Innovation Policy Handbook - Unicamp€¦ · The Innovation Policy Handbook is intended as a...

CENTER FOR INTERNATIONAL SCIENCE AND TECHNOLOGY POLICY

Innovation Policy Handbook

Nicholas S. VonortasDirector

Center for International Science and Technology PolicyThe George Washington University

Anwar AridiThe World Bank

Chapters Contributed By:Geetu Ambwani

Patrick BeshaBenjamin Boroughs

Jordan Hosmer-HennerEric Rouge

Rafif al-SayedDanny WaggonerJeffrey Williams

Timothy Williams

June 2, 2012

Contents

Preface 7

I Background 11

1 Technology, Innovation, and Economic Growth 121.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121.2 Historical Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131.3 Economic Directions and Puzzles Regarding Technological Advance . . . . . . . . 131.4 Returns to Research and Development . . . . . . . . . . . . . . . . . . . . . . . . . . 171.5 Technology Diffusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 211.6 Technology and Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221.7 Evolutionary Theorizing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261.8 Regional Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281.9 Summary Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 291.A Leveraging Investment in R&D Through

Broad-Based Policy: Finland (1960-2000) . . . . . . . . . . . . . . . . . . . . . . . . 32References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

2 Science, Technology and Innovation Policy in the Era of Globalization 412.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 412.2 Should the Government Intervene? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

2.2.1 Market failure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422.2.2 Beyond the market: System failure . . . . . . . . . . . . . . . . . . . . . . . . 432.2.3 Life cycle of products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 442.2.4 Diffusion of knowledge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

2.3 Science, Technology and Innovation (STI) Policy . . . . . . . . . . . . . . . . . . . . 472.3.1 STI Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

2.4 STI Policy and Globalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 502.4.1 Multinational Corporations (MNC) . . . . . . . . . . . . . . . . . . . . . . . . 52

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

II Framework 55

3 Systems of Innovation 56

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3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 563.2 A Brief Overview of the Innovation Systems Concept . . . . . . . . . . . . . . . . . 573.3 Innovation Systems: The Local Dimension . . . . . . . . . . . . . . . . . . . . . . . . 593.4 Innovation Systems: The Sectoral Dimension . . . . . . . . . . . . . . . . . . . . . . 593.5 The Innovation Systems Approach for Developing Countries . . . . . . . . . . . . . 603.A Jordan: National Innovation System . . . . . . . . . . . . . . . . . . . . . . . . . . . 65References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

4 The Entrepreneurial University: A Regional Perspective 704.1 Introduction: The Role of Universities in the Innovation System . . . . . . . . . . 704.2 The Link between Industry and University . . . . . . . . . . . . . . . . . . . . . . . . 724.3 The Role of Government . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 744.4 American Universities and Entrepreneurship . . . . . . . . . . . . . . . . . . . . . . 764.5 Case Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76

4.5.1 Stanford University . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 774.5.2 Singapore . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 784.5.3 Volta Redonda, Brazil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

4.6 Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 794.7 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 814.A Moving towards the Entrepreneurial University Model in the Levant Region . . . 82References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83

5 Intellectual Property, Standards 885.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 885.2 Forms of Intellectual Property Protection . . . . . . . . . . . . . . . . . . . . . . . . . 885.3 Intellectual Property in the Innovation Ecosystem . . . . . . . . . . . . . . . . . . . 905.4 Intellectual Property and Development . . . . . . . . . . . . . . . . . . . . . . . . . . 915.5 Determining the Need for and Impact of Intellectual Property . . . . . . . . . . . . 935.6 Standards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 975.A Country Details: Lebanon and Jordan . . . . . . . . . . . . . . . . . . . . . . . . . . . 100References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

6 National Competitive Advantage 1076.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1076.2 Economic Growth and Development . . . . . . . . . . . . . . . . . . . . . . . . . . . 1086.3 Defining and Measuring Competitiveness . . . . . . . . . . . . . . . . . . . . . . . . 110

6.3.1 Industry Competitiveness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1106.3.2 Global Competitiveness Index . . . . . . . . . . . . . . . . . . . . . . . . . . . 112

6.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1146.A Jordan and the GCI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1166.B China’s Solar Industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119

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III Strategy 121

7 Alliances / Knowledge-Intensive Partnerships 1227.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1227.2 Context of Strategic Alliances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124

7.2.1 Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1247.2.2 International Context . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125

7.3 A Practical Guide . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1287.3.1 Partnership Opportunities and Dangers . . . . . . . . . . . . . . . . . . . . . 1287.3.2 Partner Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1307.3.3 Partnership Negotiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

7.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1337.A Petrobrás Subsea Boosting Technology Development . . . . . . . . . . . . . . . . . 1367.B Tata-Fiat Joint Venture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1377.C Vodacom-CWN Joint Venture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1377.D Indus Towers Joint Venture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139

8 Clusters / Science Parks / Knowledge Business Incubators 1438.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1438.2 Clusters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

8.2.1 What is a Cluster and why are they desirable? . . . . . . . . . . . . . . . . . 1448.2.2 Why do Industries Cluster? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1458.2.3 Agglomeration vs. Innovative Clustering . . . . . . . . . . . . . . . . . . . . 1478.2.4 Case Studies in Cluster Formation . . . . . . . . . . . . . . . . . . . . . . . . 1498.2.5 Can Governments Stimulate Cluster Growth? . . . . . . . . . . . . . . . . . 151

8.3 Science Parks and Incubators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1518.3.1 Science Parks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1528.3.2 Knowledge Business Incubators . . . . . . . . . . . . . . . . . . . . . . . . . . 1558.3.3 Assessments of Effectiveness . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158

8.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1598.A Middle East and North Africa: Hi-Tech Entrepreneurship Efforts . . . . . . . . . . 160References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

9 Small Firms / Entrepreneurship 1639.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1639.2 Overview of SMEs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1649.3 Types of SMEs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1669.4 Entrepreneurship in the twenty-first century . . . . . . . . . . . . . . . . . . . . . . 1689.5 Challenges to growth in SMEs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1709.6 Approaches to policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1719.7 Developing programs to support innovative SMEs . . . . . . . . . . . . . . . . . . . 1739.A Comparison of SME initiatives in three European countries . . . . . . . . . . . . . 1759.B Small Business Administration and SME incubation in the U.S. . . . . . . . . . . . 1769.C SME credit financing in Korea (Korea Technology Finance Corporation) . . . . . 176

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9.D Fostering entrepreneurship in Chile (Start-Up Chile) . . . . . . . . . . . . . . . . . 1779.E Lessons in business support services from Malaysia . . . . . . . . . . . . . . . . . . 178References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179

10 High Risk Finance 18310.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18310.2 Types of financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184

10.2.1 Debt and Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18410.2.2 Equity Investors Provide Useful Expertise . . . . . . . . . . . . . . . . . . . . 18410.2.3 Investors Hindered by Information Asymmetries . . . . . . . . . . . . . . . 185

10.3 Stages of Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18610.4 Exiting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188

10.4.1 Acquisitions vs. Initial Public Offerings . . . . . . . . . . . . . . . . . . . . . 18810.4.2 Bankruptcy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18910.4.3 The Cost of Failure Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19010.4.4 Ease of Exit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190

10.5 Challenges for Emerging Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19010.5.1 Intellectual Property Rights . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19110.5.2 Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19110.5.3 Consistent and Impartial Rule of Law . . . . . . . . . . . . . . . . . . . . . . 192

10.6 Approaches for Supporting Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . 19310.6.1 Research and Development Subsidies, Microfinance, and Small Business

Support . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19510.7 Conclusion and Recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 199

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List of Figures

1.1 Percent Change in GDP for Selected Countries (IMF 2011) . . . . . . . . . . . . . . 141.2 World Average GDP Per Capita (Maddison 2008) . . . . . . . . . . . . . . . . . . . 151.3 The knowledge production function (micro level): A simplified path analysis

(Griliches, 1990) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 181.4 Countries spending >2% GDP on R&D, and selected others (World Bank 2012,

CIA Factbook, 2012) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251.5 Public R&D Spending v. World Bank KEI Rank (World Bank 2012) . . . . . . . . . 26

2.1 Transition Between Two Technology Life Cycles (Tassey 1997) . . . . . . . . . . . 452.2 Historical Sugar Cane Yield in Brazil (Food and Agriculture Organization 2012 . 472.3 Science Is Becoming Internationalized (WIPO, based on data by Thomson in

National Science Board 2010) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

3.1 Linear Model of Innovation (?) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 563.2 Evolution of Innovation Systems (Chaminade and Vang 2008) . . . . . . . . . . . 613.3 Innovation Systems and Development (Chaminade and Vang 2008) . . . . . . . . 633.4 National Innovation System of Jordan (?) . . . . . . . . . . . . . . . . . . . . . . . . 65

4.1 The Triple Helix Model () . . . . . . . . . . 71

4.2 Expansion of University Mission . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 724.3 Stakeholders in university-industry relations (Siegel et al., 2003) . . . . . . . . . 73

5.1 Top Fields for Patents Applications in Select Upper Middle Income Countries,1996 - 2010 (WIPO 2011) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96

5.2 Comparison of Lebanon, Jordan, and UAE Innovation Environments(Bank KAMCustom Scorecards:

) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

6.1 Global demand for solar PV modules (2008) . . . . . . . . . . . . . . . . . . . . . . 1186.2 Global production of solar PV modules (2008) . . . . . . . . . . . . . . . . . . . . . 118

8.1 The Diamond Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1458.2 Science Park Characteristics (Battelle 2007) . . . . . . . . . . . . . . . . . . . . . . . 153

9.1 Share of enterprises by size class (number of employees), 2006 (EIP, 2010) . . . 1659.2 Share of employment by size class (number of employees), 2006 (EIP, 2010) . . 165

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9.3 Share of high-growth firms by sector, 2006 (EIP, 2010) . . . . . . . . . . . . . . . . 1669.4 Arnold Staircase—Hierarchy of company types (Arnold and Thuriaux, 1997) . . 1679.5 The SME Research Stairway (EURAB, 2004) . . . . . . . . . . . . . . . . . . . . . . 1689.6 KOTEC Loan Program Statistics (KOTEC 2011) . . . . . . . . . . . . . . . . . . . . . 177

10.1 Angel and Venture Funding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18710.2 Venture Capital Exits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18910.3 Finland’s High-Risk Financing Institutions . . . . . . . . . . . . . . . . . . . . . . . . 197

Preface

This Innovation Policy Handbook is intended for training purposes in the Middle East region.More specifically, the Handbook has been produced for the audience of a prospective trainingcourse in science, technology and innovation (STI) policy. The audience of the training coursewas considered to comprise of middle to upper level policy decision-makers, policy analysts,and other stakeholders including representatives from industry and universities interested in(a) the important topics of STI policy, (b) a “how-to” approach and (c) lessons from aroundthe world.

The Handbook was intended to provide the background information to support the afore-mentioned training course in STI policy. It was not intended to set up the training courseitself. We assumed no particular knowledge of the subject by the intended readers and onlyelementary understanding of economics. The Handbook sets up the context for STI policy, ex-plains the institutions involved, deals with some of the most important issues in the STI policysphere, and clearly suggests the most appropriate topics to consider in setting up the trainingcourse.

We do not claim comprehensive coverage of all topics related to science, technology andinnovation policy. For example, whereas there is a chapter on higher education institutions,the Handbook does not cover basic research and the important issue of peer review in such re-search. Or, whereas we discuss intellectual property protection and standards, we do not delveinto the important topic of technological paradigms and trajectories and the importance of IPRand standards in these. And, whereas we discuss strategic alliances and high-risk finance, wehardly put the two together to deal with innovative financing of high-risk networks. Ratherthan being comprehensive—an impossible task for a single volume—our aim was to distill andprovide adequate information in one place that will prepare a diverse policy-oriented audienceto delve into the details and cases of an intensive week-long training course in STI policy.

The interested reader will find a large list of possible readings in this field to expand beyondthe present volume. First and foremost is the World Bank publication:

• World Bank. 2010. Innovation Policy: Guide for Developing Countries. World Bank

Other excellent references include (list indicative):

• J. Fagerberg, D.C. Mowery, and R.R. Nelson. 2006. The Oxford Handbook of Innovation.Oxford Handbooks. Oxford University Press

• Christopher Freeman and Luc Soete. 1997. The Economics of Industrial Innovation. Cam-bridge, Mass. : MIT Press, 1997.

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• V.W. Ruttan. 2001. Technology, Growth, and Development: An Induced Innovation Perspec-tive. Oxford University Press

• F. Malerba. 2004. Sectoral Systems of Innovation: Concepts, Issues and Analyses of SixMajor Sectors in Europe. Cambridge University Press

• F. Malerba and N.S. Vonortas. 2009. Innovation Networks in Industries. Innovation Net-works in Industries. Edward Elgar

• G. Rosegger. 1996. The Economics of Production and Innovation: An Industrial Perspective.Butterworth Heinemann

• B. Steil, D.G. Victor, and R.R. Nelson. 2002. Technological Innovation and Economic Per-formance. Council on Foreign Relations books. Princeton University Press: Council onForeign Relations

• H.R. Varian et al. 2004. The Economics of Information Technology: An Introduction. Raf-faele Mattioli Lectures. Cambridge University Press

• G. Tassey. 2007. The Technology Imperative. Edward Elgar

The Innovation Policy Handbook is intended as a practical guide to the core issues in STIpolicy as they relate specifically to economic growth and development. In building the Tableof Contents, we have assumed an intensive training course of 4-5 days. The Handbook iscomprised of 10 thematic chapters clustered under three overarching themes:

I Background: Introduces STI policy and provides the contextual background for modernapproaches at the national level. [Chapters 1-2]

II Framework: Establishes the framework conditions for STI policy. [Chapters 3-6]

III Strategy: Draws attention to specific important items in STI policy and indicates howthey are dealt with around the world. [Chapter 7-10]

Chapter 1: Technology, Innovation and Economic Growth. The Chapter builds the conceptsof technological advancement and innovation and summarizes current understanding oftheir impact on economic growth. The Chapter provides a brief history of economicgrowth, discusses the challenges for economists in handling technological advancement,summarizes findings regarding the private and social returns to research and develop-ment (R&D) expenditures, and exposes the relationship of technology and growth.

Chapter 2: Science, Technology and Innovation Policy in the Era of Globalization. TheChapter starts by posing the question of whether and why should governments intervenewhen it comes to technological advancement and innovation. Then STI policy is formallyintroduced. Finally the Chapter places national STI policy into the broader context ofglobalization indicating aspects of policy that remain within the purview of nationalgovernments and others where the leverage of national governments has been eroded.

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Chapter 3: Systems of Innovation. This Chapter introduces the modern systemic view of the“technical enterprise,” referring to: (a) the total infra- and super-structure responsi-ble for producing, adapting, and assimilating technological advancements; and (b) thebroader socio-economic system that transforms these into innovations and places theminto productive use. The Chapter indicates that the “systems” approach can be adaptedto different levels of analysis such as national, regional, or sectoral. As with other Chap-ters in this Handbook, it indicates specificities of developing countries.

Chapter 4: The Entrepreneurial University. This Chapter deals with a core sector of theTriple Helix of a country: universities. It deals with universities through the prism ofentrepreneurship and linkages with industry. The Chapter uses the Triple Helix conceptto help focus on university-industry relations and then on the role of the governmentin trying to foster these by incentivizing higher education institutions to become moreentrepreneurial. A number of specific examples are illustrated and finally lessons for theMENA region are drawn.

Chapter 5: Intellectual Property, Standards. This Chapter deals with two very importantframework conditions of contemporary innovation systems: intellectual property pro-tection and standards. Both these issues—left in the backburner for most of the modernhistory of industrialization—have been elevated to the forefront due to the arrival of theknowledge-based economy and globalization. Countries that want to be important play-ers in the global economy simply cannot disregard them, even though for most policydecision makers they sound like boring, uninteresting subjects. The Chapter summarizesthe state-of-the-art in our current understanding of these two topics and relates them toeconomic development.

Chapter 6: National Competitive Advantage. There is hardly anything more important forpolicy decision makers than being able as a first step to determine the focus of theirefforts in STI policy. For countries of relatively small size that cannot do everything,appropriate focus is a large part of the job. But how does one go about choosing? Howis comparative (current) advantage determined? How is competitive (future) advan-tage determined and developed? This Chapter closes our discussion of the frameworkconditions for STI policy by dealing with those important questions.

Chapter 7: Strategic Alliances / Knowledge-Intensive Partnerships. One of the most im-portant developments during the past few decades has been the proliferation of strate-gic partnerships around the world, especially those based on the production, exchange,and/or use of new technical knowledge. There is little doubt of the centrality of suchcollaborative agreements across all developed countries and the top tier of developingones (BRIC+). There is more of an issue perhaps for countries lower on the develop-ment ladder. Still, a strong argument can be made that the available data have severaldeficiencies and alliances have a critical role to play in the process of economic growth.This Chapter deals with this very important issue from the point of view of companystrategy and consequent policy implications. It provides a practical guide of the issuesinvolved and illustrates through several cases around the globe.

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Chapter 8: Clusters / Science Parks / Knowledge Business Incubators. Another majorstrategic topic in the context of STI policy is the creation/support of clusters and scienceparks. These two formations can overlap significantly but are not the same thing andthus this Chapter is divided into two major parts. Part I deals with the broader conceptof clusters (geographical agglomerations of industry to exploit specific locational advan-tages and spillovers). Part II deals with science parks (geographical agglomerations ofindustry to exploit proximity with universities and major research institutes). The sec-ond Part also deals with the incubation of small companies. The Chapter is sprinkledwith many examples of successful and less successful cases from around the world, alsodrawing from experiences in the Middle East.

Chapter 9: Small Firms / Entrepreneurship. This Chapter deals with one of the most criti-cal issues for any country: the nurturing of small companies and entrepreneurial activity.Small and medium-sized enterprises come in many different colors and shapes and theChapter tries to draw attention to such differences among the population. Differencesin structure, organization, internal capabilities and sectoral focus also means differencesin policy approaches. The Chapter primarily looks at this topic from the point of viewof a developing country trying to underline the particularities of the phenomenon there.For instance, what is to do with “necessity entrepreneurship” (people setting up enter-prises because they lack other employment) and how does it differ from opportunityentrepreneurship? What are common barriers to fledgling companies?

Chapter 10: High Risk Finance. An absolutely crucial aspect of innovation is the transfer ofan idea from initial concept to prototype and then to the market. A core component ofthis process is risk financing, that is, the ability to fund emerging business of higher thanaverage risk. Financial systems around the world struggle with this difficult issue which,nevertheless, has been isolated as of critical importance to development and growth.How does a government deal with the lack of “patient” capital? Venture capital? Invest-ment “angels”? And so forth. The Chapter defines the problem, provides an overviewof the various types of finance for various stages of investment, addresses the importanttopic of market exit, and then goes into the challenges for emerging markets. The Chap-ter then offers available approaches to supporting high-risk finance by the public sector,offers examples from around the world, and closes with policy recommendations.

Part I

Background

11

Chapter 1

Technology, Innovation, and EconomicGrowth

1.1 Introduction

It hardly seems necessary these days to point out the importance of technical advance.We look to it to rescue us from the consequences of exhausting essential natural resources;abate inflation through productivity increases; improve our balance of payments deficit;eliminate famine; and cure cancer, heart disease, and a variety of other ailments. Our faithin technical advance is bolstered by achievements such as the atomic bomb, electroniccomputers, the landing of a man on the moon, heart transplants, and test-tube babies. Weno longer ask if something is possible, but how soon it can be done and at what price.(Kamien and Schwartz 1982, p. 1)

Thus two important mainstream economists opened their landmark book three decadesago. It was one of a set of seminal publications in the late 1970s and early 1980s that changedthe image of economists as laggards in the study of technological advance. This set would cer-tainly include Caves (1982), Chandler (1977), Freeman, Clark, and Soete (1982), Mansfield(1977), Nelson and Winter (1982), Rosenberg (1976, 1982), and Stoneman (1983), amongothers. While only a subset of these economists would classify their work into the “main-stream”, they have all stepped more or less on the shoulders of the same giants, includingSmith (1776), Marshall (1920), and Schumpeter (1942).

Nonetheless, a stalwart in this field observed that a continuing paradox in economics“. . . has been the contrast between the general consensus that technical change is the mostimportant source of dynamism in capitalist economies and its relative neglect in most main-stream literature.” Freeman (1994, p. 463). Such views can better be explained by Nelsonand Winter’s (1982) dichotomy between “appreciative” economic theorizing and “formal” eco-nomic theorizing. Appreciative theorizing stays very close to empirical analysis and case studywork. Its strength lies in moving quickly to interpret what is going on and explain relationshipsamong important variables. The principal weakness of this kind of theorizing is its basis in theanalyst’s interpretation of events and may contain logical inconsistencies. Formal theorizing,on the other hand, often stays at some distance from applied work. Empirical work is usedto provide stylized facts rather than wholesome stories. The strength of formal theorizing is

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CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 13

the elimination of logical inconsistencies; its weakness is its slower pace that often leaves itdetached from actual events. Formal economic theorizing is basically what one has in mindwhen one talks about “economic theory”: an abstract edifice to explore logical arguments. Itsutility has been well proven, however technology has not always fit neatly into formal models.Appreciative economic theory has become a useful complement, allowing extensive progressin relating concepts and empirical findings to better understand the causes of technologicaladvance and its impact on the economy.

This Chapter presents basic economic arguments on technological advancement and itseffects on economic growth. It starts with a few historical facts on economic growth andcontinues with concepts of technological advancement and innovation, a summary of how thecurrent understanding of technology’s impact on economic growth evolved, and ends withpolicy-relevant messages emerging from this literature.

1.2 Historical Economic Growth

Most economists agree that for rich, highly developed nations, GDP growth should generallybe expected around 2% a year (Ruttan, 2001). While this may seem small, if maintained, thisstill projects GDP doubling within 35 years. Even this can appear slow in comparison withrapidly developing nations, who may see growth rates in the double digits, as with India andChina in recent years (see Figure 1.1) (IMF, 2011). Such rapid rates of growth are, in a broadhistorical sense, rather extraordinary.

Growth in output has not necessarily been at a steady and even pace through all of humanhistory. In particular, the past two or three centuries have seen a vast departure from the globalgrowth rates that persisted prior. As shown by the long-run data in Maddison (2006) for thevast majority of history humankind has experienced minimal levels of growth. Conditions inearly modern Europe were little better than those of the ancient Romans, two millennia earlier(Allen, 2007).

However, with the Industrial Revolution, beginning in Britain in the late 18th and early19th century, a new trend of nearly exponential growth emerged. In 1850 the real GDP (in2005 British pounds) of the United Kingdom was roughly 60 million pounds, and within acentury, this had experienced an over five-fold increase, roughly 316 million pounds. It is thisnew period of historically rapid growth that continues to a greater or lesser extent throughoutthe world today (see Figure 1.2) (Maddison A. (OECD), 2006).

For policy makers trying to improve the economic growth of their nations and all the qualityof life indicators that go with it, understanding the source of this remarkable expansion inoutput and the conditions conducive to it becomes an important task. For economists, thiscentral question has nonetheless proven difficult to fully answer.

1.3 Economic Directions and Puzzles RegardingTechnological Advance

Economists became concerned with the effects of technological change early on, as the indus-trial revolution unfolded around them. Unfortunately, classical economists did not perceive


Figure 1.1: Percent Change in GDP for Selected Countries (IMF 2011)

technological change as part and parcel of the economic process. For example, they failed toconceive the true nature of natural resources as “man-made” rather than “natural”, missingthe fact that changes in the relative scarcity of resources creates conditions for substitutingone resource for another (including technological advance). And they did not adequately ap-preciate the fact that rapid technological advance is not simply the outcome of capitalist forcesbut also shapes and moulds the capitalist system itself. Classical economists had to overcomesignificant limitations, however. Their understanding of the forces underlying technologicalprogress varied widely. They lacked reliable empirical information. And, the novelty of theirfield of inquiry made it difficult to agree on methodological issues.

