

19. Policy levers: (iii) Access to Information • Necessary condition for innovation: access to K, info about technology, about markets (substitutes, market size, prices). • Innovation as “recombination of ideas”, hence wide knowledge base. • Policy: • Internet access, computer and search skills • Openness and competition in media, • Encourage knowledge intermediaries, • Transparency in businesses.

20. Policy levers: (iv) Availability of Finance for Innovation • Generalized problem, given information asymmetries, lack of collateral, lack of screening expertise; more acute in emerging economies! • Need “angel investors”, internal finance, VCs, etc. Not much available. • => • Preeminent government role: provide funding for innovation, many channels possible, e.g. matching grants, conditional loans, etc. • Lots of international experience – tap it!

21. Further policy issues for ECA countries • Legacy in many ECA countries: associate innovation with centralized research institutions, disconnected from market forces. • Need to metamorphose them into commercial R&D labs – not easy! • Think foremost of incentives to innovate, of demand stemming from open markets, and not just of supply of researchers…

22. But, is Innovation Policy a viable option for ECA economies, really? • Any country can do it, regardless of size, location, and stage of development, but policies should reflect all that. • Each and all countries should do it in order to embark in long term growth, • There is no alternative but to do it!