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Innovation and learning have long been considered the keys to economic growth and development. From the Turing machine to antibiotics, technological progress is often at the cusp of all significant societal transformations, driving rapid increases in living standards across the globe.

Yet, innovation is a complex process involving a diversity of public and private sector actors. Innovation-led growth has traditionally been perceived as characteristic of free-market economies, driven primarily by the ingenuity of innovative entrepreneurs with minimal government intervention. On the other hand, governments may also play a pivotal role, setting the direction for innovative industries whilst ensuring shared economic benefits across society. This casts light on a wider policy debate: what is the appropriate level of government intervention to ensure the growth-enhancing power of innovation? Are markets sufficient on their own to ensure optimal levels of innovative growth?

Advocates of the free-market system often extol the virtues of unfettered market competition, commending its ability to provide the competitive and profit-based incentives necessary to drive rapid innovation. According to senior economist at Princeton University, William Baumol, “under capitalism, innovative activity – which in other types of economy is fortuitous and optional – becomes mandatory, a life-and-death matter for the firm.” [1] Baumol argues that firms within highly innovative sectors behave as oligopolies – competing on the basis of “innovation” rather than “price,” thus driving a self-perpetuating cycle of growth-enhancing innovation.[2]

From this perspective, the state plays a minimal role in fostering innovation, intervening solely in the event of “market failures” – instances in which free markets fail to achieve an efficient allocation of resources.[3]

Markets fail for numerous reasons. Lack of incentives for entrepreneurs is one of the major culprits for stagnant, lackluster economies.[4] As a first mover, an entrepreneur bears most of the entry costs, generating critical information required when introducing a new product to the market. This benefits subsequent entrants, whilst reducing incentives for first movers due to discrepancies between private and social returns to innovation.

Such market inefficiencies have provided justification for government intervention through rent distribution – a form of industrial policy in which governments bear a proportion of entry costs by subsidizing entrepreneurial activity. [5] South Korea’s industrial policy from the 1960s financed investment in Hyundai’s expansion into the ship industry, eventually propelling South Korea to become one of the world’s leading shipbuilders.[6]

Another source of market failure is the disproportional returns to innovation, which fail to provide widespread benefit across society. In principle, increases in productivity associated with technological innovations should make everyone better off. In practice, however, innovations that reduce demand for low-skilled labor inevitably generate both “winners” and “losers.”[7] Government intervention should therefore address issues of inequality and unemployment associated with skills-biased technological innovation.

Which side of the coin one chooses to adopt in this debate evidently has major policy implications, drawing an essential link between market structure and innovation. Different governments have adopted different approaches.

The Nordic model has been commended by economists such as Joseph Stiglitz for its ability to foster innovation whilst ensuring societal welfare.[8] Characterized by high levels of public investment in education, technology, as well as social insurance and progressive taxation systems, it provides a greater sense of security, inducing individuals to take on higher-risk entrepreneurial activity.[9]

In their model of Nordic labor market policy, economist Erling Barth and his colleagues show that Scandinavian countries’ strong union participation speeds up the process of creative destruction, allocating workers to more productive jobs within the economy.[10] In a welfare state, this ensures that gains from innovation are more equitably shared across society. This effect is even further enhanced when returns go towards developing critical learning capacities in sectors such as education and research. This is evident in Scandinavian states, which have amongst the highest public expenditures in education in the world.[11]

Close collaboration between the public and private sector is another critical factor in fostering innovation by encouraging networking and creative collaboration amongst firms, institutions and universities. Governments can act as coordinating agents in instances where private firms would benefit from common schemes or shared technology, yet lack the coordinative capacity to carry this out on their own. Argentina’s National Institute of Agricultural-Technology for instance, has worked in close collaboration with key players in the farming industry, allowing them to develop highly productive new strains of rice.

The internet itself was largely a product of state funded research and development programs, notably through the American Advanced Research Projects Agency.[12] American economist Mariana Mazzucato has proposed a framework for an “entrepreneurial state,” in which governments adopt a dominant role in creating and shaping markets through investment in technology. [13] Mazzucato also calls for a  “developmental network state,” in which governments play a central role in bringing together diverse networks of actors. By facilitating collaboration amongst a range of actors with diverse specializations and technical capacities, this can help generate new and inventive approaches to tackle some of today’s most pressing challenges – from climate change mitigation to poverty alleviation.

Close relations between the public and private sectors are not, however, without risks. One of the main criticisms of free-market systems is that they are susceptible to rent-seeking behavior and manipulation of public policy by private interests. Not only does this detract funds away from productive economic activity, but it can also generate entry barriers, protecting complacent incumbents whilst becoming a roadblock to further innovation.

Developing strong institutional capacities is essential in countering such issues. Ireland’s state-sponsored Industrial Development Agency is often credited for its ability to select winning industries based upon a carefully devised set of objective criteria.[14] This eliminates problems of asymmetric information and safeguards the integrity of the selection procedure. Assuring the quality of governance and coordinated information sharing is therefore essential in ensuring innovative growth.[15]

In questioning the government’s role in developing innovative industries, the central issue that arises is not so much the strict paradigm between state intervention and market freedom, but rather how state and private actors can work together to develop policies facilitating growth, learning, and innovation. Reconceiving the role of the government as one critical to knowledge development and transformative innovation can indeed set economies on the path to both innovative and inclusive growth.

References

[1] William J. Baumol, The Free-Market Innovation Machine (Princeton, NJ: Princeton University Press, 2004).

[2] Ibid.

[3] Mariana Mazzucato, Mario Cimoli, Giovanni Dosi, Joseph E. Stiglitz, Michael A. Landesmann, Mario Pianta, Rainer Walz, and Tim Page, 2015, “Which Industrial Policy Does Europe Need?” Intereconomics 50, no. 3 (2015): 120-155.

[4] Dani Rodrik, “Second-Best Institutions,” American Economic Review 98, no. 2 (2008): 100-104, doi:10.1257/aer.98.2.100.

[5][5] Dani Rodrik, Gene Grossman, and Victor Norman, “Getting Interventions Right: How South Korea And Taiwan Grew Rich,” Economic Policy 10, no. 20 (1995): 53.

[6] Ibid.

[7] Joseph E. Stiglitz and Bruce C. Greenwald, Creating A Learning Society (New York: Columbia University Press, 2015).

[8] Ibid.

[9] Erling Barth, Karl O. Moene, and Fredrik Willumsen, “The Scandinavian Model—An Interpretation,” Journal Of Public Economics 117 (2014): 60-72.

[10] Ibid.

[11] Ibid.

[12] Mariana Mazzucato et al., 2015. “Which Industrial Policy Does Europe Need?”

[13] Mariana Mazzucato, The Entrepreneurial State (Anthem Press, 2013).

[14] Luis Moreno, “Getting Industrial Policy Right,” Project Syndicate, January 23, 2015, https://www.project-syndicate.org/commentary/latin-america-industrial-policy-failures-by-luis-a–moreno-2015-01?barrier=accessreg,

[15] Mariana Mazzucato et al., 2015. “Which Industrial Policy Does Europe Need?”