The introduction of consistent analytical structure in economic theory was the pursuit ofthe marginal utility school, starting in the second half of the 19th century. In addition to thefactors influencing consumer behaviour, proponents of this school emphasized the objectiveaspects of production. But in the effort to produce a workable theoretical construction of theproduction function, the study of technological change was ostracized. “(A)s the importanceof the production function increased, so the question of technical change receded into thebackground. Those who produced the most mathematical treatment of the production func-tion, i.e., Walras, Wicksteed and Barone, tended to ignore the changes caused by technology.”(Heertje, 1977, p. 94). The neoclassical microfoundations were now in place.

With few exceptions — such as the early work of zealots like Kuznets and Schumpeter —


Figure 1.2: World Average GDP Per Capita (Maddison 2008)

economists were minimally interested in analyzing the process of technological advance in thefirst half of the 20th century. The time for systematic consideration of technological change,including theoretical, empirical and policy-oriented work would come well into the century,when organized research and development (R&D) activities in industry became widespreadand technology was recognized to be a central part of the engine of economic growth. Severalreasons have accounted for the renewed interest of economists in technological advance sincethe mid-20th century (see also Rosegger, 1996):

• Massive government investment in R&D during World War II demonstrated that purpose-ful searches for technological solutions to specific problems can behighly rewarding.

• Once they had engaged in the purposeful search for innovations, firms learned that thiswas an economic activity like others, albeit with some peculiar characteristics and fuzzyrelationship between inputs and outputs (Lundvall, 1992).

• It was quickly recognized that the impact of this activity transcended the conventionaleconomic measures of performance (positive and negative external effects).

• Questions of international competitiveness, relating first to the dominance of the UnitedStates and then to the emergence of Japan and Europe, increasingly focused on scientificand technological capabilities.


• A large group of newly established developing countries after the war were looking forways to close the gap with industrialized countries. Technological and, more generally,innovation capabilities seemed to be key.

• Rapid globalisation has had at its epicentre large multinational corporations, the exis-tence of which has been explained since the mid-1960s on the basis of intangible assetsand related market failures (Caves 1996). The foremost intangible asset is frequentlyargued to be technological capability and, more generally, ability to innovate.

It was the appreciative theoretical work of Schumpeter (1942) that probably contributedmost in providing the impetus for contemporary economic research into the causes and con-sequences of technological change. His stylised representation of the process of technologicaladvance as “gales of creative destruction” captured the imagination and proved a turningpoint in economists’ conceptualisation of technological progress. Schumpeter’s contributiontriggered a prolonged discourse over the relationship between market structure and evolu-tion, economic institutions, and the incentives for and the intensity of technological inventionand innovation. Sorting out the implications of these so-called neo-Schumpeterian hypothesesconcerning market concentration, firm size, and the pace of technological advance attracted alot of attention. It did not matter much that Schumpeter’s path breaking ideas were neithercomplete not always correct (Nelson, 1990). What really mattered was that economists nowhad a new handle on an issue too important to disregard. They started paying attention notonly to the effects of new technology but also to the factors inducing technological change.

However, the task of finding an appropriate procedure to incorporate technological progressinto existing formal theory proved daunting. A number of unsettling observations were madequickly:

• Endogenising technology complicated theoretical modelling significantly, especially ifdynamics were to be introduced.

• This area required new thinking given that market failure in producing technologicalknowledge was suspected to be widespread, rendering traditional models less satisfac-tory.

• The preoccupation of standard economic theory with utility maximizing rational choicesubject to known constraints created a genuine problem in explaining technological cre-ativity since the latter often implies an attack by an individual on a constraint that ev-eryone else takes as given (Mokyr, 1990).

• There was a problem with the actual process leading to technological innovation: onlyfairly simplified hypotheses of this process could be handled by standard economic the-ory, given the theory’s unsatisfactory record with investigating economic institutions.

In recent decades, formal economic theorists:

• Have moved swiftly to tackle the first two problems at both the macro-level (e.g., en-dogenous growth theory (Grossman and Helpman, 1991; Romer, 1990) and the micro-level (industrial organization, game theory (Tirole, 1988; Stoneman, 1995)


• Have been creative in going around the third

• Have largely failed to deepen in the fourth, even though there has been significant ap-preciative theorizing in this regard.

The problem of formal theory with the process of technological advance has been knownfor some time. It has, for example, beset the traditional line of research trying to measure thecontribution of past R&D investments to total factor productivity growth through an econo-metric production function (Griliches, 1979). Proxies of technology inputs and/or technologyoutput are related to some measure of the ensuing economic outcome while the analyst isagnostic of the actual process of technological change.

The exercise is sketched in Figure 1.3 which illustrates: (i) the transformation of R&Dexpenditures (R) into economically valuable, but imperfectly observable, technological knowl-edge stock (K); (ii) the approximation of the change in K over time (K = ∂ K

∂ t) with the stock

of patents (P) (or any other indicator of technology output; and (iii) the effect of K and othermeasurable factors X (e.g., physical capital, labour) on some measure of value Z (e.g., growth,productivity, profitability, or the stock market value of the firm or industry). Random compo-nents are expressed by the error terms u, v. Thus, an attempt is made to estimate the directrelationship between P

Rand Z . The intermediate stage of arriving at K and transforming it into

Z over time, as well as the complex interactions between X , K , and Z cannot be appropriatelyrepresented due to the lack of knowledge about the behaviour of the factors determining K ’sintertemporal change — that is, the lack of knowledge of the process of technological advance.

Of course, this is not entirely the result of agnosticism but also of the need to aggregateacross innovations and economic agents. To compensate, economists and business analystshave resorted to historical case studies. Detailed case studies of particular innovations arequite informative and show rather high internal rates of return to private R&D expendituresand even higher social rates of return (on the order of 10 to 50 per cent per annum) (Griliches,1995; O’Connor et al. 2009). However, they are difficult and costly to pursue and cannot begeneralized given the tendency to focus on the prominent and successful.

A lesson learned is that no single approach can fully explain the relationship of techno-logical advance and the economy. A complex, multi-dimensional phenomenon like innovationrequires multi-dimensional analytical approaches based on formal theory, empirical analysis,acute observation and appreciative theorizing to establish regularities, and data from diversesources including large databases, surveys, and case studies. It may even require new ways ofconceptualising the process, an endeavour attempted by the evolutionary economic approach.

1.4 Returns to Research and Development

A long stream of empirical research has tried to appraise the private and social returns to R&D.It has been summarized in Griliches (1984), Mansfield (1996), Hall (1996), Nadiri (1993),Alston et al. (2000). Most of this work has used variants of the production function approachand has been subject to well known limitations (see previous section). Several additionallimitations must be emphasized, including:

• The private sector has been the main subject of study


Figure 1.3: The knowledge production function (micro level): A simplified path analysis(Griliches, 1990)


• These results have tended to focus on manufacturing data, and particularly productinnovations

• The lack of consistent data has made this an “inexact science”, basing the analysis ondata that the author(s) often collect for the specific study

• Methodologies have tended to vary widely, making aggregation across studies a haz-ardous exercise.

This literature has nonetheless produced important results:

• A ubiquitous finding of the empirical studies has been that R&D expenditures contributesubstantially to the growth of output in a variety of industries.

• A strongly positive relationship between the stock of R&D and productivity at the firmlevel has been shown in several studies.

• The estimated elasticities and the rate of return to R&D investment vary considerablydepending on the type of data used (cross-section or time-series), the method of estima-tion, and the unit of analysis (firm, industry, country). At the firm level, the elasticitiesof R&D tend to fall in the range 10-30% and the rates of return in the 20-30% range.At the industry level, the respective levels are 8-30% and 20-40%. There are significantoutliers in both sets of measures at both levels.

• The majority of available econometric studies find that, for individual companies, therates of return on R&D financed internally are significantly higher than those on R&Dfinanced by the public sector. While the rates of return for private R&D range between27% and 60%, those for publicly financed R&D are often insignificant and, in somecases, negative.1 Several strong caveats apply here. First, such estimations take intoaccount only directly subsidized R&D and not the broad public investment in scientificand technological infrastructure (human and physical capital, institutions, regulations)that the private sector draws upon all the time to raise the efficiency of and returns fromits R&D. Second, it has been argued that the use of US-based data for such comparisonsis inappropriate due to the large share of defence-related R&D expenditures in thatcountry which do not directly target commercial payoff.

• The rates of return also vary significantly between product and process innovations. E.g.,Griliches and Lichtenberg (1984) calculated returns in the 58-76% range and 20-30%range respectively.2

• Results in models treating the stock of R&D as a factor of production indicate thatchanges in R&D affect the demand for inputs such as labour, materials, energy, andphysical capital. The patterns of substitution and complementarities between inputsvary across industries (Bernstein and Nadiri, 1989; Nadiri and Prucha; 1990). In gen-eral, R&D investment seems to increase demand for capital but to decrease demand

1. Lichtenberg (1988) has, for example, argued that public R&D may crowd out private R&D in an industry.2. Undoubtedly a peculiar result if juxtaposed to the clear tendency to spend far more on product R&D.


for labour and materials. Also the stock of R&D is subject to adjustment costs whichaffect the level of investment and rates of return to R&D. Investments in R&D are af-fected by changes in the prices of other factors of production and changes in demand.In short, R&D investment affects the structure of production; its own demand is affectedby changes in the prices of conventional factors of production and changes in demand.

• Private rates of return to R&D have generally been found to be lower than social rates ofreturn. This implies that the innovator often has difficulty appropriating the full returnsfrom the innovation due to the existence of one or more of three kinds of spillovers:(a) pecuniary spillovers; (b) knowledge spillovers; and (c) network spillovers. Variousstudies that Mansfield and colleagues have undertaken during the 1970s and 1980sindicated that detailed information on the nature of new products and processes arein the hands of imitators within a year from market introduction. The extent to whichthe social benefits from R&D are appropriable depends on how much competition thepotential innovator faces and on the kind of research or development activity in question(including patentability among other factors).

• Significant effort has gone into capturing the externalities between firms and industries.The pioneering work of Scherer (1982) with technology flow matrices, Jaffe (1986,1988) with estimations of “technological distance”, and Los and Verspagen (1996) didindicate the feasibility of using firm-level patent data to look at the direction of theflows of disembodied knowledge spillovers. Input-output matrices have been used forsome time to capture embodied knowledge spillovers. These roughly correspond to thecategories of knowledge spillovers and pecuniary spillovers above respectively. All avail-able studies show significant flows of technological knowledge between organizations ofdifferent kinds, universities, firms, government laboratories), industries, and nations.

• There is increasing evidence that academic research has become a major underpinningof industrial innovation in many science-based industries. In a pioneering study, Mans-field (1991) showed that 10% of the appraised innovations would not have been pos-sible without recent academic research and that the mean time lag between academicresearch and industrial innovation was seven years. Significant differences between sec-tors existed. The mean social rate of return of academic research, with the most limitingassumptions, exceeded 20%.

• A strong positive relationship between basic research expenditures in the private sectorand productivity at the firm level has been persistently shown (Griliches, 1986).

• Estimates of the rate of return to publicly funded research range from 20% to 60%(Salter and Martin, 2001). These depend on companies picking up knowledge producedby public research organizations and successfully applying it to their innovative activi-ties. These estimates do not include more general societal returns from basic researchwhich need to be appraised separately.

• A meta-analysis of 1,128 observations of internal rate of return of agricultural R&D, pri-marily publically funded, reiterated the wide range of data and difficulty in isolating a


common methodology, however concluded several points, among them: i) rate of re-turn has not diminished over time ii) rate of return may be higher in more developedcountries iii) rate of return depends on the focus of the research, or the problem it isaddressing iv) a lower rate of return for research plus extension, versus pure researchv) there are systematic variations in reported IRR that correspond with specific method-ological decisions (Alston et al. 2000).

• Several economists have drawn attention to so-called general purpose technologies (GPTs)which serve as a potential source of both application and further innovation throughoutthe economy (Bresnahan and Trajtenberg, 1995). GPTs are characterised by pervasive-ness, technological dynamism, and innovational complementarities. Information andcommunication technologies (ICTs), biotechnology, and new materials are often usedexamples. By diffusing through the economy GPTs result in disproportionate rates ofinnovation and productivity growth. While exact measurement of rates of return haseluded economists until now3, this may be attributed to our rather rudimentary under-standing of the process of technological advance through the economy. Helpman (1998)argued for an initial “time to sow,” in which resources are diverted towards producingthe adaptations necessary to allow for application of the new GPT. Output and produc-tivity continue under the old GPT with reduced resources and can actually decline. Ata certain threshold it becomes profitable to utilize the applications of the new GPT, a“time to reap” as manufacturing switches and experiences rapid productivity and outputgrowth. See also Jacobs and Nahuis (2002).

1.5 Technology Diffusion

While the importance of R&D is undeniable, new technology on its own is of limited economicsignificance. The contribution of R&D to the economic performance of a nation depends onthe ability of firms to utilize and commercialise the results by introducing profitable productsand processes. Technological diffusion is of the utmost importance (Karshenas and Stoneman,1995).

Economists have studied technology diffusion extensively through various approaches suchas “epidemic” (logistic) models leading to the popular S-curves, technology vintage models,stimulus-response models, and process models. There is general agreement that both supplyand demand factors affect the speed and direction of technology diffusion. Diffusion takestime and depends on (Rosegger, 1996):

• Factors related to the characteristics of the innovation such as its origin, expected effectson other inputs, location of the innovation in the existing production structure, changesin the innovation, complementarities among innovations

• Factors attributable to the structural characteristics of adopters and non-adopters such astechnological specificity of the existing system, the firm’s financial position, technological

3. Robert Solow famously reflected on this frustration by commenting that “we see computers everywhereexcept the productivity statistics.” This became known as the “productivity paradox.”


capability, market position and alternative strategies, managerial attitudes, age of firmsand industries

• Factors having to do with the mechanics of diffusion in a particular setting such as ex-ternal versus internal information, external interests in diffusion, international diffusion

• Factors relating to the institutional environment of the firm and the industry such asthe patent system, laws and governmental regulations, specification-writing agencies,insurance companies, labour unions.

1.6 Technology and Growth

Recent years have witnessed a resurgence of interest in growth modelling. To some extent thisis a reflection of the changed perspective concerning the sources of growth with the advent ofthe “new growth” theory.

In the basic neoclassical growth model developed by Solow (1956) there is no technologi-cal change and employment is assumed equal to the supply of labour. Restrictive assumptionsof constant returns to scale, perfectly competitive markets, two factors of production onlyone of which (capital) can be accumulated, and optimising behaviour, result in a stationarypath where capital per head does not grow over time. To accommodate the observation thateconomic growth outpaces the growth of the capital stock, Solow (1957) introduced an exoge-nous trend of technological change into the production function. While this model was laterheavily criticized for its crude treatment of technology, neoclassical growth theory continuedits development course on more or less Solowian principles for some time. According to thisapproach, growth of economic output is triggered by changes in the employed factors of pro-duction, the capital stock, the labour force, and the available technology. A good compendiumof neoclassical growth was presented by Barro and Sala-i-Martin (1999).

In the mid-1980s, a major departure from the neoclassical approach was proposed thathas resulted in an impressive collection of publications under the heading of new growththeory.4 The clear point of departure is that these studies allow for increasing returns toscale at the level of industries or economies. They stress the existence of positive externalities(Lucas, 1988; Romer, 1986) and stress that the sum of individual actions impinges upon theenvironment of such actions. Most proponents of this “new” endogenous growth theory focuson the effect of collective learning and knowledge on the efficiency of individual productionprocesses. Externalities can enter in various ways: they can be the equivalent of a growthfactor when they consist of endogenising Solow’s technological shift factor, or they can affectcapital or labour directly. Endogenous growth models have placed emphasis on human capital.Others break capital into a series of different intermediate goods, with R&D resulting in thediscovery of new intermediate inputs. Yet others incorporate innovation as a series of “creativedestructions” in an effort to introduce Schumpeterian dynamics (Aghion and Howitt, 1992).Finally, growth in these models can also be realized through public goods and infrastructurethat increase the productivity of private factors. New endogenous growth theory models are

4. See Verspagen (1992) for a review.


intuitively appealing because they are able to create a virtuous cycle of intangible investment,learning, physical investment, and market pressures at the macroeconomic level.

Endogenous growth models suffer from a tendency to lead to explosive growth paths.While intuitive appealing, their empirical appraisal has been fairly sketchy, based on reducedforms (e.g., Barro, 1991). The new growth theory has also been criticized for not beingall that “new” (Nelson 1994). The criticism is that new growth theorists have been threedecades late in incorporating the significant insights into growth and the role of technologythat appreciative economic theorists like Moses Abramovitz (1952) had been writing for a longtime.

The strong attraction to growth theory has traditionally been related to the effort to under-stand relative movements in international competitiveness and trends in convergence/divergencebetween countries. An important implication of the neoclassical growth theory is the con-vergence of economies with different initial endowments. According to the assumption ofdiminishing marginal returns, the productivity of capital is higher in countries with lower en-dowments in this factor. Hence, the growth rates in economies with lower capital endowmentsshould exceed growth in the better endowed, richer economies and in the long run endow-ments, and thereby growth rates, should converge. Evidence, however, has been quite mixed,5

requiring to move from absolute convergence (initial capital endowments determine growthrates) to conditional convergence taking into account the dynamics of growth.

A large part of the work on conditional convergence has been summarized in Baumol etal. (1994). It essentially amounts to the investigation of a convergence hypothesis accordingto which:

“When the productivity level of one (or several) country(ies) is substantially superior tothat of a number of other economies, largely as a result of differences in their productivetechniques, then those laggard countries that are not too far behind the leaders will be in aposition to embark upon a catch-up process, and many of these laggard countries will do so.The catch-up process will continue as long as the economies that are approaching the leader’sperformance have a lot to learn from the leader. However, as the distance among the twogroups narrows, the stock of knowledge unabsorbed by the followers will grow smaller andapproach exhaustion. The catch-up process will then tend to terminate unless some supple-mentary and unrelated influence comes into play. Meanwhile, those countries that are so farbehind the leaders that it is impractical for them to profit substantially from the leader” knowl-edge will generally not be able to participate in the convergence process at all, and many sucheconomies will find themselves falling even further behind.”

Overall, available long-term growth data seem to support this convergence hypothesis.It is important to mention here that the complexity of the growth process has necessitatedthe consideration of so many factors that formal economic theory still finds impossible tohandle. Hence, most insightful analyses are frequently based on appreciative theorizing. Oneexcellent example is Nelson and Wright’s (1992) analysis of the factors responsible for the rise

5. Barro and Sala-i-Martin (1999) give empirical examples for the convergence hypothesis in which they com-pare growth rates from the period from 1960 to 1985 to the initial endowment, measured by GDP per capitain 1960. In the case of 118 countries there is hardly any correlation between the two variables, the evidenceeven slightly indicates a positive relation, i.e. high endowments cause high growth rates and low endowmentsresult in lower ones. For a selection of the 20 original OECD members the hypothesis holds, the relation is clearlynegative and the sample fit is much better.


of American technological leadership in the 20th century. Another example is Abramovitz’s(1986, 1994) account of the post-war convergence boom.

Particularly appealing is Abramovitz’s distinction of two sets of conditions that influencethe ability of different countries to realize their potential (thus be members of the converginggroup). The first set of factors amounts to the so-called technological congruence. This is basedon the observation that technology does not advance evenly in all directions. It advances in abiased fashion that reflects: (i) the past influence of science and technology on the evolutionof practical knowledge; (ii) the complex adaptation of that evolution to the natural resourceand factor availabilities and to market scales, consumer demands, and technical capabilitiesof those relatively advanced countries operating at or near the frontiers of technology. Thelaggards face varying degrees of difficulties in adapting and adopting the current practice ofthe leaders according to the extent that resource availabilities, factor supplies, technologicalcapabilities, market scales and consumer demands conform well to those required by the tech-nologies that have emerged in the leading countries. The degree of difficulty is not a constantbut changes over time as the laggards’ development adapts to the factor supply and to theorganizational and institutional challenges presented by more advanced countries.

The second set of factors amounts to the so-called social capability. This covers the coun-try’s levels of general education and technical competence, the commercial, industrial andfinancial institutions that bear on its ability to finance and operate modern, large-scale busi-ness, and the political and social characteristics that influence the risks, the incentives and thepersonal rewards of economic activity including those rewards in social esteem that go beyondmoney and wealth. Social capabilities are also not constant. They evolve in the directions towhich the requirements of a leading technology point, or in the case of a leading country, inthe directions defined by those of an emerging technology.

Countries’ potentials for rapid productivity growth by catch-up, therefore, are not deter-mined solely by the gaps in the levels of technology, capital intensity and efficient allocationthat separate them from leading countries. They are also restricted by the natural resourceendowments and more generally because their market scales, relative factor supplies andincome-constrained patterns of demand make their technical capabilities and their productstructures incongruent with those that characterize countries that operate at or near the tech-nological frontiers. And they are limited by those institutional characteristics that restricttheir capabilities to finance, organize, and operate the kind of enterprises that the frontiertechnologies require.


The Importance of Preparedness for the Knowledge EconomyWhen looking at those countries that spend the most on R&D, 3% of GDP is currentlytargeted by many developed nations, and the EU has set this as a benchmark for members.(EC, 2011)

Figure 1.4: Countries spending >2% GDP on R&D, and selected others (World Bank 2012,CIA Factbook, 2012)

In 2007 (see Figure 1.4), prior to the financial crisis and the most recent full set ofdata, only five countries met this 3% threshold, and only 12 spent at least 2% of GDP. Thesecountries are among the wealthiest, and have experienced much growth through increasedproductivity and innovation, but most of the R&D spending globally is concentrated inthese few.

One way to look at this is through the lens of convergence theories. Based onAbramoviz’s language of macroeconomic convergence, the “social capability” and “techno-logical congruence,” possessed by nations, and at the micro level, the “absorbtive capacity”(Cohen and Levinthal, 1990) of firms to capture the spillovers of innovation, not all na-tions can benefit equally from spending in R&D. Some are ahead and need to continueinnovating to stay ahead, and some can benefit from the leaders’ technology, while somewill lack the capacity for even this.

These measures can be strongly linked to the World Bank Knowledge Economic Index(KEI), which takes into account the quality of incentives and institutions, human capital,rates of knowledge production and adoption, and information and communication tech-nology infrastructure, as an index of preparedness for the knowledge economy. (WorldBank, 2008)


Figure 1.5: Public R&D Spending v. World Bank KEI Rank (World Bank 2012)

As seen in Figure 1.5, there is a strong correlation between the amount of spendingallocated to research and development and how highly the country ranks in the KEI. Asthe ability of the country to benefit from the products of R&D, the increasing returns canjustify greater investments. For many of the countries at the top of the spending list,notably excepting the US, they are both relatively affluent and relatively small, and arepoor in natural resources. These countries have instead been able to develop and exploittheir human capital as a resource.

For large, less wealthy nations, the formula is different, particularly at the early stagesof development, which is shown by China, Brazil and India, which are among the fastestgrowing nations in terms of GDP, yet rank somewhat lower in R&D spending. They con-centrate resources in preparing the general economy through capital investment so thatthey are better able to benefit from the returns to both foreign spillovers and their nativeR&D spending.

It should also be noted that size is a contributing factor. The capital investmentsneeded to build infrastructure and provide education are much greater, and some per-spective is needed in looking at percentage figures. China’s R&D spending in 2010 wasstill second only to the US in absolute terms (OECD, 2012).

1.7 Evolutionary Theorizing

Perhaps the most comprehensive challenge to mainstream economic theory has come from aset of propositions and models collectively referred to as evolutionary theories.6 While the

6. Nelson and Winter (1982) is generally recognized as the cornerstone of evolutionary theory. For a broadsurvey of the approach see Nelson (1995).


development of these theories has not yet matched that of mainstream economics, there isconsiderable unanimity among the school’s adherents about the intellectual framework andfuture directions. The challenge is comprehensive because the evolutionary approach is rootedin biology, thus explicitly considering dynamics and path dependence, whereas mainstreameconomic theory is much more mechanistic, more akin to (older) physics.

