Innovation

Innovations and the Economics of New Technology

Innovation plays a central role in promoting long-term economic growth. It is innovation that drives an economy towards a higher standard of living.

Innovation consists of new products, improved products, improved technologies, more efficient use of labor and improved labor market skills.

Most innovation is not about doing the same things as before but in a better way.

It is more often about doing new things in a completely different way.

People have been using a device called a telephone since the late nineteenth century.

But the telephone of today cannot be compared with the telephone back then other than in the most primitive way.

The succession of innovations between that time and this has made this device, for all practical purposes, into an entirely different product.

Almost all innovation in an economy Opens in new window is driven by private sector entrepreneurs Opens in new window without whom almost no innovations would ever reach the market.

As earlier said, innovation plays a central role in promoting long-term economic growth.

New products, more efficient processes and novel management methods can all lead to new business opportunities and greater profitability for innovating firms.

  • In the health field, innovation can lead to groundbreaking medical breakthrough.
  • In the transportation sector, it can lead to safer and more reliable cars.
  • In retailing, it can help to get more products to consumers at lower prices.

Basically, innovation expands the range of possibilities available and leads to a more efficient allocation of existing resources.


Imperfections in the marketplace create conditions where the optimal level of innovation is not attained.

But how does one know what an “optimal” level of innovation is? In a perfectly efficient market, firms would invest in processes that (hopefully) lead to innovative outcomes.

The expected benefits or rate of return that accrue to the inventor determine the initial level of investment. The higher the expected rate of return, the higher the initial investment.

Fully functioning markets and complete property rights would ensure that the firm reaps the full benefit of the innovation.

Thus, the rate of return to the firm (that is, the private rate of return) would be the same as the rate of return to the entire economy (that is, the social rate of return, which includes that to the inventor) as the firm was able to capture all the benefits. However, first there are market imperfections that hamper the ability for innovation to be developed and for the inventor to foresee the value of the innovation:

1.    Incomplete information

Critical to the successful creation and deployment of innovative products and processes is that there is a clear understanding about the potential of such an innovation.

Yet, there are numerous instances where information is not perfectly transmitted across economic actors (entrepreneurs) or there is uncertainty about the outcomes of certain endeavors. As such, incomplete information can hamper innovation to a level below the social optimum.

The predictability of the policy environment is also critically important.

In the case of environmentally related taxation or tradable permit systems, for example, changes in the level of a tax rate or in the quantity of allowances can impact on the expected rate of return of a firm.

Market-related uncertainty is also a significant issue for any business decision.

Investing in research and development activities or yet-unproved technologies can present unknowns that may require a higher hurdle rate of return to overcome, especially where financing is being sought.

2.     Economies of scale

There are likely to be economies of scale Opens in new window in the inputs to innovation, primarily being investments in R&D. The purchase of physical infrastructure (much of which is likely indivisible) and the hiring of human resources to undertake this research likely has significantly higher returns with a higher initial level of investment, contributing to an increase in the hurdle rate of investment.

Second, the fundamental nature of innovation — that it is basically an idea — suggests further that the market will not provide the inventor with a full recovery of all the benefits of the innovation. There are a number of reasons why this occurs, including the following.

3.     Knowledge externalities

Since an inventor cannot perfectly stop others from benefitting, either directly or indirectly, from the invention, the private rate of return is lowered due to these knowledge spillovers.

This can be thought of, therefore, as the social rate of return remaining the same, in that the economy as a whole derives value from the innovation, but the private rate of return becomes lower, as some of the benefits cannot be internalized by the firm.

As firms decide what projects to undertake, these lower rates of private return suggest that fewer projects are undertaken than would be given the social rate of return.

This causes an undersupply of innovation compared to the social optimum. Governments have put in place instruments to help inventors appropriate a larger share of the value of their inventions.

Other inventors may generate ideas based on the initial idea for which the patient holder may not be remunerated. In other cases, some ideas simply cannot be patented and, as such, they may be copied by competitors.

