In my last post, we established that the reason the public sector invests in innovation is because they believe in the return on that investment, often referred to as RoI, will be as least as valuable as putting those resources towards hospital beds, highways, and high schools. So what is this expected return and what does it have to do with the Australian research community’s apparent inability to collaborate more with industry?
The return expected on any investment is generally a function of the financial reward promised for use of the resources invested, and the outcome for which the resources are to be used. In finance, it’s generally all about the former, which is usually expressed in terms of interest to be achieved, be that as an agreed rate eg 5% of the amount invested for 12 months, or an expected improvement in value through use of the resources being invested eg an increase in a property’s value from its development. To our financial investor, the outcome is relevant but as it’s usually to use that money to make more money, and the more money is how they’ll pay the interest, they usually see it as all part of the same thing.
When it comes to innovation, the variables produce a more dynamic picture. Broadly speaking, there are three classes of investors in innovation: domestic, commercial and public. Domestic investors are the most likely to be motivated by seeing the outcome realised, because they are generally supporting the innovator rather than the innovation. These are the family, friends and colleagues of the innovator, and they are generally less interested in the proposed fee or rate, although they’d really like to see their investment itself back.
The relative importance of financial reward and outcome to commercial investors is as varied as their reasons for being in the business of providing resources (generally referred to as “capital”) for innovation. While their business model focusses on individual innovators like that of domestic investors, their reasons for selecting individuals are generally more about believing in the individual’s plans, abilities and the potential of the innovation than their desire for that particular innovator to achieve their dream. They are looking for predictors of success – that the innovation will not only be deployed, but will have an impact that will create value. It is the value created that will be the source of the return commercial investors are seeking, both financially in terms of being able to both repay the investment and promised reward, and in terms of the impact achieved by the innovation in and across the field in which it operates. And make no mistake – even the most altruistic commercial investor is looking for some kind of financial reward, if only to substantiate the wisdom of their investment.
If domestic investors are more about the outcome and commercial investors want both outcome and financial reward, where does the public investor sit? Like the domestic investor, public investors are generally all about the outcome with direct financial return a much less important factor. However, their business model is all about the multitude – outcomes that will make a difference on a large scale, either in themselves or by creating a critical mass of ideas and innovations that create a momentum across an industry or industry segment. Which industry or segment could be the innovation sector itself.
According to the Organisation for Economic Cooperation and Development (OECD), innovation and the capacity to introduce new products, processes, services and business models are recognized as becoming increasingly relevant to sustaining productivity and gross domestic product (GDP) growth in the medium and long-term. Sustained productivity and GDP growth are an economy’s equivalent to good heart health and lung function are in an individual’s desire for a long and active life.
New ideas become part of the available know-how of operating efficient businesses, given they wouldn’t be implemented unless they enabled a firm to increase profitability or do more with less in some way. In the short to medium term, these efficiencies may take the form of profits to the implementer – lower costs increasing the profit margin per unit of production, for example – which is the predominant reasons individual firms invest in innovation. However, in the longer term, it is frequently the size of what is termed knowledge spill-overs that result from the innovation that deliver results to the broader economy.
Knowledge spill-overs are, in many ways, the real reason the public sector invests in science and innovation. In the words of the OECD, “[Innovative] activity may be characterized by increasing returns to scale as innovation by one entity can produce externalities, in the form of knowledge spillovers, that benefit follow-on innovators. The fact that these spillovers are often non-rival and non-excludable results in the social rate of return to many innovative activities exceeding the private rate of return.”
In non-economics-speak, this means one firm’s investment will give it an advantage over its competitors, but that only helps that one firm. However, the extent of that benefit will last only until the competitors catch on and catch-up, which they usually do. Then other firms will begin to adopt and adapt, through means legal and not. This is how the knowledge “spills over”, and it is generally hard to prevent, particularly when the innovation is a product or technology and part of the original firm capitalising on it requires it to be released publicly.
It is this unintended return to firms other than those bearing the costs i.e. the original innovator/implementor to which the OECD attributes the tendency of private firms to under-invest in innovation. The size of the broader-scale benefits is often much bigger than the benefit the firm that actually spent money, time and other resources developing and implementing the innovation. Not only did they commit the resources, they undertook the risk. They had no guarantee the innovation would have a positive impact – it could, and probably at first, did have a negative impact – unlike the recipients of the spillover, who not only had the realised innovation but the proof of success effectively established for them.
With firms responsible for wages, raw materials, costs of production, distribution, health and safety, insurance, compliance and a million other things that could easily benefit from the resources dedicated to seeking, developing and implementing innovation, one can see not doing so is definitely the easy decision.
The primary interest of an Individual firm is it benefitting itself – generally their individual interests are best served by not taking everyone with them as long as possible. For the public sector the direct opposite is true.
OECD studies show that the most advanced countries show a strong correlation between a solid base of innovative entrepreneurs, greater leverage of the scientific and technological base, and productivity growth (Development Centre Studies, 2013). Follow-on innovators adopt and adapt, and as that is replicated across an economy, and more firms are able to produce a higher volume of output for the same volume of input, we can say that the economy is achieving higher productivity. This is where the benefits of innovation shift from the individual to the economy as a whole, increasing the availability of resources for all sorts of uses by individuals, firms and government alike, including to support more innovation.
This is why the public sector invests in innovation, either directly or by trying to stimulate investment by others – because increasing productivity within the economy is a priority almost every government considers so important it is worth putting resources into even though there is risk the public money invested won’t ultimately deliver an innovation than will have any impact on productivity. Even though the increases in productivity may take a long time to be realised. Even though the impact of their investment on the ultimate success of the innovation may barely even be acknowledged.
So public investment in innovation is good, and you can’t have too much of a good thing, right? Right??? Wrong.