At the heart of the evolutionary approach is that history matters: firms are constrainedby past experience in their effort to optimise. Experience is embodied in routines — explicitand tacit rules of behaviour. Firms develop routines that incorporate both public knowledgeabout markets, technologies, and the business environment and firm-specific knowledge. Inrelatively stable competitive environments, this implies a selection process that rewards cer-tain kinds of routines (behaviour) and penalizes others. Routines are gradually adapted on thebasis of experience through learning. They tend to change more or less frequently dependingon the business and technological environment. Evolution principles also underline the emer-gence and development of all institutions affecting the general business infrastructure such aslaws, regulations, technical standards, etc.

Schumpeter’s concept of “creative destruction” is embodied in evolutionary theories in theform of “mutations” through drastic innovation. Drastic innovation changes technologies aswell as routines and institutions. The extent to which innovation succeeds or fails is dependenton a complicated interplay of initial conditions and path dependence in addition to standardefficiency criteria and technical superiority. This interplay explicitly recognizes historical andaccidental events, and thus hardly fits the characteristics of an optimisation process. Whenthey dominate, drastic innovations set a new process of evolution.

Importantly, the concept of path dependence implies that a successful technology withwidespread use may persist in dominating its market even after the reasons for its initialdominance have disappeared. In other words, a well-established technology may be verydifficult to replace by demonstrably superior innovations. In contrast, selection in conventionaleconomics is more mechanistic, largely dependent on straightforward efficiency criteria of thetechnology at hand.

The evolutionary approach is, thus, perceived by many economists to provide a new and,some say, much improved framework for the study of firms, technologies, and markets. Thisframework seems to be much closer to Schumpeter’s theorizing in which technical and in-stitutional innovations played a central role in the economic process. The net effect of theevolutionary/structuralist framework on policy decision-making and how that differs frommainstream (sometimes called neoclassical) approach is currently a matter of heated debateamong economists.

One way of arguing has been put forward by Stanley Metcalfe in several publicationswhereby policies based on the mainstream approach are concerned with resources and incen-tives taking the technological possibilities and capabilities of firms as given whereas policiesbased on the evolutionary perspective focus much more on the process of technological ad-vance, i.e., on changing and enhancing the innovation capabilities and possibilities (options)of firms. This line of argumentation may be compatible with considering the two approachesas complements, each with specific strengths and weaknesses that could be combined to drawvaluable policy advice. Yet, others strongly disagree, arguing that the chasm between the twoanalytical approaches is just too big and often leads to strong differences in policy (Lipsey andCarlow, 1998).


1.8 Regional Considerations

Studies of economic growth as experienced in the Middle East and North Africa (MENA) haveshown that circumstances such as reliance on oil, high population growth and unemploy-ment, lack of mature capital markets and institutions, and heavy state involvement in the realeconomy have resulted in the primary driver behind growth in the region for the past sev-eral decades being accumulation of capital, both physical and human. This does not howeverpreclude the potential of technological advance in driving economic growth. Information andcommunication technologies (ICTs) in particular can play a large role. In particular, a well de-veloped ICT infrastructure may not have immediate effect on domestic GDP growth, but canhelp attract the foreign direct investment. This FDI is a form of the stable and accumulatingcapital that is crucial for further development, and can have other positive effects including,but not limited to, technology transfer (Hassan 2003; Abu-Qarn and Abu-Bader 2007).

“Leapfrogging” and the increasing importance of ICTs: Mobile Phones in AfricaAfrica, and particularly Sub-Saharan Africa, has among the least developed infrastructurein the world. Transport is largely dependent on road networks, yet Africa has only 204 kmof road per 1000 sq km, with 25

This shows an example of in the process of development, there is no strict requirementto go follow the same path that other nations followed. One advantage that late develop-ers have over the leaders is the ability to borrow technologies and “leapfrog” ahead severalgenerations. The investment needed to connect landlines across continents to connect ev-ery town and village is immense. Europe and America completed it at a time when it wasthe only viable option. Africa, in contrast is able to use new mobile technologies to extendaccess to communications with a much smaller capital infrastructure investment.

More striking is the degree to which this technology, produced in high-income devel-oped countries, has been taken up and integrated into the development pattern of the lessdeveloped countries of Africa. Africans who may have had little access to the internationalcommunity are within a very short span of time, able to post text message updates to livefeeds with global reach, reporting on events as they unfold. Markets have become moreefficient as farmers can ask across a wide area for the best prices.

This is not a simple copy of the technology used in more developed nations either.Mobile phone handsets are still very expensive. The cheapest phone available in Kenyacosts half a month’s wage. Mobile phones have become a shared resource, used amongfamilies or having their costs split among many users, and while not every person mayhave their own phone, 80% still report having access to one.

Many of the high costs of owning a mobile phone are borne in the process of busi-ness, and can more than pay for themselves over time. In comparison to landline accessthat could take months and require stiff bribes, or the costs of travelling many miles togather market information or search for employment, a phone and subscription becomesa relative bargain as a business expense. (Aker and Mbiti, 2012)

Furthermore, access to the technology has inspired innovation of its own. M-Pesa is apayment system developed and popularized in Kenya that allows transfers of money via


phones, important for a population that largely does not have access to traditional banks.(Banks, 2008a) Clinics are using text messages to remind patients to take medication, andelection monitoring organizations are using crowdsourced information to increase trans-parency. (Banks, 2008b) Many of these innovations are unique to the native environment,for example a “call me” service that allows sending free messages to others to call backwhen airtime has expired, arose from the practice of quickly calling and hanging up toindicate the same. (Banks, 2008a)

In this application, the spread of mobile telephony is a technology in its own right, butalso a platform that increases the ability of the native population to collect, spread, and de-velop new ideas into innovations. These trends to date have flourished in relative informalterms, and often without government direction. As countries progress in development,the resource requirements of innovation increase greatly, and there comes a greater needfor the government and the institutional framework to properly support further growththrough smart regulation, fair intellectual property regimes, and good governance.

1.9 Summary Implications

A general observation from the brief review of economic literature in this paper is that thediscipline of economics has much more to offer in the analysis of the incentives for and resultsfrom technological innovation than is typically assumed by critics. Major advances in bothformal and appreciative economic theory have empowered economists with significant toolsto appraise the causes and effects of resources devoted to the production and dissemination ofnew technological knowledge.

A mix of important developments and results from the reviewed economic theory with richimplications for policy and policy evaluation include the following:

• No single approach can claim monopoly in explaining the relationship of technologi-cal advance and the economy. A complex, multi-dimensional phenomenon like innova-tion requires multi-dimensional analytical approaches based on formal theory, empiricalanalysis, acute observation and appreciative theorizing to establish regularities, and datafrom diverse sources including large databases, surveys, and case studies.

• R&D expenditures contribute substantially to output growth.

• There is a strong positive relationship between R&D and firm-level productivity.

• Social rates of return from R&D are much higher than private rates of return indicatinghigh levels of inter-firm and inter-industry spillovers, market failures, and need for publicsector intervention.

• Rates of return vary considerably between industries, between types of innovations, andby type of sponsor.

• R&D investment affects the structure of production.


• Academic research has become a major underpinning of industrial innovation in manyscience-based industries. There are significant differences between sectors in this re-spect. Basic research expenditures raise firm productivity.

• Available estimates of the rate of return to publicly funded research range from 20% to60%. Such rates of return are dependent on the successful application of the knowledgeproduced by public research organizations in the production process. These estimates donot include more general societal returns from basic research which need to be appraisedseparately.

• There is significant survey evidence that publicly funded research is responsible for sig-nificant knowledge flows to industry.

• The contribution of R&D to the economic performance of a nation depends on the abilityof firms to utilize and commercialise the results by introducing profitable products andprocesses. Technological diffusion is thus of utmost importance. Diffusion depends onfactors related to the characteristics of the innovation, the structural characteristics ofadopters and non-adopters, the mechanics of diffusion in particular settings, and theinstitutional environment.

• Even where institutional absorptive capacity is still under development, there is still evi-dence that investments in technology infrastructure, particularly ICT, can have a positiveeffect on attracting foreign direct investment, providing the capital for further develop-ment, as well as many intangible factors.

• Demand (tastes), technological opportunity, and appropriability conditions are nowwidely recognized to determine inter-industry differences in innovative activity over rel-atively long periods. All these conditions are subject to change themselves, particularlyin response to radical innovations.

• General purpose technologies (GPTs) such as ICTs, biotechnology, and advanced mate-rials serve as a source of widespread innovation throughout the economy. By diffusingthrough the economy GPTs result in disproportionate rates of innovation and productiv-ity growth.

• The resurgence of interest in growth theory has coincided with the advent of the “newgrowth” theory that focuses on endogenous technological advance, increasing returns toscale from R&D at the levels of industry or the economy, positive externalities, the effectof knowledge and learning on production efficiency, human capital, and the importanceof public goods and infrastructure.

• A major development in the economic analysis of technological advance has been con-tributed by evolutionary economics, following on the tradition of Veblen and Schum-peter. While the development of this line of theory has not yet matched that of main-stream economics, there is considerable unanimity among the school’s adherents aboutthe intellectual framework and future directions. Important factors in the evolutionaryapproach to technological advance include:


– History matters

– Firms develop routines that incorporate both public knowledge about markets,technologies, and the business environment and firm-specific knowledge. Routinesare gradually adapted on the basis of experience through learning. They tend tochange more or less frequently depending on the business and technological envi-ronment.

– A selection process (market, other) rewards certain kinds of routines (behaviour)and penalizes others

– Evolution principles also underline the emergence and development of all institu-tions affecting the general business infrastructure such as laws, regulations, tech-nical standards, etc.

– Schumpeter’s concept of “creative destruction” is embodied in evolutionary theoriesin the form of “mutations” through drastic innovation. Drastic innovation changestechnologies as well as routines and institutions

– Path dependence. E.g., a successful technology with widespread use may persistin dominating its market even after the reasons for its initial dominance have dis-appeared. In other words, a well-established technology may be very difficult toreplace.

The net effect of the evolutionary/structuralist framework on policy decision-making andthe differences from the mainstream approach is currently a matter of heated debate amongeconomists. An important argument has been that policies based on the mainstream approachare concerned with resources and incentives taking the technological possibilities and capabil-ities of firms as given whereas policies based on the evolutionary perspective focus much moreon the process of technological advance, i.e., on changing and enhancing the innovation capa-bilities and possibilities (options) of firms. This line of argumentation may be compatible withconsidering the two approaches as complements, each with specific strengths and weaknessesthat could be combined to draw valuable policy advice.

Appendix 1.A Leveraging Investment in R&D ThroughBroad-Based Policy: Finland (1960-2000)

In trying to evaluate the impact of R&D spending on GDP growth, many of the countrieswith high R&D budgets have healthy rates of GDP growth, but the factors involved are oftencomplex and it can be difficult to isolate increased spending in R&D from increases in othergovernment expenditures. R&D spending is often higher in small, wealthy nations that manynot have significant natural resources.

The case of Finland, in the last decade of the 20th century however, provides a uniqueexample of a relatively small country that made large gains in GDP over a short time perioddue to deliberate and intense efforts to increase technological output, with a focus on theelectronics industry, and at the same time extensive data collection by Finnish authorities andthe OECD provides an excellent record. (Walwyn, 2007)

In 1991, with the fall of the Soviet Union, Finland saw one of its largest export marketsrapidly wither, dropping 61% between 1985 and 1991. The paper, pulp, and other woodproducts industries had dominated the Finnish economy until then, comprising 45% of exportsin 1980. The early 1990s saw considerable economic turmoil for Finland, as it sought aredirection towards Western markets. GDP dropped by 20% from 1991-1993, the bankingsector experienced a major crisis, and unemployment dramatically increased, reaching 20%by 1994.

In the face of this bleak economic situation, Finland’s government, in cooperation withthe private sector made several key decisions that took advantage of many native strengths,leading to a dramatic turnaround. The fledgling electronics industry expanded rapidly, andNokia, the main mobile phone manufacturer rose to be a global leader in mobile telephony,capturing 38% of the world market for mobile handsets in 2008. By that same year, electronicshad become a dominant force, representing 31% of Finnish exports. (OECD, 2008) Between1993 and 2000, GDP increased by a total of 39%. (World Bank, 2012)

The success of Finland in this regard was the product of many factors. The government’sdecision to increase spending on R&D during the recession proved to be wise, but such abelief in the power of R&D did not arise overnight, nor was the government the sole forcefor growth. While Finland’s government spends proportionally more on R&D than others,as is often the case in other countries, government R&D is ultimately dwarfed by industrialinvestments. While this does not diminish the necessity of sound research policy, it emphasizesthat many different components make up the overall national innovation system, and indeed,Finland had already been learning this lesson through the several preceding decades.

In the 1960s Finland had already begun expanding its university system and establishinga central Ministry of Trade and Industry to oversee funding for goal-oriented research, alongwith a separate national fund for industrial research. Though through the 1960s and 1970sFinland was among the lowest spending governments on R&D in the OECD, and the 1960swas late to start a coordinated science policy, Finland’s membership in the rich nation groupand proximity to other technologically advanced countries like Sweden contributed to muchof this early institutional activity. In this period, much of the focus was on policy for science,operating through basic research and the universities, and promotion of general societal goalsin research, with limited linkages between academia and industry.

32

Through the 1970s this focus changed, with contributions from the success of Japan, andthe government shifted from creating and supporting research institutions to actively attempt-ing to increase industrial competitiveness. A committee of leaders from industry, unions,government, and research institutions came together and recommended that the country usethe opportunity of a new wave of electronics innovation as a means of moving from old in-dustries to new, knowledge intensive high technologies. The National Technology Agency wasfounded in 1983, and was given responsibilities formerly held by the old Ministry of Trade andIndustry.

The Ministry had focused on central planning aimed at broad scientific goals, where thenew Agency served to create connections between researchers, industry, and government. Pro-grams were started to specifically develop technology transfer and diffusion. This model ofnetworked collaboration was extended throughout the 1980s to include international cooper-ation, where Finland was able to be actively engaged with other innovative nations and learnfrom them. (Lemola, 2003)

The economy deregulated many sectors, encouraging competition, particularly in the telecom-munication sector, which even into the 1990s remained largely under state supervision in mostOECD countries. The company Nokia was able to take its invention of a new telecommunica-tion standard, and turn it into a regional standard for cellular communications. (OECD, 2008)Through this process, Finland began to see great returns, with their paper products industryinternationally recognized, and well above average GDP growth. (Lemola, 2003)

In light of this history, their decisions in the face of the economic crisis of the early 1990sare a simple reaffirmation on the part of the Finns in the success of their research and exportdriven model, where other countries might have turned inward. The concept of the “nationalinnovation system” introduced by evolutionary economists in the late 1980s became an ex-plicit concept in Finnish science and technology policy, with a clear recognition that drivingtechnologically led growth requires attention to a much broader set of actors and relationshipsthan simple industrial policy.

By adopting this systemic view, and by developing both research and the infrastructureneeded to turn knowledge production into innovation and growth, Finland was able to justifyits added investment in R&D by the industrial R&D activity that followed. Given the foun-dation of basic research, human capital, institutional support, and infrastructure, industrywas then in turn able to recognize an even greater rate of return on its R&D investment. A2007 study that modelled these investments with growth and determined that governmentinvestment increased the returns to industrial R&D threefold, while the ultimate return ongovernment spending in GDP was 66 to 1. (Walwyn, 2007)

A 2003 OECD report summarized the key factors in Finland’s success, affirming that busi-ness was the ultimate engine for innovation and growth, but that it was made possible throughseveral key policy decisions, including:

• The government taking an active and early role in developing mobile telephony stan-dards that gave its industry a first mover advantage.

• Liberalization and deregulation of telecommunications networks, unlike many othercompetitor nations.

• Investments in R&D strengthened by a systemic, cluster based approach that brought

33


many different players together.

• Effective education policies to develop the workforce.

• Liberal trade and investment policies allowing integration into world markets as well asa visible presence in important standard setting international organizations.


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Smith, Adam. 1776. An Inquiry Into the Nature and Causes of the Wealth of Nations. Ed. T.Cadell, William Strahan, Robert Hoe, and Henry N. Ess. London: : Printed for W. Stra-han; / T. Cadell, in the Strand., MDCCLXXVI. [1776].

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Solow, Robert M. 1956. A contribution to the theory of economic growth. Quarterly Journal ofEconomics 70 (1): 65 –94. ISSN: 00335533.

Steinmueller, W. Edward. 1994. Basic Research and Industrial Innovation. In The Handbook ofIndustrial Innovation, 54 –66. MERIT and U Limburg: Aldershot, U.K.:


Stoneman, Paul. 1983. The Economic Analysis of Technological Change. Oxford [Oxfordshire] ;New York : Oxford University Press, 1983.

———. 1995. Handbook of the Economics of Innovation and Technological Change. Oxford, UK; Cambridge, Mass. : Blackwell.

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———. 2012. Data: science & technology. World Bank..

Chapter 2

Science, Technology and Innovation Policyin the Era of Globalization

2.1 Introduction

Fostering a culture of innovation, where scientific inspiration is transformed into new prod-ucts, processes and services to improve people’s lives, is a goal of countries around the world.The astute use of knowledge and information has allowed many countries to greatly improveproductivity and spur rapid economic growth, leading to better standards of living and in-creased national competitiveness. Naturally, policymakers seek to leverage the resources ofgovernment, whether associated with budgets, policies, regulations, or the legal system, tosupport innovation. Broadly speaking, this effort is encapsulated in a set of policies collec-tively known as Science, Technology and Innovation (STI) policy.

While there are fairly standard concepts of science and of technology, the definition ofinnovation has been subject to rather long debates. Economists have traditionally definedinnovation as the first introduction of a new idea in the market as a new or improved product,service, or production technique. Reasonable as a start, and useful for pedagogical purposes,this concept of innovation leaves a lot to be desired when one tries to apply it. The mostauthoritative definitions of innovation, and what is involved in it, have been provided by aseries of “Oslo Manuals” by the Organization for Economic Cooperation and Development(OECD).

The Oslo Manual defines innovation as “the implementation of a new or significantly im-proved product (good or service), or process, a new marketing method, or a new organiza-tional method in business practices, workplace organization or external relations”(OECD/Eurostat,2005). Innovation is to be understood as distinct from merely the invention of new products.It can apply to creative new practices, processes, relationships or business models and eveninstitutional innovations such as open-source computing. Innovation, in short, is the ability tocreate and capture economic value from invention.

Let us address a misconception before we proceed. Developing countries face a startlingarray of socio-economic problems and limited resource endowments. Such a climate raisesquestions about the relevance or need for innovation policy. One should not lose sight ofthe fact that learning and innovation were the fundamental drivers of growth and industrial

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CHAPTER 2. STI POLICY IN THE ERA OF GLOBALIZATION 42

competitiveness for all countries considered advanced nowadays. They will remain so for thecatching-up efforts of developing economies. If innovation does not just refer to the intro-duction of processes or products that are “new to the world” but also to the absorption andproductive use of technology that is “new to the firm” (Viotti, 2002) or “new to the region”,countries working towards catching-up to the technology frontier cannot simply overlook pol-icy that deals with it directly.

The needs of any nation are highly contextual with regards to the state of development ofits economy at any given point in time as well as a multitude of political, economic and socialfactors. For instance, policies appropriate for the rich agricultural farmland of Brazil will differfrom those applicable to the vast ocean expanses of Kiribati.

Innovation policy can be fine-tuned to solving or mitigating problems that are specific toa country’s particular development context. Micro-credit financing, for instance, may not beeffective in the developed economies of Japan or Germany, but represents a major policy inno-vation in Bangladesh to support a broad range of the population that the formal banking sectorwill not service. Innovation, broadly defined, is crucial for a socially inclusive catching-up pro-cess and can be the cornerstone for a nation’s development strategy(Chaminade, Lundvall,Vang-Lauridsen, and Joseph, 2010).

In this Chapter, we review the basic concepts behind STI policy, and discuss the impact ofglobalization on national innovation efforts.

2.2 Should the Government Intervene?

A key question facing both developed and developing countries concerns whether the pub-lic sector should fund research and implement policies specifically aimed at improving thenation’s science and technology base. STI policy purports to develop a social and economicenvironment most conducive to producing advances in science and technology, and to fosterthe commercialization of such advances through innovation. At the national level, this oftenentails funding for basic science research and efforts to communicate existing scientific knowl-edge to applied research outfits to develop domestic applications. The task of turning researchresults into specific products and services is typically left to the private sector. Noting thelinkages between national research funding and economic growth, countries are increasinglydeveloping policies to guide funding for science, technology and innovation into areas thatwill generate the greatest results. But why is the government needed?

2.2.1 Market failure

The first clear rationale for public intervention due to market failures in research and devel-opment was developed in the 1950s and 1960s. Richard Nelson (1959), for example, arguedthat the social returns to research investment exceeded the private returns realized by theindividual firm undertaking the investment. In other words, scientific and technical knowl-edge were said to possess a public good dimension: the benefits from advances in science andtechnology spill over to other firms and consumers. As a result, the private sector could beexpected to underinvest in scientific research, necessitating the addition of public investmentto achieve a socially optimal level of research.


Not all research has the same level of public good qualities. Basic research is experimentaland theoretical work that advances the state of scientific knowledge. It can be considered asan important input that enhances the productivity of applied research and technology devel-opment. Applied research draws upon basic research to create new applications and achievespecific objectives. Businesses typically focus on applied research because the results are mucheasier to commercialize and bring to market than results from basic research. If businesses donot wish to spend money on basic research — who will foot the bill? This responsibilitytypically falls to government.

In addition to imperfect appropriability of research results (reduced ability to keep knowl-edge proprietary and benefit from it while excluding others), another market failure was saidto be the result of uncertainty associated with R&D investment and innovation more generally(Arrow, 1962). Such uncertainty can only be partly insured—as when, for example, an innova-tive company sells stock, thus, spreading the risk among multiple owners. Market failure canalso be the result of factor indivisibilities—certain investments can only be undertaken at largescales—and information asymmetries between the various parties involved (stakeholders).

2.2.2 Beyond the market: System failure

This traditional economic rationale for public support of STI has underlined government pol-icy in capitalist economies until very recently and remains the major tool in policy circles.It has, however, been supplemented more recently by newer approaches coming from evo-lutionary and institutional economics, the theory of complexity, and the study of innovationsystems. These approaches have focused on system failures due to technical complexity andmore general systemic complexity involved in scientific and technological advancement and ininnovation. One line of argument, associated with the work of Brian Arthur and Paul David,suggests that the economies of scale realized by firms that are first to introduce a new technol-ogy may result in a lock-in of the initial technological trajectory, even though an alternativepath of technological developments might be more efficient.

A second line of argument emphasizes the institutional constraints on the utilization anddiffusion of knowledge. In this view it is insufficient for the government to support the gen-eration of new knowledge and technology. Greater weight should be given to more effectiveinstitutional arrangements for the transfer of technology. As a result of the systemic natureof innovation, there are many feedback loops between the various stages of innovation pro-cess. Institutional relationships and the flows of knowledge between actors in the system areof critical importance. The innovative performance of a country/region is argued to dependupon the development of a balanced system of knowledge production and distribution. Gov-ernment intervention is thus justified to avoid the coordination and institutional failures thatmay occur. The role of the government is also related to the necessary investments in humancapital and in mechanisms to intensify the flows and absorption of knowledge.

A major challenge today is the complexity of modern technology. Most important technolo-gies, including information and communication technologies (ICT), are essentially systems ofcomponents that must work efficiently together. The components themselves are often basedon scientific knowledge from several disciplines. Industry has found the development of suchtechnological systems increasingly challenging. Several barriers to attaining long-term com-petitive advantage have emerged:


• An increased segmentation of R&D across industries making up the various supply chainsresults in private sector R&D that is more specific and less coordinated. This implies afailure to capture both economies of scale and scope, with a major consequence beingunderinvestment in new, broadly applicable technology platforms.

• Private sector investment is pushed into the commercialization range of the R&D cycle,resulting in the magnification of traditional funding gaps found in the early phases ofR&D.

• More pronounced private sector underinvestment in a range of critical technical infras-tructure and standards.