4.     Externalities related to use

Many times, the value of an innovative product or process grows as users use it — that is, there are dynamic increasing returns to its use. They become better at using and/or making the item, and this knowledge can leak, providing positive externalities to others. The two main categories are:

  1. Learning-by-using: New users of technology must learn how to effectively use the innovation and adapt and integrate it into their routines. In some cases, this learning experience can be a source of information for other users, thereby creating externalities for others.
  2. Learning-by-doing: In much the same way but from the production aspect, manufacturers learn efficiencies in reproducing the technology. Inasmuch as these knowledge gains can be seen by other manufacturers, they represent an unrecoverable transfer of knowledge wealth to others.

Other people can also just adopt a technology. While not devising better ways to use the technology, their use alone provides benefits to others and can be thought of as network externalities.

That is, others’ use of technology increases the utility of one’s own use because the value of the product has increased. Telephones and social networking sites are classic examples. These returns cannot generally be captured and therefore provide positive externalities to other users.

These various market imperfections and other constraints clearly suggest that the realized level of innovation will be below that of the social optimum unless public policies are put in place to stimulate innovation.

Besides only affecting the level of innovation and technological change, these market failures can influence the type of innovation as well.

Along the innovation continuum, there is an infinite range of innovations that can span from, at one extreme, innovations with significant public benefits (such as basic research into nuclear fusion, for example) to those with significantly private benefits (such as a more efficient production technique that can be patented and employed by a monopolist).

Firms will focus more attention on innovations with more private benefits. Issues of appropriability and the uncertainty of some significantly longer-term projects suggest that with market failures, innovations with more public aspects are even more reduced than those with more private aspects.


Innovation is critical and governments have long recognized the issues creating an undersupply of innovation.

Numerous government programs (programmes) and initiatives have been launched in an attempt to spur greater levels of technological change Opens in new window.

Five major efforts typify this response (the first deals with the general innovative environment, the remaining four deal with addressing the externality issue more directly):

1.   Creating a conducive business and innovative environment:

Reducing barriers to creating and commercializing innovation as well as ensuring adequate returns from its use create a general business climate that is conducive to innovation.

This should be an addition to an environment that is supportive of general innovation activities, such as through a society that is research-driven and open to new technologies.

2.   Patent protection

Intellectual property rights regimes provide some legal protections to creators of intellectual property for a number of years; however, such structures are not perfect and cannot prevent all leakages of information.

3.   Direct support of basic research

Governments directly invest in basic research through government laboratories and research stations or through grant-providing bodies. They can also subsidies private firms’ R&D efforts, either directly or through joint venture with higher education institutions.

4.   Supply of researchers

Governments encourage the supply of researchers through university placements. The goal is to both create a more conducive environment for fostering innovation as well as allow for an expansion of R&D budgets that is not simply consumed through higher wages.

5.   R&D tax measures

Most OECD countries employ tax incentives for research and development activities as a means to encourage innovative activities by overcoming the difficulties mentioned before.

These measures typically attempt to reduce the marginal cost of capital for firms by providing tax credits for R&D expenses or providing favorable treatment to capital and/or labor expenses.

To overcome the fact that social and private rates of return are different, patent protection regimes attempt to fully internalize the positive externalities for the inventor by increasing the revenues accruing to the inventor, but not affecting the costs to innovate.

By contrast, R&D tax credits/subsidies alone seek to lower the costs of innovation, but do not attempt to increase the revenues for the innovator. Both are likely to have scale effects, as the private rate of return is now closer to the social rate of return.

The difference between the approaches is that while both mechanisms seek to provide a higher return to innovation efforts (approaching the social rate of return), R&D tax credits do it without internalizing the externality and therefore maintain the positive spillovers of innovation, benefiting the economy as a whole. Assessing the proper balance, couple with other pressures on governments, remains a difficult issue.

The case for governments attempting to provide full internalization of innovation externalities is not as clear cut.

On the one hand, ensuring that innovators can internalize a large share of the returns to their creations is important for providing incentives to innovate.

On the other hand, the spillovers from innovations positively benefit the rest of the economy by providing impetus and ideas for future growth and additional innovation. This may be especially true with issues such as the environment.

Governments must therefore balance these two objectives and the usage of different tools in innovation policy is likely required.