Moreover, the issue of investment timing has gained attention in an era of shrinking tech-nology life cycles. Technologies appear, mature, and become obsolete in a series of evolution-ary phases, which greatly affect R&D decisions. Thus, an important economic factor is thetiming of R&D investments relative to the evolution of a technology. The timing issue has twodimensions: investment decisions directed at attaining market share within a technology’s lifecycle and those focused on making the transition between life cycles.

2.2.3 Life cycle of products

As the market for a product technology expands and the technology is integrated into largersystems, successive improvements in both design and process technologies increase total mar-ket value and standardize production processes. Dominant designs emerge, and a subset offirms that have participated in this market take controlwhile most others end in failure. Even-tually, opportunities to apply the underlying or generic technology decline and the product’sstructure takes on a commodity character (e.g., personal computer). Competition shifts toefficiency in production processes, and price and service become increasingly important deter-minants of market performance.

This process disadvantages high-cost, developed economies. Sustained economic growth,then, requires not only constant attention to competitive factors over a life cycle, it demandsadvance planning for access to the next generation technology. This transition between twogeneric technology life cycles presents a different set of competitive threats and policy compli-cations. The greater the differences between two generations of a technology are, the greaterthe investment risk for individual companies and entire industries. Transitions to new tech-nology life cycles typically demand different sets of research skills than those of existing firms.Hence, these firms tend to assign higher technical and market risk valuations to the prospectiveresearch program, with the result that necessary investments are postponed.1

Figure 2.1 provides an illustration. A company appraising the risk of investing in the newtechnology faces a projected potential performance pattern such as curve 2. Initially, theperformance of the new technology (especially relative to cost and hence the price charged)is often below that of the defender technology represented by curve 1 (compare points A and

1. This enhances the dominant firms’ tendency to avoid jeopardizing profitable production lines in the prevail-ing technology life cycle.


Figure 2.1: Transition Between Two Technology Life Cycles (Tassey 1997)

B). The probability of lower technical or economic performance, possibly for some time, addsto the risk associated with the dynamics of the marketplace.2

These arguments on the technology life cycle raise two key policy concerns related to therole of government in facilitating efficiency within life cycles and facilitating the critical transi-tions between cycles. First, within a life cycle, the amount and speed of technological advanceachieved by a domestic industry over a technology’s economic life is critical, because suchgains in performance determine economic returns. Second, transitioning between technologylife cycles is an even more difficult issue. A number of high-tech companies manage transi-tions among successive product life cycles effectively. However, the transition to a radicallynew generic technology—disruptive technology—is infrequently achieved by firms champi-oning the defender technology. Most of these companies lose out to new companies. Thisprocess of “creative destruction” should only be a problem for policy makers if the new in-dustry players reside outside the domestic economy, implying a loss of value added (jobs andprofits). In addition, changes in competitive dynamics are altering the reward/risk ratio forR&D investments within and between technology life cycles. As life cycles compress, R&D atthe company level can no longer exist in isolation of a supporting network.

2.2.4 Diffusion of knowledge

Another major conclusion of recent research on the impact of public investment in science andtechnology concerns the benefits of increasing international trade and global integration. Tra-ditional economic theory explains that the persistent poverty of many less developed nationsis the result of a lack of natural resources or capital goods. In contrast, Paul Romer and otherssuggest that it is a paucity of ideas and knowledge that most contributes to poverty in poor

2. In addition, as Nathan Rosenberg (1976) has eloquently argued, the defenders of the old technology seldomgive up without a fight, meaning that curve 1 may become steeper under intense competition. This furthercompounds the innovator’s risk and has accounted for several new technology failures in the past.


countries (Romer 2007). In some ways, developing countries are at an advantage in the questfor new knowledge, because they can pick from the rich store of existing knowledge alreadycreated by the developed, industrialized nations. Access to this knowledge is facilitated by in-ternational trade and integration, whereby companies introduce new products and processes,scholars exchange ideas, and governments coordinate policies for mutual benefit. Countriescan encourage such knowledge flows through the use of STI policies that seek to protect patentrights, permit foreign direct investment, and establish property rights.

For these reasons, STI policies seek to create a climate conducive to the growth of domesticbusiness—a goal which is addressed through the development of fundamental S&T capabilitiesand R&D activities at national ministries, basic research institutes, universities, and to someextent, private businesses.

A firm can be innovative by creating a new product, but it can also be innovative by imple-menting a product that is new to the firm, new to the industry, or new to the country. Thus,innovation is also the diffusion of new ideas, practices or inventions into an economy. Theprocess of diffusion is particularly relevant and important to developing countries. While theymay seek to invent new-to-the-world products, a more significant source of technology comesvia the successful diffusion of existing foreign technologies into the domestic economy. Suchtechnology diffusion is a hallmark of globalization and the networked nature of knowledgeeconomies.

Case Study of Brazil’s Agricultural StrengthBrazil’s current economic strength comes in part from its role as the world’s bread basket.Within its rich territory, Brazil is one of the most important producers of key commoditiessuch as sugar, cattle, soybeans, beans, chicken, pigs, oranges, rice, corn, and coffee. Buteven with such valuable natural resources, the country struggled economically for most ofthe twentieth century.Finally in1973, Brazil began a fascinating and uniquely successfulexperiment in knowledge and technology creation—the world-class system of cutting-edgeresearch known as the “Brazilian Agricultural Research Corporation”, or EMBRAPA.

EMBRAPA is a national research system supported by the country’s science, technologyand innovation policies. Composed of a large network of laboratories and research centers,the institution focuses on soil science, plant and animal health, agricultural techniques,ecology and the environment and genetics. EMBRAPA partners with academic institutions,private companies, municipal governments and international organizations to achieve itsgoal of the sustainable development of Brazil’s agricultural sector. Consider the benefitsof Brazil’s investment in agricultural technology: From 1970-2010, using advanced agri-cultural technology, Brazil nearly doubled its hectogram per hectare sugar cane yield. Thework of EMBRAPA optimizes the country’s use of agricultural resources and contributes toeconomic growth.


Figure 2.2: Historical Sugar Cane Yield in Brazil (Food and Agriculture Organization 2012

2.3 Science, Technology and Innovation (STI) Policy

The literature on innovation has discredited any suggestion of a linear process where S&Tinvestments lead to knowledge production and eventually innovation. Innovation is insteadthe result of a complex interplay of factors working harmoniously together in the sense ofan “innovation system”, defined as “elements and relations, which interact in the production,diffusion and use of new, and economically useful, knowledge. . . ” (Lundvall, 1992). Sucha system includes key organizations and institutions, as well as the many linkages betweenactors including the triad of public sector, private sector, and universities. Institutions gen-erally refer to the spectrum of established norms and practices, laws and regulations thatgovern relations between individuals, groups and organizations involved in science, technol-ogy and innovation. Examples include the intellectual property regime (and patent system),industrial policy, labor regulations, and various other institutions. Linkages refer to the myriadinteractions between and within the organizations and institutions. Links between research in-stitutes, or between public universities and private companies enable the broad utilization andenhancement of advances in science and technology. To the extent that STI policy addressesthe “system”, then, it can be effective by seeking to strengthen the organizations and the in-stitutions which allow knowledge to be produced as well as the methods by which knowledgecan be distributed widely. We will return to innovation systems in Chapter 3.

2.3.1 STI Policies

The role of public sector is not to replace the private sector in promoting advances in science,technology and innovation. Rather, the former seeks to support a policy and business environ-


ment most conducive to the latter. A 2008 World Bank report on the role of government insupporting innovation policy noted the following broad objectives:

• Supporting innovators through appropriate incentives and mechanisms

• Removing obstacles to innovative initiatives

• Establishing responsive research structures

• Forming a creative and receptive population through appropriate educational systems

The range of public policies to promote these science, technology and innovation goals isextensive. It includes (Tassey, 2009):

• R&D funding programs

• Tax incentive programs (R&D tax credit)

• Research at public research laboratories and institutes

• Coordination and management of public research portfolios

• Intellectual property management

• Technology transfer functions

• Innovation incubators and science parks

• Education and training programs in universities and vocational schools

• Entrepreneurial training in university outreach programs

• Technical management information from government agencies

R&D funding programs

In advanced countries, the public sector typically funds the majority of basic research, a largechunk of applied research, and a much smaller share of development research (exceptingnational defense). The participation of the public sector in national R&D expenditure variesbetween a fifth in East Asian countries such as Korea and Japan and a half in several countriesof the European Union, with the United States in the middle (more than one-third). The publicsector comes at higher levels in developing countries, ranging from very high in less developedto relatively lower higher up on the development ladder. The advantage of such subsidies istheir selective nature: one can decide what to fund and what not to fund. The disadvantageis possible distortion of the market by decision makers removed from the market.


Tax incentive programs

The most well-known implementation is the R&D tax credit, now widely used around theglobe. In the US version, incremental R&D dollars (or research and experimentation dollars)are taxed at lower rates. R&D tax credits are considered neutral in the sense that beneficiariesdecide their R&D focus. Funding authorities now do not have a choice regarding the type ofresearch to fund.

Intellectual property management

The patent system is one of the most important ways inventors can secure ownership rightsfor their inventions. In addition to their individual country of origin, inventors will seek topatent their most valuable inventions in the largest prospective markets which traditionallyhave included the U.S., Europe and Japan and more recently are expanding to include largerapidly developing nations. Increasingly the practice also includes universities which havebeen emboldened in the US since the passage of the Bayh-Dole Act in 1980. This Act alloweduniversities to patent inventions created through public funding. It also lent support to jointcommercial projects between universities and businesses. In more recent years the Act hasbeen emulated in various countries around the world.

Technology transfer functions

Government institutions and universities develop technology of significant commercial value.Technology transfer from public research institutes and universities to industry has attracteda lot of attention in the past three decades or so. Setting up university-industry linkages andtechnology transfer offices aids this process. Innovation incubators and science parks. We willreturn to this STI policy tool later in this volume (Chapter 8). Suffice it here to say that theadvantages of innovation incubators and science parks are based on the concept of clusters.Clusters refer to the geographical agglomerations of people, firms and institutions working ina similar or related field(s). The basic idea is that in such a scenario knowledge can flow muchmore easily across people and organizations, spurring innovation and development. A virtuouscycle may develop whereby successful businesses generate economic returns, and draw otherbusinesses to the area. Science parks grow around universities, aiming to facilitate universityindustry interaction.

Education and training programs in universities and vocational schools

Education and training are the foundation of effective systems of innovation and knowledge-based societies. Increasingly complex technologies rely upon the competencies of educatedcitizens who handle them. Ensuring that schools produce citizens with the skills needed tofunction in a modern economy is important, and even more so as a country seeks to foster anadvanced, knowledge-based economy.


Entrepreneurial training in university outreach programs

Instilling some basic concepts of business, a tolerance for risk and appetite for reward, andan understanding of economics in young people can help a country develop. Because animportant factor in economic growth is the creation of new businesses, educational programsthat inform young people and turn them to prospective business owners provide an invaluableservice.

Even in countries with limited capacity for large-scale public investment in science andtechnology, a strong STI policy can create an environment conducive to a robust economy.Government regulates the markets in which companies thrive and grow, sets national ed-ucation and training policies, provides support for entrepreneurs, and encourages networklinkages between government, academia and business. Government can also play a role instrengthening demand-side policies by implementing regulations, setting standards, modify-ing pricing, educating consumers and setting tax and public procurement priorities (OECD2011). Recognizing the role of knowledge and information as a driver of productivity andeconomic growth leads countries to formulate STI policies to support the development of a“knowledge-based economy”. Such an economy is based on the production, distribution anduse of knowledge (OECD 1996). Many nations, including those in the Arab world, are in-terested in developing a knowledge-based economy to support competitive and innovativeindustries.

2.4 STI Policy and Globalization

Globalization can be perceived as the compression of space and time relations as a result ofeconomic liberalization and improved information, communication and transportation tech-nologies. We feel its effects every day, whether it involves academics in Jordan and the UnitedStates exchanging drafts of their latest manuscripts, or a family in Egypt preparing a meal withLebanese figs and Brazilian oranges. At the same time, this new closeness, or compression ofspace and time, also presents many challenges to nations and their economies. Simply put,the process of globalization creates economic pressure via intensifying world competition andthe need to be globally competitive. The effects of globalization are profound (Box 2).

GlobalizationOECD (1996a) summarizes the main resulting features of globalization as follows:

• Simultaneous competition in each market between numerous new competitors fromall countries. Each firm now has to compete in its own market with other firms andnew players from all over the world. This new competition necessitates in numerousareas extremely rapid structural adjustment.

• Internationalization of production: multinational origin of components, products,services and capital. The various elements that enter into the manufacture of aproduct (capital, labor, technology, raw materials, intermediate goods, distribution)may come from many sources; countries and firms are now so interdependent, and


the links between the so complex, that it is sometimes quite difficult to determineexactly where the various elements come from.

• Growing interdependence of the various levels of globalization (trade, direct invest-ment flows, technology transfers, capital movements, etc.) High degree of interpen-etration of national economies.

• The structure of international trade is becoming increasingly intra-industry or intra-product in nature.

• Relatively diminished importance of trade, which is no longer the sole, or even themost important, vector of globalization.

• Foreign direct investment has become a crucial factor in the worldwide process ofindustrial structuring and the development of genuinely global industries. Direct in-vestment flow generates exports from the countries making the investment; theseexports are accompanied by transfers of technology and know-how, and capitalmovements (equity investments, international loans, repatriated profits, interest,royalties, etc.).

• National comparative advantages increasingly correspond to advantages of location,which vary according to corporate strategies.

• Financial sector tightly entwined with the industrial sector.

• Emergence of specific regional and cultural factors in response to globalization. Mul-tiplication of regional free trade agreements.

Science, technology and innovation related activities are also becoming internationalized,albeit at a much slower rate than other business activities such as production, marketing, anddistribution. It is a subject that worries policy decision makers disproportionately. However,given that it relates to high valued-activities, the internationalization of STI activities is alreadya significant enterprise which is largely driven by the private sector. In 2007, global combinedinvestment in R&D reached an estimated $1.1 trillion (National Science Foundation). The vastmajority of this investment was directed and committed by industry.3

Since industry is quickly internationalizing, R&D is expected to follow suit. The mainchannels for STI internationalization include: i) an increase in the number of R&D laboratorieslocated abroad; ii) the rising number of cooperation agreements or alliances either betweenfirms or between firms and government or university R&D bodies; and iii) an increase incontract R&D to foreign organizations.

Globalization presents both opportunities and challenges for national economies in theMiddle East. On one hand, the opening of borders allows high-wage countries to shift produc-tion of some goods to companies in the region and sell their goods to a much wider group ofcustomers. Countries with a liberal economy and superior information, communication and

3. In the U.S., industry funded approx. 67%, while in Europe the average is about 55%, with German and UKindustry spending 70% and 45% of their respective national totals. East Asian countries like Japan and Koreahave even higher shares by the private sector, reaching 80%.


Figure 2.3: Science Is Becoming Internationalized (WIPO, based on data by Thomson in Na-tional Science Board 2010)

transportation infrastructure can become central to regional and global trade. Globalizationalso offers much wider access to new knowledge: knowledge flows from advanced nations todeveloping nations have multiplied as a result, to the great benefit of the latter. Greater accessto knowledge funnels expectations of faster steps towards a knowledge-based society (Vonor-tas and Tolnay, 2001). On the other hand, domestic companies face increased competition andsome of them may find it more profitable to relocate, resulting in the loss of domestic jobs.Modern STI policies deal with all these issues, essentially trying to maximize the positive andminimize the negative effects of globalization.

2.4.1 Multinational Corporations (MNC)

One of the most significant drivers of globalization is the multinational corporation (MNC).MNCs are responsible for two-thirds of global trade and 80% of investment around the world(UNCTAD, 2005). As a major source of both knowledge flows and foreign direct investment,MNCs are vital to the diffusion of science and technology.


However, as a long series of annual UNCTAD publications (World Investment Report) havemade abundantly clear, MNCs invest selectively. While many countries would like to learn fromthem, few actually manage to do so and become hubs of international business. Internationalspillovers have their greatest impact on domestic productivity when local firms learn to bothinnovate and imitate other countries’ and firms’ innovations.

Foreign Investment in R&DThere is an increasing number of offshore R&D centers in emerging economies like Chinaand India which have also concurrently seen a rapid growth in domestic R&D expendituresand patent applications at home and abroad.

Intel’s US$300 million semiconductor assembly plant in Costa Rica is one of the bestknown cases of positive spillover effects. Intel’s two plants directly employ 2,900, but theindustry in Costa Rica now employs 12,000. The local support businesses for Intel alonereflects a base of 460 suppliers. The initial investment decision was the catalyst for arealignment of Costa Rica’s competitive platform and has led to subsequently secured FDIin other targeted sectors.

It is important to note here that the nature of the innovation process itself is changingin today’s internationalized economy. Peculiar terms only a little while ago, such as openinnovation, are becoming standard business practices. Value chains are being reorganized atan international level. Since innovation is the outcome of interactions between different actorsin a system, policy decision makers must concentrate on knowledge distribution (flows) andconnectivity in the system.

The possibilities for “smart” STI policy by small developing countries like Jordan andLebanon are immense. One does not need to replicate the whole value chain anymore. Rather,strategically choosing and positioning oneself in specific niches of the value chain becomes thename of the game. The difficulty is in understanding relative strengths, locating market niches,and moving aggressively with STI policy in agreement with more general economic policy.

By creating and enhancing competitive advantage STI policy has become indispensable.We will return to issues of this nature in Chapter 6.


References

Arab Knowledge Report. 2009. Towards productive intercommunication for knowledge. Tech-nical report. UNDP.

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Arrow, Kenneth J. 1963. Uncertainty and the welfare economics of medical care. AmericanEconomic Review 53, no. 5 (Dec.): 941–973.

Lundvall, B-Å., KJ. Joseph, C. Chaminade, and J. Vang. 2009. Handbook of Innovation Systemsand Developing Countries. pp. 360-379. Press: Edward Elgar.

Lundvall, Bengt-Åke. 1992. National Systems of Innovation: Towards a Theory of Innovation andInteractive Learning. London: Pinter Publishers.

Nelson, R. R. 1959. The simple economics of basic scientific research. Journal of Political Econ-omy 67:297–306.

OECD. 1996. The knowledge-based economy. Technical report. Organisation for Economic Co-operation and Development.

———. 2009. Policy responses to the economic crisis: investing in innovation for long-termgrowth. Technical report. Organisation for Economic Cooperation and Development.

Romer, Paul. 2007. Economic growth. In The concise encyclopedia of economics, ed. David R.Hendersen.

Tassey, Gregory. 2007. The Technology Imperative. Edward Elgar.

UNCTAD. 2005. World investment report. Technical report. United Nations Conference onTrade and Development.

Vonortas, Nicholas S., and A. Tolnay. 2001. Towards the knowledge-based economy: US and itsAPEC partners. In Technology policy for the knowledge-based economy, kluwer, ed. MaryannFeldman and Albert Link. Academic Publishers.

WIPO. 2011. The changing face of innovation. Technical report. World Intellectual PropertyOrganization.

Part II

Framework

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Chapter 3

Systems of Innovation

3.1 Introduction

The conventional view of technological advancement as a linear process rested on a seriesof sequential steps starting out with basic research, progressing to applied research and thedevelopment of final products and services that reached the market and supported economicgrowth . This view of the process leading to innovation with research and development (R&D)as input, on the one hand, and new/improved products and processes as output, on the other,has been gradually displaced by more sophisticated approaches that provide alternative frame-works and look at innovation from a systemic perspective.

Figure 3.1: Linear Model of Innovation (?)

The innovation systems concept was brought into prominence with the work of scholarslike Freeman , Lundvall and others. This concept emerged as the conventional linear model ofinnovation was seen to have limited explanatory power. The innovation-systems frameworksees innovation in a more systemic, interactive and evolutionary way, whereby networks oforganizations, together with the institutions and policies that affect their innovative behaviorand performance, bring new products and processes into economic and social use (Lundvall1992) (Edquist, 1997).

The framework can also be applied at different levels of the economy, be it national ,regional , or sectoral depending on the granularity of interactions one wants to study. Theinnovation system concept has now gained widespread acceptance and is increasingly madeuse by policy decision makers at all levels of government and international advising organi-zations such as the World Bank, United Nations Agencies, and the Organization for EconomicCooperation and Development (OECD).

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CHAPTER 3. SYSTEMS OF INNOVATION 57

3.2 A Brief Overview of the Innovation Systems Concept

Freeman (1987) defined the innovation system as “. . . the network of institutions in the publicand private sectors whose activities and interactions initiate, import, modify and diffuse newtechnologies.” Lundvall’s (1992) A rather definition focuses on “elements and relations, whichinteract in the production, diffusion and use of new, and economically useful, knowledge . . . .”

The systems approach to innovation focuses on the linkages among the agents involved ininnovation, including private enterprises, universities, and public research institutes. Techni-cal advancement and innovation are viewed as the outcome of complex sets of relationshipsamong such agents (and their people) targeting the production, dissemination and applicationof knowledge. The innovative performance of a country is said to depend to a large extent onhow these actors relate to each other as elements of a collective system of knowledge creationand use.

A Tale Of Two Nations: Interactions MatterWhy, given two countries with almost the same level of risk, does one attract clustersof foreign investment, while the other fails? Mauritius and Senegal, both former Frenchcolonies, initially engaged in the same type of policy reforms and established export pro-cessing zones (EPZs). Both are poor but not landlocked and enjoyed political stability.Senegal has a comparative advantage from its larger size, greater amount of arable land,and has a higher population. Yet it was Mauritius that managed to attract considerableforeign investment, to become one of the few African countries with relatively high percapita income. It successfully transformed itself to from a mono-crop culture (sugar) toone diversified into manufactured exports and tourism. The success of the manufactur-ing sector is attributed to the successful establishment of EPZs in 1970. However, EPZ’sin Senegal did not show similar success. Studies (Yehoue 2005) suggest that at the coreof the Mauritius’ success story was the interplay of the government leadership (throughincentives and institutions) and the dynamism of its domestic entrepreneurs, which makeavailable positive externalities for foreigners by clustering their investments. This inter-play seems to have not been present in many other African countries.

The national innovation systems approach stresses that the flows of technology andinformation among people, enterprises and institutions are key to the innovative process.Innovation and technology development are the result of a complex set of relationshipsamong actors in the system, which includes enterprises, universities and government re-search institutes. For policy-makers, an understanding of the national innovation systemcan help identify leverage points for enhancing innovative performance and overall com-petitiveness. It can assist in pinpointing mismatches within the system, both among insti-tutions and in relation to government policies, which can thwart technology developmentand innovation. Policies which seek to improve networking among the actors and institu-tions in the system and which aim at enhancing the innovative capacity of firms, partic-ularly their ability to identify and absorb technologies, are most valuable in this context.(OECD 1996)

The main components of an innovation system are organizations and institutions as well


as the relationships that link them (Edquist 2001). Together, these elements make up theecosystem in which interactive learning leading to innovation takes place. The three essentialelements are:

• Organizations: These comprise the actors in the system. These run the full gamut fromfirms in the private sector to universities and academic actors. They also include financ-ing organizations (venture capital etc), governmental funding and public policy makinginstitutions, as well as users and consumers.

• Institutions: These comprise the full spectrum of established norms and practices, lawsand regulations that govern the relation and interactions between individuals, groupsand organizations that undertake innovation activities. Examples of such influencinginstitutions are the prevailing intellectual property regime, corporate governance struc-ture, industrial policy, labor regulations, as well as societal norms regarding corruptionetc.

• Linkages: These refer to the interactions that occur within and across organizations andinstitutions. These relationships are often complex (one way or reciprocal), dynamic(continually shape and are shaped by) and based on the underlying tension of collabo-ration and competition among actors. They enable and influence the nature and degreeof knowledge flows through innovation systems and in so doing shape specific trajecto-ries of specialization and learning. (Kraemer-Mbula and Wamae 2010).

The innovation systems approach represents a paradigm shift in viewing systems of knowl-edge production. Whereas the traditional approach emphasized innovation resulting fromknowledge production by focusing on research in science and technology, the new approachto innovation takes into account the system as a whole and recognizes that innovation is a com-plex interactive process that takes place within a network of organizations that are involvedin the creation, diffusion, adaptation, coordination, diffusion and application of scientific andtechnical knowledge. There is a complicated two-way relationship of mutual embeddednessbetween institutions and organizations, and this relationship influences innovation processesand thereby also both the performance and change of systems of innovation (Edquist, 1997).

A key insight of the innovation systems approach is that firms do not innovate in isolation.Rather the innovations are based on interactive learning between organizations. A second keyinsight is that institutions are a critical component of the system: they shape (and are shapedby) the actions of the organizations and relations between them (Edquist, 1997). In summary,the three salient features of innovation system approach are

• Innovation is the result of an interactive process between actors and institutions

• Innovation does not follow a linear path from research to development and then pro-duction but instead involves continuous feedback looks between the different stages ofthe innovation process.

• Different levels of economy can be analyzed depending on whether one is studying in-novation at an international, national, regional, local or sectoral level.


3.3 Innovation Systems: The Local Dimension

Increasingly there is growing recognition of localized networks, i.e. the extent to which learn-ing processes between organizations are interactive within regions rather than whole coun-tries. It is now well understood that in nearly every industrialized nation, a few metropolitanregions have become focal points of knowledge creation and innovation. Silicon Valley &Boston’s Route 128 (Maskell and Malmberg 1999) in the United States are two celebratedexamples of such regional agglomerations (clusters) of high technology industry. Economicclusters can be viewed as networks of production of strongly interdependent firms linked toeach other in a value-adding production chain. Clusters are, in principle, a specific type ofinnovation systems, if in miniature form.

Clusters are highly idiosyncratic. They arise from a unique interplay of a set of factors,including geographic, economic, organizational, social and cultural. Moreover, the interplayof these factors changes over time as clusters evolve. It is important to note that cluster for-mation is mostly a market-induced and market-led process without much direct governmentalinterference. However, the government does play a critical role as a facilitator of networkingand institution building (OECD 1999). Clusters will be analyzed at greater length in Chapter8 of this volume. A closely related concept is that of the regional system of innovation (RIS). ARIS generally has two features: the first is firms that interact with each other, especially thosethat display clustering tendencies, and the second is the supporting regional infrastructurewhich comprises public and private research laboratories, universities and colleges, technol-ogy transfer agencies, etc. A RIS can, in principle, contain several clusters as long as there arefirms and knowledge organizations that interact systematically within the boundaries of thatregion.

3.4 Innovation Systems: The Sectoral Dimension

A look at history of specific cases of development and catching up brought forth a new di-mension to the innovation forefront. Very often economic development and catching up byindividual countries has been associated with the emergence and growth of a certain indus-trial sector. Cases in point are the catch up of Japan during the 1970s led by sectors such asautomobile and electronics (Goto and Odagiri, 1993), of Korea led by auto and electronics(Lee and Lim, 2001), and of Taiwan led by electronics (Amsden and Chu, 2003). A sectoralperspective is relevant for the analysis of the determinants and the factors driving the catch-up process because it identifies key driving dimensions of catching-up. Key findings in theliterature include:

• Catching up takes place in different sectors whose importance may change over time

• The factors affecting catching up differ greatly from one sector to the next

A sectoral system framework focuses on the nature, structure, organization and dynamicsof innovation and production in sectors. This perspective primarily focuses on firms, capabili-ties and learning processes as major drivers of innovation and growth. But in addition to theknowledge base of sectors, it also emphasizes the role of other actors in the innovation ecosys-tems such as individuals, users, universities, the government, financiers; links and networks


among actors; and finally the processes of competition, cooperation and co-evolution. It isimportant to note that the boundaries of sectoral systems are not easy to set. Boundaries maytranscend local, regional, an national communities.

The Great Telecommunications Transition: Divergent Paths to Catching-upAll four countries Brazil, China, India and Korea had all once developed more or less‘indigenously’ digital telephone switches. All four countries crafted a state led sectoralsystem of innovation with a government research institute at the core for technology de-velopment which was licensed to public and private sector domestic enterprises whichconverted this technology to manufacture equipment that in turn were sold to monopolystate-owned service providers. However the recent wave of privatization and deregulationof the industry and the arrival of mobile technologies has led to a radical altering in theindustry has completely altered the working of the established systems.

In transitioning to wireless telecommunication systems, we see two broad divergentpaths emerge—at one end, we have the Chinese and Korean systems that have largelysucceeded in coping with the challenges posed by globalization and emerged as major ex-porters of telecom equipment; while at the other end we have Brazil and India which havebecome increasingly net importers of telecom equipment. Some of the enterprises fromthe former group have now become important world players and have become the MNCsin their own right (Samsung, Huawei, XTE). In contrast, there are no major domesticmanufacturers in Brazil & India and manufacturing is dominated by MNC affiliates.

The variations among the four can be explained by the critical role of government.While the governments in China and Korea took an active role of promotion and co-ordination through R&D support, R&D consortia and public research organizations, thegovernments in India & Brazil followed a less directed and coordinated intervention ap-proach. This difference in government action was the seed for the divergence between thetwo groups of countries. An interesting thing to note is that once indigenous capabilityhas been developed, then paradigm shifts can serve as a window of opportunity as seenby the commercialization of the CDMA technology in Korea and development of the 3Gwireless standard (TD-SCDMA) in China. For India & Brazil whose local production andR&D capabilities are still weak, compared to the MNCs both in capabilities and markets,the different technological shifts served as further barriers to entry and catch up (Malerbaand Mani 2009) (Malerba and Nelson 2011) (Lee and Mu 2011).

3.5 The Innovation Systems Approach forDeveloping Countries

Innovation systems first originated in and have seen rapid acceptance in the policy circles ofthe developed world. One of the key reasons for adopting the innovation systems analyticalapproach is the underlying assumption that innovation is a dynamic and interactive process,where the results depend on the types of relations between different firms, organizations and


sectors, as well as on the cultural and institutional behaviors and norms associated with theregion or nation in question. The context specificity of the various case studies in the richinnovation systems literature lead us to conclude that there is no single model to generalizethe dynamics of successful innovation systems. The innovation systems approach of looking atthe system as a whole and examining various interactions and feedback cycles therein allowsfor the co-evolutionary development of institutions and technologies—an aspect which seemsespecially promising when it comes to developing countries.

In developing economies, innovation systems are best understood as emergent i.e. onlysome of the building blocks are in place and where the interactions and relationships be-tween components are still being formed. This is in contrast to mature innovation systemswhere interactions between the building blocks take place through market and non- marketmechanisms such as informational links, interactions and other kinds of formal and informalnetworks. (Chaminade, Lundvall, et al. 2010).

Figure 3.2: Evolution of Innovation Systems (Chaminade and Vang 2008)

Innovation systems in developing countries do not just differ extensively from those inadvanced countries. They are also quite heterogeneous among themselves. Hi-tech sectorsexist alongside more informal sectors characterized by low productivity. Broad geographicvariations in knowledge bases abound. As an analytical tool, however, the innovation sys-tems approach can help identify systemic failures that impede the development of a country’sinnovation ecosystem.

Viewing the whole innovation process in a systemic way can help guide policy initiativesthat are intended to address all the components needed by an economic system to facilitate


learning and innovation. The table below shows a list of systemic challenges in developingcountries and tries to draw a contrast between mature and emergent innovation systems.

The Brazilian health biotechnology innovation system (See Box I) is a great example ofan emergent “weakly linked” ecosystem that was able to make the shift to a more dynamicstrongly networked innovation system. Their effort carries several valuable lessons for policy-makers in developing countries. In the case study, we view FIOCRUZ as a microcosm of thestructure of the Brazilian health biotechnology innovation system. It illustrates the imbalancesthat can occur between the supply of high-level scientific knowledge and limited demands forresearch, development and design in manufacturing. It also shows how institutions (particu-larly policies) influence the behavior of individual organizations. At the same time, it showshow organizations can address systemic failures, and how their accumulation of technologicalcapabilities can have a positive impact on public policies.


Figure 3.3: Innovation Systems and Development (Chaminade and Vang 2008)


Learning from the Brazilian ExperienceBrazil had considerable success in its research efforts in health biotechnology as measuredin academic output. Yet this success was not translated into relevant economic goods andoutput. This could be attributed to the way in which the sector was initially developed.The knowledge production was mainly concentrated in public sector R&D institutions andacademic organizations. This close collaboration led Brazil to some spectacular successeslike the sequencing in 2000 of Xylella fastidiosa—a plant pathogen that affects citrus fruits.However, inspite of the strong knowledge base, there was no corresponding boost in in-dustry production. Brazilian firms continued to rely on imported licenses and genericmedicine production. There were very weak links between the basic research sector andthe technology development sector.

FIOCRUZ is a federal institute founded in 1900 with the goals of controlling bubonicplague, yellow fever and smallpox. This institution, affiliated to Brazil’s Ministry of Health(Brasilia), became the central knowledge-producing hub of the health biotech- nologyfield in Brazil. More than 16% of the papers originating from Brazil in internationalpeer-reviewed literature from 1991 to 2002 came from scientists of this institute. Theinstitute also created a manufacturing plant, Bio-Manguinhos (Rio de Janeiro, Brazil), tocentralize FIOCRUZ vaccine production. Until the mid-1990s, Bio-Manguinhos relied onbasic process technologies and mostly concentrated on low value-added products. Therewere not much collaboration between the other FIOCRUZ institutes and Bio-Manguinhos,and the plant was unable to meet the needs of the Brazilian market. Brazil remained alarge-scale importer of vaccines.

In the mid-1990s, the National Immunization Programme threatened the Bio-Manguinhos with closure. The National Immunization Programme and Bio-Manguinhosentered into a technology transfer agreement with Smith-Kline Beecham (later Glaxo-SmithKline) to acquire the technologies to produce a pneumonia and meningitis vaccine(Hib).

From that, the plant followed a path of technological learning—going from less tomore complex technology-changing activities—starting with production, then engineer-ing and entering development activities. At the initial stage, it absorbed the importedtechnologies, and started producing the vaccine. It used the new expertise to revamp itsother lines of products. As a result, it became the largest producer of vaccines in Brazil,and the largest producer and exporter of yellow fever vaccine in the world.

It started to introduce cost-reducing and quality-enhancing incremental changes inthe acquired technology. It used the extra revenue generated to invest in technologicaldevelopment, seeking partnerships with other FIOCRUZ institutes and other domestic andinternational organizations to develop new products and processes.

As a result of these developments, Bio-Manguinhos has become increasingly prominentin the policy networks in the health biotechnology innovation system. FIOCRUZ is startingto bridge the gap between government agencies, linking actors in the system to coordinategovernment programs and actions in health biotechnology (SciDev Net 2005).

Appendix 3.A Jordan: National Innovation System

Jordan has long recognized the role of science and technology in socio-economic progress.The country has worked to develop national S&T policies since 1978, when the first nationalassessment of capabilities was undertaken (Bdour, 2009). Successive national plans have tra-ditionally included strategies and policies for the promotion of scientific and technologicalactivities. The Higher Council for Science and Technology (HCST) has led efforts over time tocatalog S&T statistics and encourage the development of a national S&T base. The HCST hashelped to establish a variety of basic research centers such as the National Nanotechnologyprogram of Jordan (NANCEJ), the Biotechnology Research Program, the Energy Research Pro-gram, the Jordan Badia Research and Development Program (BRDP), the National Center forHuman Resources Development (NCHRD), the National Center for Diabetes, Endocrine andInherited Diseases (NCDID), and others.

Figure 3.4: National Innovation System of Jordan (?)

The Jordanian innovation ecosystem is, not surprisingly, idiosyncratic with unique featuresdue to historical, cultural, and socio-economic factors. Nevertheless, like any other, it is alsosubject to two major concerns. One is with strengthening the national scientific and techno-logical base. The other is with the utilization of this base, that is, ensuring that the linkagesbetween the S&T institutions and the productive economy are strong.

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Typical for developing countries, one of the key contributors to a country’s knowledge baseis public spending on R&D. Government expenditure accounted for the largest share of a lownational R&D budget which stood at just 0.38% of Gross Domestic Product (GDP) in 2007 (Al-Bdour and Shahateet 2009). Much of the country’s research is undertaken by universities but,again not surprisingly, the transfer of research results to the commercial sector leaves muchto be desired. This reportedly reflects very weak links between the university and industrialspheres. Official statistics indicate that R&D is heavily concentrated in Jordanian universities,research institutions and a few large firms.

A recent study of the Jordanian innovation system commissioned by the German govern-ment (Seidel, Domrose and Kocker. 2009) found that, although progress had been made withrespect to the innovation capacity level, there still remained a huge scope for improvement.Some of the main findings are listed below:

• Innovation is a strong topic on the policy agenda but focus still too much on R&D.

• There is no written national innovation policy even though various departments andgovernmental institutes have announced separate initiatives of their own. Lack of coor-dination at the national level.

• Lack of a coordinated cluster policy in spite of the existence of promising industrialagglomerations in the pharmaceutical and ICT sectors.

• Business promotion agencies and innovation service providers contribute to the innova-tion process while technology transfer centers, science parks and clusters are still imma-ture.

• Programs aiming to support entrepreneurial efforts are rated highly. Jordan has startedto stimulate technology transfer between researchers and industry by launching pro-grammes like Faculties for Factory.

• Competitive funding for R&D is relatively new in Jordan—the Fund for Scientific Re-search was set up by the government in 2007.

• The majority of researchers are concentrated in the public sector and universities.

• Private industry R&D efforts are limited and not measured formally.

• Social support for entrepreneurship is high, but the lack of R&D capacity and directincentives has led to a lot of brain drain.

The following recommendations were considered to have high impact potential for theJordanian system of innovation:

• Design and implement a harmonized national innovation strategy.

• Make support to entrepreneurship a central focus of Jordanian policy and improveframework conditions for this support.

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• Turn nascent agglomerations in ICT and pharmaceuticals into innovative networks andclusters by setting up and implementing a national cluster policy, accompanied by ap-propriate supporting measures.

Overall, it should be a national task for the government to convince all actors within theNIS to orient their activities around catalyzing innovation. Jordan needs to create the appro-priate economic, political, social and scientific institutions, and build technological infrastruc-ture and interactions between institutions. Learning from the experiences of other nationsregarding the creation of a wider range of technological capabilities and linkages was said tooffer low hanging fruits for Jordanian authorities.


References

Al-Bdour, Dr. Jaber Mohammad, and Dr. Mohammed Issa Shahateet. 2009. Science and tech-nology statistics in Jordan: present status and future prospects. In. Islamabad, Interna-tional Workshop on S&T Statistics and Policy Making, Pakistan Council for Science /Technology.

Chaminade, C., B. Å. Lundvall, J. Vang-Lauridsen, and KJ. Joseph. 2010. Innovation policies fordevelopment: towards a systemic experimentation based approach. In. CIRCLE ElectronicWorking Paper Series. Paper no. 2010/01, Center for Innovation, Research / Competencein the Learning Economy.

Chaminade, C., and J. Vang. 2008. Globalisation of knowledge production and regional inno-vation policy: supporting specialized hubs in developing countries. In, 1684–97. ResearchPolicy ,37(10).

Edquist, Charles. 1997. Systems of Innovation: Technologies, Institutions, and Organizations.Ed. Charles Edquist. London, Pinter/Cassell.

———. 2001. The systems of innovation approach and innovation policy:an account of thestate of the art. In. Aalborg, DRUID Conference.

Freeman, C. 1988. Japan: a new national innovation system? In Technology and economy the-ory, ed. G. Dosi, C. Freeman, R. R. Nelson, G. Silverberg, and L. Soete. London: Pinter.

Gu, Shulin. 1999. Implications of national innovation systems for developing countries: man-aging change and complexity in economic development. In. Maastricht, INTECH Discus-sion Paper 9903, UNU.

Kraemer-Mbula, Erika, and Watu Wamae. 2010. The Relevance of Innovation Systems To De-veloping Countries. In Innovation and the Development Agenda. OECD.

Lee, Keun, Qing, and Sunil Mu Mani. 2011. Explaining divergent stories of catch-up in thetelecommunication equipment industry in Brazil, China, India, and Korea. In Catching-upin Sectoral Systems of Innovation. Oxford University Press.

Lundvall, B.-Å. 1985. Product innovation and user-producer interaction, industrial development. 31.Research Series. Aalborg: Aalborg University Press.

Lundvall, Bengt-Åke. 1992. National Systems of Innovation. Towards a Theory of Innovation andInteractive Learning. London: Pinter Publishers.

Malerba, F., and S. Mani. 2009. The structure and evolution of sectoral systems in developingcountries. In. Elgar.

Malerba, F., and R. Nelson. 2011. Catching up in different sectoral systems: evidence from sixindustries. Ind Corp Change.

Malerba, Franco, ed. 2004. Sectoral Systems of Innovation. Cambridge University Press.

Maskell, P., and A. Malmberg. 1999. Localized learning and industrial competitiveness. In,167–185. Vol. 23. Cambridge Journal of Economics.


Mytelka, L. K. 2000. Local systems of innovation in a globalized world economy. Industry andInnovation 77 (1): 15–32.

Nelson, R. R. 1993. National Innovation Systems: Comparative Study. Oxford: Oxford UniversityPress.

OECD. 1996. National innovation systems. Technical report. Paris, Organization for EconomicCooperation and Development.

———. 1997. National innovation systems. Technical report. Organization for Economic Co-operation and Development.

———. 1999. Boosting Innovation: The Cluster Approach.

OECD/Eurostat. 2005. Oslo manual: guidelines for collecting and interpreting innovation data.Paris, OECD.

Rothwell, Roy. 1994. Towards the fifth-generation innovation process. International MarketingReview 11 (1): 7–31.

SciDev Net. 2005. The ’system of innovation’ approach, and its relevance to developing countries.

Seidel, Uwe, Dr. Wolfgang Domröse, and Dr. Gerd Meier zu Köcker. 2009. Study on the nationalinnovation system in Jordan. Technical report. VDI/VDE, Innovation + Technik GmbH (onbehalf of the German Ministry for Economic Cooperation, and Development).

Viotti, E.B. 2002. National learning systems: a new approach on technological change in lateindustrializing economies and evidences from the cases of Brazil and South Korea. In,69:653–80. Technological Forecasting and Social Change.

Yehoue, E.B. 2005. Clusters as a driving engine for FDI. Technical report. International MonetaryFund.

Chapter 4

The Entrepreneurial University: ARegional Perspective

4.1 Introduction: The Role of Universities in the InnovationSystem

The conventional role of universities as centers for learning and creation of new knowledge hasevolved dramatically in the past three decades. Universities are increasingly being regarded asan integral part of the National Innovation System (NIS) and their role is being re-evaluatedaccordingly, with major paradigm shifts in the definition and conceptualization of a success-ful university. Universities need to operate increasingly in close interaction with industry andgovernment. This triple helix of university-industry-government relations is based upon inde-pendent, overlapping institutional spheres in which each can interact freely and occasionally“take the role of the other” (Figure 1). The Triple Helix has been recognized as form of socialorganization that is highly conducive to innovation (Etzkowitz et al, 2000). The triple helix ofuniversity–industry-government linkages can be regarded as a metaphor for the joint effortsof the three parties with respect to regional economic development.

From this perspective, the universities are not only regarded as promoters of knowledgeand innovation, but also supporters of its exploitation and commercialization through en-trepreneurial activities. Such universities, known generally as Entrepreneurial Universities,have formally incorporated regional economic development into their mission statements, andhave implemented strong mechanisms to promote innovation, entrepreneurship and technol-ogy transfer (Premus et al, 2003).

In developed countries, a lot of emphasis is placed on the economic utilization of publiclyfunded research. This is particularly true for high technology and knowledge based sectorswhere scientific inputs are of key importance in the innovation process. In innovation systemsnetworks of companies and organizations influence the innovation process in a particular areathrough their cooperation and interaction where universities are key elements in the subsys-tem of knowledge generation and diffusion (Lundvall, 1992; Edquist, 2005). The ‘regional’dimension of the NIS is a key dimension of innovation. Regions differ with respect to theirR&D and innovation capabilities as well as innovation performance.

But what is precisely the role of universities in the innovation system? According to the

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CHAPTER 4. THE ENTREPRENEURIAL UNIVERSITY: A REGIONAL PERSPECTIVE 71

Figure 4.1: The Triple Helix Model ()

Organization for Economic Cooperation and Development (OECD), universities are most ef-fective as “antenna” for adopting external knowledge and mediator for local knowledge cir-culation, they are also a source of highly qualified labor, a knowledge provider in university-industry linkages, and an incubator for academic spin-off companies (Todtling, 2006). Qualityeducation and fostering an entrepreneurial culture are key for that end (Gibb, 2010).

Innovation is taking place increasingly in concurrent activities of many actors; the knowl-edge base is becoming more ‘distributed’ (Smith, 2002), thus external knowledge becomesmore important for generating new knowledge and innovations. Universities hold a key func-tion in this respect interacting with global knowledge communities and networks through con-ferences, workshops, research collaborations, co-publication, co-patenting etc. Additionally,the well functioning of the innovation system requires local circulation of absorbed knowledgethrough various mechanisms—another role that the university could effectively contribute to(Etzkowitz and Leydesdorff, 1995).

A traditional role of universities which is becoming more important for national and re-gional innovation systems in the emerging knowledge economy relates to the fact that gradu-ates and highly skilled labor are one of the most powerful mechanisms for knowledge transferto industry and a key factor for the development of high technology clusters (Saxenian, 2007).

Etzkowitz (2003) summarized in the Table 1. the expansion of the university mission fromteaching to research and then to commercializing of the inventions and moving towards beingentrepreneurial.


Figure 4.2: Expansion of University Mission

4.2 The Link between Industry and University

Linkages between universities and the industry have become more prominent in the past fewdecades as universities have become important knowledge sources for industry (Fargerberg etal, 2005) This is reflected in a variety of relationships such as R&D contracts, R&D collabora-tions, innovation partnerships, joint use of facilities and informal knowledge exchange. Theobjective has become to move from simple knowledge transfer towards knowledge sharingand interaction. Still, in this partnership with industry universities face difficulties in terms ofcommercializing academic inventions. Universities are increasingly challenged to produce, ifnot incubate, spin-off companies, especially in high tech industries and clusters such as ICT orbiotechnology.

The one main challenge for universities in this evolving relationship is how to interactwith industry but preserve the freedom and diversity of academic research. All stakeholdersshould keep in mind that the role of universities is to contribute critical views, new ideas andcomplementary knowledge and not merely carry on R&D projects commissioned by industry(Atkinson and Pelfrey 2010).

The role of universities in innovation is more subtle than government policies often ac-knowledge (Lord Sainsbury of Turville, 2007). Universities that are active at the heart ofsuccessful technology clusters do not just spin out companies. They develop highly skilledpersonnel who move between industry and academia; they incubate businesses and provideexpertise; they produce knowledge that is used by technology businesses; they provide publicspace in which people from various branches of research meet.

In the context of an entrepreneurial university, scientists do not have to become innovators;rather, they should make it their work routine to talk to innovators constantly and informally.This can be achieved through the creation of more co-funded shared spaces where academicsand industrial researchers can interact and/or work together on research issues of common in-terest. The exact form and structure of these co-funded centers should remain flexible (Wong,2007). They should be more than science parks, and should provide accommodation forstart-ups, as well as opening collegiate networking between academia and business, betweenstart-up companies and sources of expert knowledge (Etzkowitz, 2000). Table 2 presents thedifferent stakeholders in university–industry relations.

In general, universities have less experience and lower capability to commercialize knowl-edge. The concept of the entrepreneurial university exactly addresses this weakness (Vickerset al, 2001). Different individuals have a different mix of capacities for demonstrating andacquiring entrepreneurial behaviors, skills and attributes. These behaviors can be practiced,


Figure 4.3: Stakeholders in university-industry relations (Siegel et al., 2003)

developed and learned. This can be done through a variety of means, such as the creation ofa technology licensing office that focuses on greater deployment of the university-generatedtechnology to the marketplace.

This focused support aims at creating new ventures, and launching programs to provideassistance to professors and students to commercialize their inventions and knowledge (Crow,2008). This can also be done by the provision of incubator facilities on campus and in ad-jacent technology parks (see Chapter 8). Naturally, the concept of entrepreneurship shouldalso be nurtured throughout the curricula and through early involvement of students in smallentrepreneurial projects and start-ups. There must be a major emphasis on developing en-trepreneurial capacities for all students and staff. This also necessitates the adoption of inno-vative learning techniques that inspire entrepreneurial action (Etzkowitz et al, 2008).

The relationship between the new style entrepreneurial university and SMEs they partnerwith must be win-win. Both partners must have strong positions, each one in its respectiverole so that their collaboration generates significant added value. Thus, researchers from theuniversity develop their best technical solutions and the partner SMEs implement productdevelopment, production and marketing in order to reinforce their competitive advantage onthe markets or to create new ones.

Entrepreneurial universities have, by their nature, open boundaries that encourage effec-tive flows of knowledge and transfer of technology between organizations. Also, multidisci-plinary approaches to education that mimic real-world experience and focus on solving com-plex world challenges is a major characteristic of entrepreneurial universities (Guerero andUrbano, 2010).

An entrepreneurial university, on its own, actively seeks to innovate how it goes aboutits business. It seeks to work out a substantial shift in organizational character so asto arrive at a more promising posture for the future. Entrepreneurial universities seekto become ‘stand-up’ universities that are significant actors on their own terms (Clark,1998:4).

According to Clark (2004) five characteristics of entrepreneurial change can be introduced:


• A consolidated steering core

• An expanded developmental periphery that makes connections with industry and in-cludes outreach offices to industry, such as Transfer Technology Offices, liaison to indus-try, etc.

• Diversified funding options

• An integrated and well promoted entrepreneurial culture

• A highly motivated academic faculty.

Technology licensing and company spin-offs are both ‘push’ forms of knowledge exchangethat assume that the university has identified which technology to commercialize. They ignorethe importance of informal networks and relationships. ‘Pull’ models, which engage businessat every stage in the research process and allow business to select which technologies to com-mercialize, are more effective (Fazackerley et al, 2009). Nevertheless, they require long-lastingnetworked relationships and trust based on the recognition that scientists produce knowledge,which commercial innovators then turn into useful products that improve productivity.

Recent studies find that spillovers result to a larger extent from knowledge communicatedthrough networks than through formal mechanisms. Further evidence suggests that informalknowledge exchange is quite effective (Abramovsky et al, 2008). Nonetheless, patents, whichare a formal way of transferring knowledge, granted to major Western universities have dou-bled in the period 2000-06 and, accordingly, licensing income tripled (Lord Sainsbury 2007).The important issue here is that a balance must be achieved: universities are publicly fundedto contribute to intellectual, economic and social progress. A practice that increases theirincome but prevents industry from accessing their knowledge is counterproductive.

The model that should be aimed for is open innovation between universities and busi-nesses. Open innovation describes a model whereby businesses appreciate that external sourcesbring knowledge and expertise and seek to integrate them into their innovation processes. Itis essential to keep in mind that the purpose of industrial collaboration is not for universitiesto make money but to create wider economic and social benefits for society.

4.3 The Role of Government

The aforementioned triple helix model presumes a proactive role played by the government forthe evolution and sustenance of truly entrepreneurial culture in academia. However, the roleof the government is still an issue of discussion and deliberations. The major question to be putforward is what exactly should be the role of the government as supporter of the universities’missions? Additional questions may explore whether there is one fit-for-all governmentalpolicy, or should the government(s) have a per-case approach and a per-country policy?

A prevalent school of thought among discussants of governmental roles is that the govern-ment should not play a direct role in any aspect. However, a careful examination of manysuccess stories (or failures) evince that the picture is more complex than simply to deregulateand step aside. Most studies recommend providing incentives and rewards directly to faculty


to encourage invention disclosures and commercialization activities (Friedman and Silberman,2003; Debackere and Veugelers, 2005).

Evidence points out that when governments formulated policies to support entrepreneurialuniversities or give incentive to move forward toward commercialization, these policies wereonly received positively by their target groups when they took into account the regulations,context, and structural determinants between countries and university systems. (Mowery andSampat 2005).

The complex role of government can be illustrated by a concrete example of the public pol-icy will be discussed here. This relates to single legislation in the US, that of the Bayh-DoleAct,which is considered to have attributed to the evolution of the entrepreneurial university morethan any other act or decision by a government.

Originally, the U.S. government retained rights to use all inventions made by researchfunded through federal agencies ((Schacht, (2011); Mowery and Sampat 2001;). Further-more, twenty six different policies regarding the use of federally funded research existedwhich presented an enormous amount of obstacles. Pascoe and Vonortas (2012) discussedcomprehensively the impact of Bayh-Dole act on universities entrepreneurship, as it movedthe ownership of the invention to the university rather than the government, as well as re-placed the bureaucratic myriad of regulations with a single national policy stated that theincentives this act has provided for technology transfer are a critical institutional factor in in-novation. As a consequence of Bayh-Dole, American universities have substantially increasedinvestment in technology transfer programs, faculty have become aware of the commercialpotential of their research results, and industry has realized the benefits of collaborating withuniversities.

The wide popularity of the Bayh-Dole act notwithstanding, many researches criticized thisact as not really significant, for they considered that the true institutional factor that helpedentrepreneurial universities to succeed was really the establishment of the technology transferoffices (Pascoe and Vonortas 2012).

Others point out that it was universities which were already active in technology transferthat pushed for the Bayh-Dole Act. Thus, the Act came as a result rather than as a determinantof technology transfer. It merely allowed universities to benefit from their inventions. Manyworried that the Bayh-Dole act contributed to the creation of a highly individualized and verycompetitive environment, which may hinder joint research innovation (Boetigger and Bennet,2006).

Some researchers warned that it will not be useful to copy the Bayh-Dole act in other coun-tries in the absence of a comprehensive policy that takes into account structural factors anddifferences between universities and university systems. (Mowery and Sampat, 2005).). Gov-ernmental policies, in their zeal to promote entrepreneurship might undermine the university’sprimary education, research and discovery roles. This is why a well formulated policy shouldbalance the thrust for entrepreneurship with the conventional role of universities (Smith etal, 2010). However, for Levine (2009) the belief that the commercialization of inventions atuniversities will lead to entrepreneurshuo is a kind of a false promise.

A policy for the promotion of entrepreneurial universities should be explicit about whatshould be done not to aggravate the conflict between advancing knowledge and generatingrevenues.

Furthermore, Litan and Mitchell (2010) suggest that a policy to promote and create an


open, competitive licensing system for university technology can play a positive role in the suc-cessful addressing of the potential conflict between universities’ commercialization activitiesand their role in disseminating knowledge. Despite the criticisms, the Act played a significantrole in fostering innovation and economic growth.

4.4 American Universities and Entrepreneurship

It is widely agreed that American Universities, in general, enjoy the most entrepreneurialethos relative to their foreign counterparts. Moreover, they have proven themselves to bemore prescient and responsive to changes in the social and economic world environment thanany other group of universities around the world (Rosenberg, 2003). They are seen worldwideto be successful in a very distinctive aspect in the intensity of entrepreneurial activities andsource of commercial innovation. US universities produce collectively about 3000 US patentsper year (AUTM, 2006). By 2006, academia was responsible for more than 70% of the top100 innovations (Mitchell, 2010).

In order to understand the reasons behind such ability to respond flexibly to the differentchanges and requirements of the socioeconomic context, along with supporting entrepreneur-ship that marks a crucial element of both regional and national economies it is importantto notice the salient features of the US universities in comparison with universities in othercountries such as China and Europe.

These features include (Rosenberg, 2003; Thorp and Goldstein; Byers et al, 2000): gener-ous governmental funding for both basic and applied research, high levels of autonomy, andfreedom from any external authorities; the traditional role of the university’s leaders as firstand foremost fundraisers and network builders; the firmly rooted traditions of relations withthe industry and high regard for the commercialization of new inventions especially in ICTand biotechnology; accumulated wealth and big endowments that allow recruiting the mosttalented and distinguished faculty members (which applies to both private and state univer-sities); and, finally, rapid changes in the curriculum and introduction of new courses in whatwas relevant to the needs of the newly emerging industries( Nelson and Rosenberg, 1993).This explains to a high degree why science-parks, spin-offs and incubators are consideredmore successful in the United States than in other parts of the world. The major contributionof US universities has been the exchange of people: academics working with companies whilealso holding a university position, or cycling in and out of business and academia, taking ad-vantage of the American society’s better appreciation of the link between the abstract and thepractical.

4.5 Case Studies

In the following, three case studies of widely different universities will be discussed. Theseuniversities have had different experiences in moving towards the entrepreneurial universitymodel allowing to draw lessons.


4.5.1 Stanford University

Stanford and MIT are two schools renowned for taping the knowledge creation and inven-tion that take place on their campuses to create high quality companies (O’Shea et al, 2005;Feldman, 2003). In contrast, many schools do not achieve such results, even with similar char-acteristics (Schramm, 2006). Stanford is considered a paradigm model of a university withintensity of Entrepreneurial activities and university generating innovations that lead to newtechnology-based firms.

Stanford is a model of a research university that supports entrepreneurship and marksvital impacts on regional and national economies (Lenoir et al, 2004). The Notable inven-tions through the last decades have proven the great contributions of the university to majortechnology breakthroughs such as Recombinant DNA (with returns of $255M in1974); Func-tional Antibodies ($318.9M in 1984); Improved Hypertext Searching ($337M in 1996) (OTLOverview url) . A careful examination of the factors that make Stanford a conspicuous exam-ple of entrepreneurship can be very useful for other universities in different parts of the worldaspiring to evolve into a successful entrepreneurial model. Principal among these factors wasStanford’s early realization of the importance of attracting the best talent.

Stanford University: The Recipe of DistinctionThe recipe for distinction that, was developed by Stanford administration in the 1950swas straightforward: focus on attracting and retaining the scientific and engineering tal-ent most capable of winning federally funded research grants and contracts- steeples ofexcellence-and use these funds to support cutting-edge research that stimulated indus-trially relevant inventions which in turn, reinforces the capability to do more and betterresearch. As early as 1970, Stanford established the office of technology licensing to pro-mote the transfer of Stanford technology for society’s use and benefit while generatingincome to support research and education. Starting from such a position Stanford wasamong the main beneficiaries from the Bayh-Dole.

Stanford’s policy of spin-offs as a major tool for marketing inventions was particularlyintensive and productive. It adhered to the belief that establishing new venture companieswas often preferable to licensing its inventions to big established companies. For instance,Stanford alumni and faculty accounts for more than 1800 technology based firms in theSilicon Valley responsible for 37 percent of all high-tech employment in the region (Byerset al, 2000) Hewelett-Packard, Sun Microsystems and Cisco Systems belong to this grouo(Ku, 2002). In addition, the establishment of the Stanford industrial park was a meansto create profitable exchange relations between industry and research labs, particularlyin areas of electronics and computers. The relationship with industrial partners has beensymmetric and co-evolutionary (Lenoir et al, 2004).

Another important feature was that Stanford paid special attention, and was very suc-cessful in its licensing of inventions and establishing faculty consulting relations as meansfor getting Stanford ideas into the core of industry. (Lenoir et al, 2004).

The philosophy of Stanford is based on autonomy, flexibility and readiness to change.A kind of synergy between units exists while maintaining a good degree of autonomy, suchas in entrepreneurial education and technology transfer. The Stanford arrangement there-


fore reflects a “modular” organization in which administrative interdependence and hi-erarchical structures are minimized, while cross-unit awareness and bottom-up processesare maximized (Nelson and Byers, 2005; Martin and Eisenhardt, 2003).

4.5.2 Singapore

Policy makers in Singapore sought to transform their country from an investment-driven to aninnovation-driven economy emphasizing the building of intellectual capital and its commer-cialization to create value and jobs. They considered transforming their conventional nationaluniversity to an entrepreneurial university as a top priority in their strategic plan in order tocompensate for three factors, also typical of numerous countries across the world: 1) a rigidbureaucratic control by the state; 2) a lower base of research and inventive outputs comingout from the university; 3) lower demand and ability of private enterprises to commercializeuniversity knowledge.

All these factors suggest that the pre-conditions for Triple-Helix dynamic interactions aremuch weaker in countries with such factors than in the advanced economies. Thus, there ismore urgency for universities to assume an entrepreneurial role to compensate for the less-favorable preconditions that they start from.

The National University of Singapore NUSThe government of Singapore’s policy towards its national university stems from thestrategic National Innovation Policy adopted by the government to move from a stagewhere the primary focus was on developing innovative capability to support applied R&Das adopted in the 1980s and 1990s to a stage where the primary focus is on developingintellectual capital creation and commercialization and the entrepreneurial capability tosupport knowledge-based economic growth.

The NUS has taken on an additional economic role not mentioned in the literatureon entrepreneurial universities, that of the attraction of foreign talent. Given the smalllocal population, Singapore needs to be able to tap top foreign talent to help staff thetop echelons of specialized knowledge workers. In addition to emphasizing the technol-ogy commercialization role of the university, the NUS experience added more significantemphasis on injecting a greater dimension of entrepreneurship to the contents of univer-sity education itself. This amounts to a re-orientation of the university’s core function ofeducation.

Its particularities notwithstanding, the NUS went through the well-established prac-tices of establishing technology licensing offices and introducing structural changes suchas the creation of a new division in the university known as the NUS Enterprise. This divi-sion introduced a number of major initiatives to reform the university policies with respectto governance of technology commercialization and to inject a stronger entrepreneurialelement in university education. It also introduced two new units: 1) a Venture Supportunit to provide focused assistance to new venture activities; and (2) an Overseas College


program to launch experimental programs in international entrepreneurship education(Wong et al, 2007).

4.5.3 Volta Redonda, Brazil

The transformation of a conventional university to an entrepreneurial academic institution isfraught with difficulties. The following case study of the Regional University of Volta RedondaPUVR in Rio Do Janiero by Amaral et al. (2011) helps highlight the challenges and resultingfailures to reach objectives.

Since the 1990s the Brazilian Public Research Universities (BPRUs) have emphasized theneed for efficiency, effectiveness and innovation in order to advance industry competitiveness.For that purpose, technology-based incubators, science and technology parks and technologytransfer offices were created in the BPRUs in order to promote and encourage university-industry linkages and collaboration in order to transform the universities to entrepreneurialones.

The Regional University of Volta RedondaThe study of PURV’s activities indicated that the university did not manage to play anactive role in the interaction process. There was no successful bridging to industry fortransferring knowledge. An apparent major obstacle was the differences in behavior be-tween academic faculty and industry researchers. Another was the rudimentary mecha-nisms designed to promote university-industry linkages, thwarting the desire to cooper-ate. Inadequate and outdated operating structures and excessive bureaucracy at PUVRwas considered a major barrier to innovation management and industry cooperation.

From the side of industry too there was no great willingness to interact and cooper-ate with the university. None of various typical mechanisms of accessing the universityresources was strong, including the development of common ventures or projects, hiringof researchers, development of equipment, and other kinds of technology transfer. Hence,the study concluded that at present, it cannot be said that PUVR is moving towards be-coming an entrepreneurial university Amaral et al. (2011).

4.6 Discussion

Reviewing these three case studies, we can extract common elements as well as distinctivecharacteristics in their approaches to entrepreneurship.

Among the three, Stanford, of course, has the most important experience. What really dis-tinguished Stanford is that that relation between it and its surrounding industries is organic,multifaceted, and bidirectional. On the other end of the spectrum we find that a major prob-lem facing Volta Redonda was its apparent inability to bridge the gap with the surroundingindustries. Singapore’s NUS is different; it is taking advantage of the strong governmentalcommitment to its National Innovation System to gain strong support in its cooperation with


the new knowledge-based industries. The challenge for the Brazilian university would be tofocus on emerging knowledge-intensive industries, rather than the already established, mainlyconventional manufacturing industries in its surroundings.

As compared to many universities across the world, one might argue that Stanford is aspecial case that cannot be emulated. This is only partially true. While the enormous resourcesof Stanford would be difficult to match, the innovative approaches to their commercializationof inventions, seeking the talent as well as its agile and flexible structures can be a source ofinspiration for many universities worldwide.

As for the case of Singapore, it is worth noting that while the specific governance modeland initiatives/programs adopted may be unique to the specific national context, the reformexperience of the NUS may nonetheless be instructive for other universities seeking to de-velop their own entrepreneurial model. This is particularly true when these universities wantto replicate the NUS experience in making its technical graduates more business savvy andentrepreneurially-minded. More importantly, the comprehensive approach of the govern-ment of Singapore to the relationship between its National Innovation System and the En-trepreneurial University, can be a good model worth emulating by many governments andpolicy makers in countries seeking to enter the age of Knowledge-Based economies.

The challenges facing Volta Redonda are typical of most universities that think that trans-formation into an entrepreneurial institution is an easy path. Restructuring and introducingthe entrepreneurial culture are good and useful, but the real challenges are for university lead-ers to define the required entrepreneurial attributes and flexible processes for interacting withlocal industry, with an adequate understanding of the needs and demands of the region wherethe university is located. If Volta Redonda will succeed in consolidating her ‘quasi-firms’—leading to some sort of a second academic revolution at Volta Redonda, then it will establishitself as a successful entrepreneurial university. Otherwise, it will retreat to mostly teachingfunctions with no significant research activities and diminishing ability to raise extramuralfunds.

Based on the above three cases, the factors of success that can be drawn are as follows:

• Introducing entrepreneurship in the culture of the university from the earliest stagespossible, i.e. starting with curricula of undergraduates, and not merely depending onlicensing offices and similar structures.

• Enjoying a nurturing relationship with the government where governments appropriateresources but do not attempt to influence research policies or to control the inventionsresulting from research funded by these resources.

• Encouraging small scale spin offs to commercialize inventions instead of solely depend-ing on licensing and consulting relations with the industry.

• Introducing as much autonomy and flexibility as possible into the structure of the univer-sity to allow maximum freedom for researchers to explore possibilities of cooperation,partnerships, or the creation of spin-offs.

• Realizing that the main asset of this age of knowledge-based economy is what universi-ties are already well endowed with: talent and creative minds. Universities should bemore attuned to recruiting top talent than ever before.


4.7 Conclusion

This chapter has presented an overview of the University-industry-government relationships.It took into account the international trend to move forward from the conventional role ofuniversities to an entrepreneurial context, where universities become an integral part of theinnovation system, and their linkages with the industry is the cornerstone for this integration.The Chapter investigated prospects for such a transformation.

Examining three case studies from the U.S., Brazil and Singapore helped shed light onthe challenges and issues that need to be addressed by universities in the Levant to achieve asuccessful transformation into an entrepreneurial university.

In a nutshell, there are various concerns related to the process of transformation toward anentrepreneurial university in the region that can be divided into three levels: human factors,infrastructure and partnering policies, and institutional culture. Each of these factors deservesdetailed scrutiny.

If the university along with local and central government and industry can share resourcesand work together to promote entrepreneurial activities which would foster region-wide eco-nomic development, then this transformation process will be worth the intellectual, financialand human resource investment that is going to be spent. A future where a university canturn into a constant source of talented manpower and knowledge whereas other economicdevelopment organizations and public institutions can put forth an adequate infrastructure,funding, and business environment to promote economic development will charge the inno-vation systems of the region. This is something that policy decision makers in the region willbe looking into for some time to come.


Appendix 4.A Moving towards the Entrepreneurial Univer-sity Model in the Levant Region

The question that arises here is whether existing universities in the Levant should/could evolveinto entrepreneurial universities in order for university to make significant impacts on regionaland national economies, or whether a new breed of specialized universities should be estab-lished to replace (or co-exist) with the older conventional universities. Should the state pushand encourage extant universities to evolve and transform into new entrepreneurial univer-sities? Are governments of the region willing to support robust policies to give incentives touniversities, but not to interfere in budget allocation and in the research agenda? And do theyunderstand the importance of investing in funding and supporting research, without imposingtheir agendas? Or should they just give up on these universities and establish new ones with amission and vision focused on entrepreneurship? Examination of the previous three case stud-ies and a serious understanding of the distinctive characteristics of universities in the Levantregion can help suggest these approaches.

In Jordan and Lebanon, where conditions may be somewhat similar to those of Singapore,at least one new pioneering entrepreneurial university should be established. There is a learn-ing experience that must be acquired and a need for at least one successful model that can beemulated. There is a clear need to establish a new institution with a fresh sense of mission andunbounded by any previous legacy. Unlike the situation in Singapore, Lebanon and Jordan arenot ‘considered newly industrialized countries’ but they have very strong motivations to jointhe knowledge based economy age with their highly educated population and highly drivendevelopmental policies.

In this region, major state universities (e.g., the University of Damascus, the JordanianUniversity, the Lebanese University and many others) are mammoth institutions encumberedwith bureaucracy and an extremely conventional approach to their academic roles. While itwill be challenging to nudge them towards an entrepreneurial culture, it will be unwise toleave them doing their business as usual. They can start by introducing courses and projectsthat nurture the entrepreneurial culture and practices to selective units and departments inthese universities, as well as establish science parks that deal directly with these units, pro-vided they are guaranteed the autonomy and flexibility to be able to perform in this differentcontext.

A number of smaller universities in the region with relatively good academic records (mostof them private) can become viable candidates for a transformation into fully-fledged en-trepreneurial universities (e.g. the Lebanese American University in Beirut and the YarmukUniversity in Jordan). Their transformation can be phased and gradual, but the opportunityis worth taking, not only because of the benefits that will accrue to these universities, but alsobecause the transformation process can become a learning experience from which lessons canbe learned and used later with other institutions.

Specialized universities are likely to find such change easier than comprehensive ones. Thespecialized universities already have a focus and are often characterized by an engineering orbusiness-type rationality that eases the contradictions of the old and the new. As the case inSingapore, emphasis should be directed at introducing the entrepreneurial culture to studentsfrom the earliest possible stages. We must be prepared to face the situation where some


big universities will choose to resist any change in their culture and mission, and entrenchthemselves in their old ways (not taking into account that they will become less and lessrelevant with the advent of time). At one point, if the new wave of entrepreneurial universitieswill result in a major paradigm shift in the scene of higher education in the Levant, then theseuniversities are risking becoming irrelevant and obsolete.

The key challenge for universities in the region is the lack of sufficient quality education.This lack of quality education has led to employees with inefficient and inadequate skills,thus making the industry-academia linkage weak over the years (UNDP, 2009). While it maybe asking too much from the region’s universities to emulate Stanford, it is worth takinginto account that only through recruiting and retaining the best brains did Stanford reach itscurrent position.

There is also concern for lack of support mechanisms, which include research funds, ven-ture capital funds, or start-up capital, as well as a lack of awareness programs and initiatives(UNDP, 2009). The governments of the region can also learn lessons from how other gov-ernments in more advanced countries commit large funds to support research and qualityeducation. Investment in these institutions is the only guarantee for the region’s countries tosurvive in the new economic paradigm of the world.


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Chapter 5

Intellectual Property, Standards

5.1 Introduction

This chapter examines intellectual property and standards, two elements of the innovationlandscape that in the past have often been overlooked by policy practitioners in developingcountries. First to be highlighted will be intellectual property (IP), a set of rules and institu-tions designed to foster innovation and ideas. As developing countries are often technologyfollowers, the primary role of IP is often to encourage foreign investment and trade with thehopes of economic and knowledge spillovers into the domestic economy. The chapter will thendiscuss standards and their role in domestic innovation and in international trade. Standardshave the potential to boost innovation in developing countries, but also have the potential tostifle domestic industrial creativity. The chapter concludes with short profiles of the currentstate and impacts of IP and standards in Lebanon and Jordan.

5.2 Forms of Intellectual Property Protection1

Intellectual property (IP) is an idea, or a collection of ideas, produced in the expectation ofdirect or indirect economic gain. Intellectual property regimes are nation-level mechanismsdesigned to protect these ideas by assigning control over their use to their creator. Generally,governments are concerned about ideas in so far as they are used to spur innovation andeconomic growth, and thus the implementation of IP regimes to protect those ideas will havea strong bias towards fostering economic growth.

There are four methods of formal IPR protection: patents, copyright, trademarks, and tradesecrets. Patents and copyright will form the bulk of the IP discussion in this chapter as theyare the most complex forms of IP protection related to innovation and trade issues.

Patents are offered to stimulate production of new ideas. They work by providing a limited-time right of exclusion to the creator of an idea. Violators of this right of exclusion often mustpay a fine or other penalty to the owner of the idea. Patents must be applied for and mustprove (a) patentable subject matter, (b) utility, (c) novelty, and (d) non-obviousness. Patentslast twenty years from the date of filing.

1. This section relies on Scotchmer (2005).

88

CHAPTER 5. INTELLECTUAL PROPERTY, STANDARDS 89

Copyright is offered to stimulate expression. Protection is automatically given to any orig-inal work of authorship such as books, software, music, and movies. Copyright gives holdersthe right to copy, reproduce, distribute, adapt, perform, or display their works. Importantly,copyright allows creators of ideas to prevent others from selling reproductions of the origi-nal idea but does not prevent others from expressing similar yet distinct ideas. For example,copyright laws forbid the unauthorized copying of a specific love song, but it is perfectly legalfor someone to write a different love song. The idea of love cannot be copyrighted; only itsexpressed form. Copyright lasts for the life of the life of the author plus 70 years.

Trademarks allow markets to function smoothly by supplying information to buyers. Specif-ically, brand names of products and distinct slogans or phrases describing a product are pro-tected and cannot be used by competing goods or services.

Trade secrets protect various types of firm-specific technical and business knowledge. Inprinciple, anything can be kept secret. Proof of violation requires evidence that informationwas obtained by improper means (e.g., industrial espionage). Trade secrets that are discoveredaccidentally (e.g., reverse engineering) are not protected.

Informal IPR protection includes the use of secrecy, complex routines, and speed in tech-nological advancement.

Secrecy refers to the ability to keep abstract or applied technical ideas secret. It is probablythe most effective informal method for retaining proprietary intellectual property. Whetherknowledge can be kept secret is a matter of the technology involved. If reverse engineeringis relatively easy, then formal protection is necessary. Secrecy helps avoid the revelation ofinformation to prospective competitors through published patents, thus, avoiding “inventingaround” patents.

Complex routines refers to the situation where competitive advantage consists of accumu-lated experience (routines). In such cases, firms may consider themselves reasonably pro-tected from imitators. This may be the case of established companies that deal with complex,systemic products.

Speed refers to the practice of speedy development of ideas in rapidly changing technolo-gies. By the time a competitor obtains the ability to copy an existing product or process,the IP owner has developed a more advanced product or process that diminishes the marketimportance of the first product or process.

Formal IP protection is based on legal measures. With the exception of trade secrets,all other forms of formal protection require the provision of detailed information about theobject of protection. Inventors will rely upon them as long as the explicit and implicit costs ofdoing so appear justified by the potential benefits. Frequently they decide not to use formalprotection in order to avoid revealing too much information. Informal protection thus seemsto be used extensively.

Two well known studies of US firms (Levin et al 1987; Cohen et al 2000) found that, formost manufacturing sectors, informal methods of IP protection were seen as being more im-portant than formal IP protection for maintaining an innovative advantage. While the resultshave since been replicated elsewhere, the fact of the matter is that companies pursue intellec-tual property protection today more than ever before. When asked, they reply they do so forstrategic reasons.


5.3 Intellectual Property in the Innovation Ecosystem

Nations have separate sets of regulations to protect IP and physical property because theyare fundamentally different types of goods. Today’s global economy is built largely off of theexchange of knowledge-based goods (Harris 2001; Powell and Snellman 2004; Godin 2005;OECD 2005). These are goods with significant value added from scientific research and theapplication of learning and technical ideas, and it is the knowledge behind these goods that isprotected by IP regimes.

But how exactly are IP and physical property different? For one, knowledge is a cumulativegood; what we know today is built off of what we learned yesterday. Another way to phrasethe previous statement would be to say that knowledge follows a path dependency (Malerbaet al 1999). A country may decide that it will be world leader in nanotechnology, but if thereis no history of nanotechnology expertise in that country, then it will be difficult to innovatein that arena. In contrast, a country with a tradition of agricultural excellence likely is able toswiftly and efficiently adopt and adapt new agricultural techniques.

A second characteristic of knowledge is that it is irreversibly transferrable; once someonelearns something, that knowledge cannot be taken away. From an industrial standpoint, thismeans that personnel do not forget what they know when they move to a different companyor country, and once a competitor understands a firm’s internal processes, that understandingcannot suddenly disappear.

Third, knowledge is subject to increasing returns to scale, meaning that outputs stemmingfrom knowledge increase at a proportionally greater rate than an increase in inputs for its pro-duction. It is this characteristic of increasing returns that allows knowledge-based economiesto be so dynamic.2

Fourth, knowledge has high initial costs and much lower marginal costs of production (insome cases close to zero). Piracy of software receives so much attention exactly for this reason;it takes significant resources to create, and virtually no resources, training, or skills to illegallycopy and resell. Same for music and many other knowledge-based goods.3

The major impact of IP, specifically patents, is in the ability of the owner of a piece ofknowledge to appropriate rents stemming from the development and commercialization ofthat knowledge. In order for company A to invest in the creation of a new piece of knowledge(an invention), that company must have reasonable expectations that it can profit from theinvention, and thus it wants to be sure that it can appropriate that invention, keep it private.As we saw in the previous paragraph, however, one of the characteristics of knowledge is thatit is easy to spread (spill over). Employees can jump to new firms and carry knowledge overwith them and competitors can reverse engineer a finished good. Secondary parties then couldexploit the knowledge company A paid to create. As one of the characteristics of knowledge ishigh up-front costs for its production and low marginal costs for its reproduction, competingproducers of products largely based on this specific piece of knowledge appropriated withoutproper payment to the owner are now at a huge cost advantage which can allow them toprofitably undercut company A in the market.4

2. It is this feature of knowledge that underlies the explanations of economic advance of new growth theorydiscussed in Chapter 1 of this volume.

3. For more details on knowledge as an economic input see Romer (1996), OECD (1996), Grandstrand (1999).4. Albeit at a cost. Research has shown that the costs of imitation vary across industries and across activities


For example, if a firm creates a new pharmaceutical, it may pay an up-front cost of up-wards of $500 million in R&D and clinical trials readying the product for human consumption(DiMasi et al 2003). The firm will need to set market prices in order to recoup that cost.Without IP protection, a second firm could copy that drug and sell it profitably at little morethan marginal cost, greatly undercutting the first firm and taking control of the market for thatdrug. In this situation, the first firm will not have the incentive to create the drug at all, asit is highly likely that it will never recoup enough money to cover the initial expense. On thecontrary, a strong IP regime will allow the first firm to enforce its patent and recoup its costs,thus encouraging it to invest in R&D in the first place.

As we see with the contents of the other chapters in this work, it is critical that any IPregime be reflective of and be incorporated into the overall innovative framework of a nation;it is not a stand-alone mechanism (World Bank 2010). In the pharmaceutical example above,there could be strong IP laws in a country, but if the legal system was not able to enforcethose laws due to lack of resources, training, or enforcement authority, then it would be as ifthe laws did not exist; there would be no encouragement for innovation. As will be shownin the discussion on Lebanon and Jordan later in the chapter, lack of enforcement and weakpenalties for infringement are seen as undermining the IP system in both of those countries.

5.4 Intellectual Property and Development

The previous section asked what was the role of IP in the innovation framework. Now we aska more nuanced question: what is the role of IP in the innovation frameworks of countries atvarying stages of development?

Let’s start from a basic idea, at the core of economic thinking since at least Arrow (1962).The economic rationale for IP protection rests on the trade-off between allocative efficiencyand dynamic efficiency. Simply put, allocative efficiency means that, assuming no future in-ventions, the efficiency of the economic system is maximized by spreading knowledge around:everybody knows everything. Dynamic efficiency changes the basic assumption: if there isknowledge to be created and things to be invented in the future, then some sort of monopolypower expectation must be created to incentivize the necessary expenditure from individu-als or organizations. In the extreme, allocative efficiency corresponds to the absence of IPprotection.

In contrast, dynamic efficiency requires such protection. The problem is that in actuality weneed both: prospective inventors must have some guarantee of legal appropriability, whereasthe economic system will progress with people other than the inventor eventually getting holdof the specific knowledge. Extant IPR regimes have sought the middle ground by providingmonopoly rights for new patentable ideas but for a price and for a limited time period afterwhich the knowledge becomes public.56

In addition, however, one might ponder the question whether all countries need the same

and can be significant. See Mansfield (1985), Mansfield et al. (1981), Levin et al. (1987).5. For an excellent historical exposition of how IPRs came to be and what they mean see David (1992).6. Other more esoteric issues are also relevant here and have been widely discussed by economists regarding

the warranted strength of the patent system including the breadth of protection (how broad a patent is) and thenumber of claims on a single patent. We refrain from these topics herein.


extent of intellectual property protection. In particular, could it be that countries at differentstages of economic development would benefit from different degrees of protection? The an-swer may well be affirmative given that countries at the top of the development ladder basetheir competitiveness on the creation and application of state-of-the-art technologies based onadvanced scientific research, whereas those on the other end often find it more profitable toconcentrate limited resources to the identification, adaptation and adoption of extant tech-nologies and broad dissemination of information (Lall 2003). In other words, advanced na-tions are expected to push for stricter IPR regimes focusing primarily on dynamic efficiencywhereas lesser developed nations are expected to push for laxer IPR regimes as they are pri-marily concerned with allocative efficiency.

The question above proves, in fact, to be one with no easy answer. Intellectual propertyhas different impacts on innovation for countries at varying levels of development largelybecause of trade issues; specifically, trade related to technology. In less developed countries,innovation occurs primarily through importation of technology from more developed nations(World Bank 2010). Firms engaged in selling technology in international markets are goingto want to be assured of protection for their investments, and most are more eager to sell incountries where a reasonable IPR regime is in place (Branstetter et al 2005). The presence ofa functioning IPR system is a strong market signal to prospective firms.

Are, then, countries that lack a reasonably functioning IPR regime effectively cut off fromtechnology imports? Not at all, as firms will export technology in a format appropriate toa customer nation’s level of technological capacity. Specifically, there are two factors thatdetermine a country’s technology capacity (or absorptive capacity). The first characteristic isappropriability, which conditions technology transfer on the ability of domestic R&D concernsto incorporate foreign technology and learning into their own production processes.

The second is usability, which argues that the level of technology imported depends onthe level of development of the target country (Gibson and Smilor 1991; Javocik 2005; Parkand Lippolt 2008). For example, a less developed nation may import semi-conductor technol-ogy in the form of finished computers (usability), but there might not be any domestic firmsthat could import the latest semi-conductor know-how and use it to develop a new computerthemselves (appropriability). Firms, then, generally will export finished, high tech goods toareas with weak IP protection and are more comfortable exporting know-how to a countrywith stronger IP protection.7 Know-how exports may be in the form of a factory or processingfacility, or a collaborative venture with local firms, or direct licensing agreements.

When putting together policy for IP and standards, developing nations should use bothmultilateral and bilateral agreements. The latter are more flexible and might be able toprovide more targeted innovation help.

Just as firms have determinants for the type of technology they are willing to export,developing countries have determinants for the type of technology that is imported. Less

7. Usability and appropriability are also time specific; as a country develops, its technology capacity changes.See the text box on South Korea’s technology development.


developed nations will see much more efficient outcomes by focusing on importing technologyrather than creating the infrastructure to create it locally (WIPO 2011). Moreover, IP regimesthat are too stringent for a developing nation may lead to technology-associated economicrents being directed to foreign firms (Ganslandt et al 2005; World Bank 2010), thus decreasingthe efficiency of a national system. On the other hand, developed nations will see much moreefficient outcomes by pushing the boundaries of a technology through constant innovation(Abel et al 1989). In this situation, strong IP regimes encourage domestic producers to investin innovative activities by providing a more secure appropriability of rents.

5.5 Determining the Need for and Impact ofIntellectual Property

As with any other policy option, it is important to understand the needs of the populationdirectly impacted by that policy. While it may be a simple matter for a developing countrygovernment to copy an IP policy framework from somewhere like the US or an EU memberstate, it must be remembered that each country has a unique innovation footprint and, ideally,that country’s IP regime should be appropriately tailored.

IP is complex in that it affects two populations to varying degrees. First, it affects thoseentities active in invention and innovation, such as firms, universities, and entrepreneurs.More generally, an IP policy affects the entire country in which it is enacted. If the policy ingeneral encourages innovation, and if innovation is associated with economic growth, then IPcan affect the economic climate of the entire country. Determining if an IP policy is effective,therefore, involves more than just counting the number of patents, or relying on a singlemeasure of impact.

For example, Branstetter et al (2005) point out that stronger IPRs will attract more tech-nology investment from foreign firms, but that measurement alone does not tell us if the newinvestment is putting domestic firms out of business, leading to a trade imbalance, or over-burdening existing infrastructure. Outside of the explicit innovation environment, consumersin general might be affected if stronger IP rules attract more foreign technology imports withthe unplanned effect of pricing that technology out of the reach of the domestic consumer(Fink and Maskus 2005). In Jordan, for example, one study found that adhering to WTO IPstandards has led to a diminished domestic innovative capacity in the area of pharmaceuticals(Malpani 2009). Thus, evaluating an IP policy involves understanding the innovation ecologyof one’s country, and the impact of IP on that whole system.

Developing nations face a clouded path to IP implementation. The pure allocative or dy-namic efficiencies discussed earlier will not apply uniformly across their economies. Someareas of technological skill in a developing nation will be far from the cutting edge, whileothers might be much closer. The rapidly advancing BRIC nations—Brazil, Russia, India, andChina—represent this middle ground on a grand scale. All of them, in various fields of tech-nology, are innovative leaders and followers (Tseng 2009). From an IP policy standpoint, thisis a difficult position to occupy and all four of these nations have tried varying forms of IPlegislation in an effort to encourage simultaneously domestic innovation and foreign technol-ogy investment. The act of balancing domestic innovation needs and foreign IP requirements,


while stimulating growth at home, have at times attracted sanctions or threats of sanctionsfrom more developed nations (Bird and Cahoy 2007).

Countries further away from the cutting edge of a technology may find it beneficial, or atleast tempting, to relax IP rules and enforcement. While this increases access to knowledgefrom foreign sources and lowers the barrier to innovation for domestic producers, care mustbe taken that laws are enforced appropriately. Purposeful lax enforcement of strong rules orcreation of weak rules that deliberately allow domestic firms to “legally” steal foreign tech-nology can drive away foreign investment and technology and harm the domestic innovationlandscape. For example, in the early 1980s, South Korean IP laws tacitly allowed for whatessentially amounted to theft of foreign IP. In one instance, trademarks were considered validonly if the brand was familiar to most Koreans, a loophole that meant many foreign-madegoods de facto lacked IP protection. The response of foreign technology suppliers was a roundof steep trade sanctions (Ryan 1998).

Korean Pharmaceutical Industry and DevelopmentIn the 1960s and 1970s, Korea, like many industrialized, developing nations, was build-ing its technology base by copying mature foreign technology. With relatively cheap laborcosts, Korean firms were able to produce these mature technologies for domestic andinternational consumption at competitive prices. As the nation developed economically,however, those labor costs rose. At the same time, other nations, such as China, hadworkforces with even lower wages, and were thus able to out-compete Korean firms on apricing basis on the international market. In the 1980s, Korean firms began to manufac-ture more sophisticated, value-added technological goods, with increased technologicalknow-how coming from three sources: copying cutting edge foreign technology, increasedspending on R&D, and a base of domestic technology experience developed from copyingmature foreign technology.

Intellectual property became a concern for Korea in the 1980s. Prior to that period, theforeign technologies that Korean firms were able to copy were mature, with innovationcoming mainly in the marketing and manufacturing processes and costs highly driven byworker wages. With such mature technologies, IP played a much smaller role in main-taining a competitive advantage, and thus foreign firms were less likely to block Koreanfirms from using that technology. However, once Korean firms began to create and copymore value-added products like pharmaceuticals, they came into more frequent conflictwith foreign firms who owned the more advanced IP.

The pharmaceutical industry in Korea grew very rapidly in the 1980s, and this wasalmost entirely due to the copying of foreign products. At first, Korea officially honoredprocess patents, but not product patents, which allowed for domestic firms to jump intohigh-tech manufacturing once a product’s manufacture was deciphered. And as mentionedin the text of this chapter, Korea’s trademark law only allowed trademarks for productsthat were well-known to the Korean people, thus tacitly allowing the copying of any for-eign good. Foreign governments cried foul, and the Korean government created tougherlaws. However, enforcement was notoriously lax, and the copying continued. By the endof the 1980s, nearly 90% of the Korean pharmaceutical market was supplied by domestic


firms, a percentage much higher than equivalently developed nations at that time. Even-tually, threats of sanctions from international partners forced the institution of real IPenforcement.

Today, Korea has a thriving pharmaceutical industry, thanks in large part to the laxenforcement of IP during the formative years of the industry in the 1980s. Certainly, thispath of development is not conducive to winning the trust of international partners. Italso important to not let lax IP enforcement undercut one’s own internal development byde-incentivizing investment in domestic high-tech industries. The Korean experience thusprovides lessons on both the balancing of IP enforcement and technology development, aswell as the trade problems associated with IP as a nation moves up the development curve(Ryan 1988; UNCTAD 2033; The Economist 2011).

As the above examples emphasize, designing an IP system that both encourages domesticinnovation and supports the legal importation of foreign technology is difficult. It is criticalfor policymakers in these situations to understand the needs and capabilities of prospectivedomestic innovators and be able to revisit and rebalance the national IPR regime. The toolsto do so are variable. Surveys are a useful tool because they assist in obtaining detailed infor-mation such as frequency of patents and copyrights, ease of obtaining IP protection, incomegenerated from IP-protected goods, whether IP owners consider the process a good investmentof resources, manufacturing, marketing, or distribution problems solved or caused by IP, etc.

Generally, it is not feasible to survey every entity involved in an innovation ecosystem, butmaking contact with as many business owners as possible, both innovators and those who usetheir innovations, is critical. A good example are the OECD Economic Surveys, which describethe innovation environment for individual countries. Interestingly, Lebanon and Jordan, thetwo countries detailed later, have rates of patenting that are low enough that each couldactually survey the entire population of domestic patent holders for any given year.

Another method of determining the effectiveness of an IP policy is through analysis ofpatent data. Patents have the advantage of being a distinct, quantifiable phenomenon. Patentdata can be broken down into a number of useful categories, such as area of technology,location of inventor, location of owner if different from inventor, and previous knowledge onwhich the patent is based. The danger of patent data alone, however, is that it lacks context.Mowery and Sampat (2005) describe a good example of the need for context. In the US,there has been a surge in patenting by universities, which many interpret as validating thegovernment’s efforts to have universities participate more in the innovation process. But suchan increase in patenting may be missing a possible long-term effect in decreased innovationas universities redirect their focus towards short term research.

Briefly, another form of intellectual property protection that is growing in importance anduse will be discussed: geographical indicators (GI) (OECD 2011). A GI is applied to a specificproduct or good that is ethnically or geographically distinct and attributable to specific regionor territory. For example, champagne is a type of sparkling wine from the Champagne regionof France. Recently, it was ruled that any sparkling wine of the same vintage as champagne butnot from the Champagne region in France cannot use the word “champagne” in its productname (Bramley and Kirsten 2007). As the example above shows, a GI functions in muchthe same way as a trademark, except that it is applied to a type of product associated with


Figure 5.1: Top Fields for Patents Applications in Select Upper Middle Income Countries, 1996- 2010 (WIPO 2011)

geography rather than a specific company (USPTO 2011; WIPO 2011).Importantly for developing countries, a GI does not require long term investments and

is not dependent on the technology development and appropriation issues discussed earlier.A country either has a good with associated GI properties or it does not, and the processof having that good registered with the WTO or recognized through multilateral or bilateraltrade is more administrative than developmental. Of course, as the example of Basmati riceshows, the negotiation process may still run up against powerful commercial and governmentinterests (IPR Commission 2002). Even countries or regions that do find recognition for ageographically-based good, that does not guarantee any sort of income. As with a trademarkeditem, the reason behind filing for a GI at least partly is that it has some sort of marketablevalue (USPTO 2011). All countries should take advantage of any available opportunities inthis matter, but as a course of development, a focus on the fundamental drivers of innovativepush and pull likely will have more payoff in the long run.

The principal take-away is that IP is a necessary but complex policy tool implemented ina complex innovation environment. Not only does an IPR regime need to be calibrated to en-courage domestic innovation and remove barriers to the spreading of new technology, but, fordeveloping nations especially, it must provide foreign technology providers with confidencethat their knowledge investments will be safe. This is a difficult path to navigate, and requirespolicymakers to pay careful attention to the creation and implementation of laws and insti-tutions. Table 1, below, is indicative of the lack of uniformity of technology and developingcountries. In that table, a selection of Upper Middle Income countries is provided, along withthe major technology fields for patent applications. With the exception of Jordan, no countryin this list has a major focus in any one technology. Such an arrangement highlights the needfor IP policies that are able to incentivize domestic innovation and foreign technology transferin multiple fields simultaneously.


5.6 Standards

Standards constitute another driver of innovation, and they are becoming more important asmarkets internationalize. Goods and services are no longer sold to just the neighboring citybut to a wide variety of markets and cultures with different requirements on materials andprocesses and different preconceptions of what is good or bad. “Standards are not only a tech-nical question. They determine the technology that will implement the Information Society,and consequently the way in which industry, users, consumers and administrations will ben-efit from it” (EC 1996) Standards encompass an increasingly wide range of manufacturing,process, and ethical requirements placed on commercial goods. Standards can be imposedby governments, international bodies, trade associations, or can be the outcome of regularmarket transactions.

Less developed countries rarely have the opportunity to set their own technology stan-dards. Typically, only those countries on the technological frontier will be able to set thestandards for technologies for which they are the primary producers, users, and sellers. Spe-cific technologies develop along a series of steps, one of which involves the intentional orcircumstantial setting of standards (Gort and Klepper 1982). Technology followers by defini-tion come upon a technology after it has already been in development for some period of time,and often miss the standard-setting stage. However, specific circumstances occasionally pro-vide the opportunity for developing countries close to the frontier of a specific technologicalfield to set or influence standards.

Market size is one of those circumstances. A great example is China’s attempt to set its ownsignal security standard for all wireless devices sold in China, including imports. Makers ofwireless devices from other nations balked at this proposal, as it would have created a secondset of security standards for makers to meet, upending international markets and virtuallyforcing foreign firms to provide Chinese manufacturers with proprietary information (Gibson2007). While the proposal for the new standard was ultimately withdrawn due to internationalresistance, the chain of events indicated a couple of things: (a) China was advanced enoughtechnologically to set their own wireless security standard; (b) China had a large enoughinternal market that international makers could not simply ignore it.

Most developing countries, however, rarely find themselves at the technology frontier. Pol-icy makers in these nations are generally going to be more centered on the impact on thedomestic innovation environment stemming from acceptance of extant technology standards.

There are three common ways for standards to be set: the marketplace, negotiation, and astandards leader (Varian et al 2004). First are standard wars conducted in the marketplace. Aclassic example of this is the VHS and Betamax technology battle (Hall 2005) replayed todayin Blue Ray versus DVD. The benefit of allowing markets to set standards is that it follows thepath of least resistance in terms of existing innovation. Technology flows where the skills andthe markets already exist.

Governments are not required participants in setting standards in this manner, but clearly,the legal, IP, innovation, and trade environments all play a part in determining how marketsoperate, and these are all areas in which governments set the tone. For countries that havenational champions, allowing the markets to set standards can be tricky, as there is no guaran-tee that the home country’s firm will survive the standard war. Nor is there a guarantee thatconsumers will direct the market to the best possible outcome; small events at different stages


of development of a technology and a market can decide the outcome of a standards race,regardless of which product is technically superior (Arthur 1989; Malerba et al 1999; Gallego2010).

The second channel for setting standards is negotiation. Governments can play a directrole here. Recall the example of wireless signal security and China, and how it was resolvedwith international negotiations (primarily the US government). Negotiation typically involvescompromise, which means that all players may have to sacrifice some element of gain for thebetterment of the whole. Consumers can be the big losers in these situations as negotiationsmight not settle on the most cost effective or well-functioning standard. It is also difficultto determine exactly when a standard would be set naturally (Jakobs 2000) leading to thepossibility that the necessity of entering into negotiations artificially sets the limit to furtherstandard development.

Having a standard leader is the third form of standard setting. Such a leader can comeout of a market fight, or by virtue of being the first to develop and disseminate a technology.Those wanting to supplant the standard may face extreme barriers to entry erected simply bythe standard having been in place for a long period of time, or requiring a vast infrastructurethat is infeasible to duplicate for a new standard (Gallego 2010). Perhaps no greater exampleexists of this than the Internet.

Brazil’s Personal Computer EndeavorIn 1985, Brazil passed the National Information Technology Policy in an attempt to turnits burgeoning, domestic IT industry into a pillar of productivity and growth. The lawblocked imports of some foreign computer and IT-related goods and for those importsthat were permitted, foreign firms were required to interact with Brazilian-owned firmsfor in-country sales. This protectionist move had two goals: boost domestic technologygrowth by keeping out foreign competition; and provide an avenue for domestic economicdevelopment.

At the time of the passage of the Informatics Law, as it was called, Brazil did havea small computer manufacturing sector. Most of the domestically produced computersfollowed international standards and were clones of foreign market-leaders, while periph-erals and software tended to have a higher degree of local content. The Informatics Lawshifted all of the standard-setting to domestic producers.

Recall from this chapter that the three methods for setting a standard are the market-place, negotiation, or having a standard leader. At the time of the passage of this law,Brazil did not meet any of the three requirements for setting a standard. The marketwas not large enough to be self-sustaining, the protectionist move was unilateral and in-volved no negotiation with other countries or multilateral bodies, and Brazil possessed nodomestic producer that was already a standard leader.

Brazil did see a growth in the domestic technology capability of some producers asthe vacuum of foreign goods was filled. However, consumers suffered as the Brazilianproducts generally were more expensive and less reliable than their foreign competition.By the end of the 1980s, policymakers saw how countries like Taiwan and Korea wereenjoying booming IT growth through much more liberal trade policies. Consequently,


the Informatics Law was changed to allow for more foreign competition in the IT sector,and to de-emphasize the need for Brazil to set internal standards in that sector. Today,decentralized knowledge spillovers, as opposed to protectionist standards, are creditedwith boosting the IT growth of Brazil. (Botelho and Smith 1985; Perini 2006; Magalhaeset al 2009)

For developing country practitioners, care must be taken when agreeing to standards.Standards can be a benefit to a country’s innovation efforts by providing guidelines for aentrepreneurs entering the international market. Standards also can inhibit local innovationby preventing entrepreneurs from selling their products on the global market (Gibson 2007;World Bank 2010). The OECD recently compiled a review of empirical assessments of theimpact of standards on international trade. Importantly, the studies examined found a mixof positive and negative impacts of both national and international standards on the conductof international trade (Swann 2010). For a fitting example of variable impacts of a standard,one need look no further than the well-documented controversies associated with one of themost important modern efforts at international standardization, that of IP under the TRIPSagreement.

All in all, policymakers must consider the impact of standards on domestic innovation. Inthe same manner to IP legislation discussed earlier in this Chapter, any decision on standardsmust be made in light of factors such as the level of domestic innovation, domestic technologyappropriability and usability (absorptive capacity), specific areas of technological strengthsand weaknesses, and areas of potential trade growth.


Appendix 5.A Country Details: Lebanon and Jordan

Lebanon is a country of just over four million people, nearly half of whom live in the capitalcity of Beirut. Literacy rates are impressive, at nearly 90%, and the 2010 GNI of close to $9,000puts the country in the World Bank ranking of Upper Middle Income. Like Lebanon, Jordanis considered to be Upper Middle Income by the World Bank, though GNI, at around $4300,is just under half of that in Lebanon. Other countries in that rank include Brazil, Russia, andChina. The population of Jordan stands at just over 6.5 million, with an overall literacy rateof about 90%.

IP protection and standards have received little attention in the past from governmentofficials in these two nations. They are currently experiencing increasing interest due to thedetermination of public authorities that technological advancement and innovation is going tobe an important element of growth in both nations’ economies.

In Lebanon, the government confronts a relatively young, well-educated population withfew opportunities for high-growth employment (National Council for Scientific Research 2006).The links between universities and the private sector are few and this gives little opportunityfor new research talent to be trained in the full set of skills needed for private sector innova-tion (Arvanitis and M’henni 2010; Bizri et al 2010). This lack of connection, combined with alow government investment in research (Arvanitis and M’henni 2010), creates a strong barrieragainst innovative activity.

Jordan, in comparison, has a stronger current potential for innovation. It is home to multi-ple universities, and has a large population of engineers. Like Lebanon, Jordanian leadershipis focused explicitly on the issue of innovation for economic growth (Rischard et al 2010).However, these seeds of innovation have difficulty taking root. Major barriers include a focuson theoretical and not applied research at universities, very small and scattered governmentexpenditures on R&D, almost zero private sector R&D, and a limited creative class (Rischardet al 2010).

IP appears to be of limited impact on the domestic innovation environment for bothLebanon and Jordan. Based on patent data (WIPO 2007; Arab Knowledge Report (MBRF-UNDP) 2009), Lebanon has very low patenting activity. Whether this is a problem of supplyof innovation or demand is not clear from the data. However, given that small, informal firmswith fewer than five employees make up 90% of the country’s employment (Bizri et al 2010),it is likely that there is not a great demand for stronger patent institutions internally. Ide-ally, that demand will grow as Lebanon implements more of its planned innovation-friendlypolicies. Where domestic demand might be found is in the copyright-based creative sector,including software, music, and film. A 2007 WIPO report estimated that the creative sectorwas responsible for close to $1 billion of Lebanon’s GDP and 50,000 employees (WIPO 2007).

In Jordan, only 43 nationals applied for patents in 2010, and 22 patents were granted inthat same time period. 431 patent applications were submitted from international entities thatsame year, with 64 being granted (Ministry of Industry and Trade 2011). Domestic demandfor IP likely is low because close to 95% of businesses are family-owned concerns in non-innovative fields. What’s more, a formerly protectionist atmosphere has lessened the perceivedneed for innovation among most business owners (Rischard et al 2010). Even for businessowners who are entrepreneurial, a lack of angel, seed, and venture capital sources inhibits risk-taking. Despite low domestic demand for strong IP, there is recognition from the government


that IP is an important issue. The Jordanian Higher Council for Science and Technology nowactively educates potential innovators about the benefits of IP and has built IP targets intoits national S&T plan (ESTIME no date provided; Higher Council for Science and Technology2004). Interestingly, around 5% of Jordan’s exports in 2005 were high-tech finished goods.That same year, upwards of 70% of Jordan’s total exports were manufactured goods, which incontrast to most Arab countries which tend to export agricultural goods and natural resources(Arab Knowledge Report (MBRF-UNDP) 2009).

Domestic demand for strong IP institutions in Lebanon and Jordan may be weak, but callsfor more aggressive enforcement are coming from foreign trading partners. Despite Lebanon’scurrent, well-defined IP laws (Ministry of Economy and Trade 2011b), there is a perceptionamong foreign IP owners that the courts are not strong enough to enforce existing laws (In-ternational Intellectual Property Alliance 2011). Standing in the way of an effective IP envi-ronment are said to be the high level of corruption, red tape, and general inefficiencies thatmake it difficult to enforce properly IP institutions (Bizri et al 2010). Lebanon is also not yet amember of the WTO (WTO 2011), though it is in the accession process, which may be a deter-rent for some foreign investors. And while Lebanon is a member of WIPO, it is not signatoryto several of that body’s treaties, especially those centering on copyright (WIPO 2011a). InJordan, piracy of foreign copyrighted works, especially music and software, is a huge problem.Progress has been made on mitigating the impacts of that practice since Jordan signed a freetrade agreement with the US in 2001, but problems still remain (International IntellectualProperty Alliance 2009; Office of the US Trade Representative 2011). Jordan is a member ofboth the WIPO and the WTO, which should theoretically encourage FDI which can then fostergrowth in the local innovation environment.

It is likely that in the foreseeable future both Lebanon and Jordan will remain consumers ofstandards. Neither of these countries has a large internal economy to command internationalauthority or is near the technological frontier. At just over 4 million people, Lebanon is not alarge economy, nor, apparently, does the nation control enough of a single good to allow it todictate market structure outside of its border. Natural resources and farm products make upthe bulk of exported goods. Though some machinery is exported, it isn’t clear that Lebanonis at the forefront of any technology field (Ministry of Economy and Trade 2011). Jordan isin very much the same situation as Lebanon. However, as one of the more innovative Arabcountries, there is opportunity for Jordan to become a leader of that regional set of nations asthey develop into a coherent cultural, market, and innovative body.

Chart 1, shown below, provides an overview of innovation environments for Lebanon andJordan. The United Arab Emirates (UAE) is also included for comparison as it is consideredone the most innovatively advanced Arab nations (Arab Knowledge Report (MBRF-UNDP)2009). It is important to note the information shown, but also what information is missing.Data on private sector R&D spending for Lebanon, royalty fees and payments for Jordan, andresearchers per million inhabitants for all three selected countries are not available, at least inthis format. Assuming this is the most current data, these countries have incomplete knowl-edge of their internal innovation environments. Therefore, any IP regulations or decisionson technology standards run the risk of being inefficient as they will be based on incompleteinformation.


Figure 5.2: Comparison of Lebanon, Jordan, and UAE Innovation Environments(Bank KAMCustom Scorecards: )


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.

Chapter 6

National Competitive Advantage

6.1 Introduction

Countries seek national competitiveness as a way to promote economic growth and spur devel-opment. Excelling in a specific sector or sectors allows a nation to increase national productiv-ity through specialization. National competitiveness encourages the production of goods andservices that can be traded internationally to benefit a rising and sustainable standard of livingin a country.

Economists have tried to understand the conditions that allow countries to pursue this vir-tuous path (Abramovitz, 1986, 1994; Baumol et al., 1994; Freeman and Soete, 1997; Rostow,1990; Ruttan, 2001; Tassey, 2007). Targeting specific sectors to provide capital investmentrepresents a rational decision by policymakers to enhance the quality and quantity of products(e.g., an agriculture-based economy may seek to develop biotechnology related to farming toincrease crop variety and yields) or move up the value chain (e.g., in addition to extracting oreand minerals from the ground, a mining company may choose to begin smelting or refiningactivities).

In the past few decades economists have also been very much concerned with the pro-cesses that allow countries to restructure and upgrade their economies in order to retain andenhance their international competitiveness in the face of increasing international competition(Chesnais, 1986; Nelson, 1994, 1995; Nelson and Wright; 1992; Porter, 1990; Romer, 1990;Rosegger, 1996). Analysis has critically depended on the ability to: (1) benchmark past andcurrent performance and international competitiveness of individual sectors and (2) assess theprospects of individual sectors for future growth and decline.

Assessing national competitiveness is as much an art as it is a science, and the best ap-proaches are interdisciplinary, featuring analysis rooted in a variety of fields including eco-nomics, politics and sociology. The best outcome of policy intended to promote national com-petitiveness is likely to be an increase in national productivity, as certain sectors expand. Suchexpansion is not necessarily at the expense of other countries, as international trade is not nec-essarily a zero-sum game. That is, as one country expands, other nations do not necessarilycontract, as one might expect between two competing corporations. Each country seeks eco-nomic growth and specialization in order to develop on an appropriate scale, size and speed.Furthermore, in its quest for growth, each country generally seeks to improve the share of

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CHAPTER 6. NATIONAL COMPETITIVE ADVANTAGE 108

high value-added products and services in its national output. For example, countries thatspecialize in the production of raw textiles, a relatively low value-added industry, may seekto broaden the number of sectors in which they can compete internationally and enjoy highereconomic returns.1

6.2 Economic Growth and Development

Before delving into the specific factors and processes by which nations become competitive, itis useful to review some basic concepts related to economic growth and development.

Countries generate economic growth through four fundamental processes. The ability ofa country to harness these four processes effectively leads to increased national productivityand competitive advantage.

• Investment: The productivity of the average worker is constrained by the quality of histools. Increasing the level of capital input—improving the quality or quantity of the toolsused—can lead to economic growth. Consider the differences in productivity between afarmer with a hoe and the farmer with a tractor. The latter will be able to plow an entirefield in the time it takes the first farmer to turn over a single row.

• Exchange of goods: Increasing trade and creating new opportunities for commerce canyield increases in income. A nation may seek to enter a market in which it can havea comparative cost advantage as a producer of goods. International trade is based oncomparative, and not absolute advantage (i.e., a country need not be the lowest-costproducer of products in order to trade). Furthermore, each economy also considerswhich industries will provide the highest added value to GDP. A country may seek tospecialize in a particular industry which affords a balance of comparative advantage andsatisfactory value added. Lowering the transaction costs associated with trade, such asrents charged to farmers to operate market stalls, costs of commercial transportation, orimport/export duties can contribute to increases in commerce.

• Scale: Population growth can contribute to economic growth, because it allows for in-creased specialization of labor. For example, a small town may grow large enough tosupport a variety of vocations including farmers, carpenters, mechanics, politicians,teachers and even artists. However, it appears that population growth can also leadto a tightening of resources to slow economic growth, so some effects of scale work bothways.

• Knowledge/Technology/Innovation: A significant input to economic growth is the appli-cation of information to the production process, which may result in increases in quality,efficiency, or new inventions and innovations. In addition to capital and labor inputs,technology is one of the key determinants of economic growth. Technology contributesto development through enhanced standards of living, improved education among youthand the workforce and increased ability to manufacture high-value-added goods and ser-vices.

1. The economist Paul Krugman (1994) cautions that a belief that a country’s economic problems are solelythe result of national competitiveness (or lack thereof) in the world markets is misleading.


This last input—technological change—is an important determinant of national produc-tivity growth and, ultimately, of the standard of living in a country. The economic effects oftechnological change can be studied by analyzing the relationship between research & devel-opment (R&D) spending and productivity growth. There are three main aspects of R&D (CBO,2005):

• Pure basic research: Experimental and theoretical work that advances the state of scien-tific knowledge.

• Applied research: Work that utilizes advances in basic research to create new applicationsand achieve specific objectives.

• Experimental development: Work that uses existing knowledge to produce new materials,products or devices; install new processes, systems or services; or substantially improveupon past inventions and innovations.

The government principally funds basic research and some applied research, while theprivate sector primarily funds applied research and experimental development.

The impacts of technological change on economic growth have been explored by a widevariety of experts, reaching a broad consensus that technical knowledge has been a crucialdriver of productivity growth.2 A primary question is how large this contribution has been,with estimates varying significantly (CBO, 2005). The CBO survey of the literature concludedthat the most robust estimations utilize econometric analysis focusing on the effects of changesin R&D on production costs, output and productivity. A commonly used function is a typicalCobb-Douglas production function:

Qt = At eλKαt−1 Lβt Rγt−1e�

where Q is real output, A is total factor productivity (TFP), K is the stock of physical capital, Lis the labor input, and R is a measure of R&D effort.

Estimated returns to public and private R&D expenditure across all principal areas of in-vestment can be quantified using such techniques. Policymakers may consider both the privatereturns—to the organization undertaking the research—as well as the broader returns to so-ciety.

Consider that technical knowledge can be used by many people at the same time (nonrivalin consumption). Also, consider that most technical knowledge cannot be completely withheldfrom others (partially nonexcludable). The result is that some knowledge created by an indi-vidual, a company or a country will inevitably spill over to others not involved in its creation.This spillover effect can yield significant benefits, as one highly innovative and successful firmcan develop ideas that other firms may use in different ways to develop even more new ideas.Such spillovers provide one of the main justifications for industry clusters where groups of in-novative businesses, academic institutions and research partners are co-located (see Chapter8).

2. Chapter 1 of this volume focuses on this issue


6.3 Defining and Measuring Competitiveness

6.3.1 Industry Competitiveness

In the mid-1980s, the U.S. President’s Commission on Industrial Competitiveness provided adefinition of competitiveness that has since been the foundation of almost any other.

A nation’s competitiveness is the degree to which it can, under free and fair marketconditions, produce goods and services that meet the test of international markets whilesimultaneously expanding the real incomes of its citizens. Competitiveness at the nationallevel is based on superior productivity performance and the economy’s ability to shiftoutput to high productivity activities which in turn can generate high levels of real wages.(PCIC, 1985, p.1)

Chesnais (1986) supplemented this definition by arguing that the international compet-itiveness of national economies is built on the competitiveness of firms that operate withinnational borders. To a large extent, then, it is an expression of the dynamism of domesticfirms (reflecting management practice) and their capacity to invest and to innovate both as aconsequence of their own research and development (R&D) and of successful appropriationof technologies developed elsewhere. Importantly, however, it was argued that internationalcompetitiveness increasingly depends on “structural factors” such as the flexible and profi-cient productive structure of the national economy’s industries, the rate and pattern of capitalinvestment, its technical infrastructure and other factors determining the “externalities” onwhich firms can build.

This is to say the productivity of firms populating a particular sector largely defines thesector’s performance. A number of fundamental points in the brief definitional discussionabove points at the type of indicators allowing us to judge industry competitiveness:

• The ultimate judge of performance is the market, especially the international market,where products and services compete for a share of the domestic and foreign markets.Thus, the most basic indicators of industry performance (first line indicators) shouldbe productivity and market share. When seeking to identify competitive industries, oneshould examine these two indicators first.

• It is necessary to understand the more general socio-economic fundamentals affectingcompany actions. A second line of indicators becomes necessary which deal with the fac-tors determining the socio-economic environment. Such indicators can be relative prices,unit labor costs (relative to labor quality (productivity), capital costs, rate of investment,foreign direct investment, and the rate of exposure to foreign competition.

• The competitiveness of a sector is a dynamic concept that takes into account the abilityof firms to react to changing economic/technological conditions, to restructure and toupgrade. A third line of performance indicators is thus suggested which take a moredynamic approach by considering industry evolution and changing company capabili-ties. Such indicators may include those related to: (i) the dynamics of competition in anindustry, such as firm entry and exit, the rise and fall of incumbents, patterns of large-and small-firm mobility, measures of market structure and intensity of competition; (ii)


the innovative capability of firms in an industry, such as the rate of introduction of newproducts and production processes, upgrade of the product mix, upgrade of the qual-ity of the factors of production, technology output (patents, licenses, etc.), technologyimports and exports, R&D expenditures/intensity; and (iii) the participation of domesticproducers in regional, national, and international production and innovation networks.

Nurturing competitive industry: Chile’s wine industryBecause of its ideal climate and cultural history, for centuries the world’s finest wine wasproduced in certain regions of continental Europe. However, new winemaking regions inthe southern hemisphere are slowly displacing the old. Chile’s wine industry has emergedas an important and globally competitive player. Globalization allowed Chilean wines,produced using inexpensive labor and abundant natural resources, to compete at a lowercost compared to European varieties.

Beginning in the late 1970’s, the country liberalized its economy and allowed greaterforeign direct investment. The participation by globally competitive companies such asSpanish giant Miguel Torres introduced new technology and displaced outdated methodsof production (Chilevid, 2006). The clear advantages of stainless steel tanks, temperature-controlled facilities and advanced production lines quickly became apparent. Technologyand knowledge transfer occurred through spillovers from one company to another in theregional winemaking clusters that sprung up around fertile valleys. Domestic productioncapacity and national exports soared in the early 1990’s after domestic firms fully imple-mented the technology, leading to an expansion in the number and size of vineyards.

The country’s economic opening and introduction of foreign firms also improved mar-ket access. Giant multinational companies either set up production facilities in Chile (e.g.,Miguel Torres) or set up joint ventures with local firms (e.g., Robert Mondavi). Suchcompanies then leveraged their distribution networks to sell wine around the world.

The government also provided funding to increase national research capacity, with anaim to develop technology and knowledge that could support the agriculture and wine-making industries. Joint public-private R&D centers such as the Irrigation and Agrocli-matology Research Center (CITRA) and the Grape and Wine Center work on basic andapplied sciences research. In recent years, these efforts have increased crop yields andimproved the quality of grapes, which support the shift by Chilean winemakers into super-premium and higher value-added segments of the global market. Public R&D funding isoften complemented by funding from private industry associations such as Asociación deProductores de Vinos Finos de Exportación A.G. (Chilevid).

The Chilean wine industry demonstrates several potential lessons for nurturing com-petitive domestic firms. First, the introduction of foreign companies and foreign directinvestment proved to be a vital source of new technology necessary to upgrade existingproduction capabilities. Second, the increased linkages with glboal firms improved distri-bution networks, leading to an increase in export volume. Third, the winemaking clustersin thirteen of Chile’s most fertile valleys facilitated knowledge spillovers and the diffu-sion of technology. Finally, the role of government in supporting public R&D funding foragricultural research, and support for public-private partnerships between universities andprivate companies greatly aided the development of new technology, production processes


and biotechnology. As noted in Chapter 1, there is a strong positive relationship betweenR&D and firm-level productivity.

6.3.2 Global Competitiveness Index3

Developed by the World Economic Forum, the Global Competitiveness Index (GCI) measuresthe macroeconomic and microeconomic bases for national competitiveness.

The GCI is broad in scope and focuses on twelve “pillars of competitiveness”:

1. Institutions: The legal and administrative framework within which individuals, businessand governments interact to generate wealth. Measures include: property rights, ethicsand corruption, undue influence, government inefficiency, security, corporate ethics, ac-countability.

2. Infrastructure: Transport, energy, and telephony infrastructure. Measures include: qual-ity of overall infrastructure, quality of road, railroad, port, and air infrastructure, andavailable seat kilometers.

3. Macroeconomic environment: The stability and effectiveness of a nation’s fiscal and mon-etary policies as well as the health of government finances. Measures include: govern-ment budget balance, national savings rate, inflation, interest rate spread, governmentdebt, and country credit rating.

4. Health and primary education: Investment in the provision of health services and thequantity and quality of basic education received by the population. Measures include:business impact and incidence of malaria, tuberculosis, HIV/AIDS, infant mortality, lifeexpectancy, quality of primary education,. And primary education enrollment rate.

5. Higher education and training: Secondary and tertiary enrollment rates, evaluation ofthe quality of education evaluated by the business community, vocational and contin-uous on-the-job training of staff. Measures include: secondary and tertiary educationenrollment rates, quality of the educational system, quality of math and science educa-tion, quality of management schools, internet access in schools, specialized research andtraining services, extent of staff training.

6. Goods market efficiency: Market efficiency, degree of competition, impediments to busi-ness activity through government intervention, and demand conditions. Measures in-clude: intensity of local competition, extent of market dominance, effectiveness of anti-monopoly policy, extent and effect of taxation, total tax rate, number of procedures andtime required to start a business, agricultural policy costs, trade barriers, trade tariffs,prevalence of foreign ownership, business impact of rules for FDI, burden of customprocedures, imports as a percent of GDP, degree of customer orientation, buyer sophisti-cation.

3. This section is based on World Economic Forum (2011).


7. Labor market efficiency: Efficiency and flexibility of the labor market. Measures include:labor-employer relations, flexibility in wage determination, rigidity of employment, hir-ing and firing practices, redundancy costs, extent and effect of taxation, pay and produc-tivity, reliance on professional management, brain drain, female participation in laborforce.

8. Financial market development: Degree of existence of sound and well-functioning finan-cial sector which is efficient, trustworthy and well regulated.

Importantly, the twelve “pillars of competitiveness” are weighted differently for differentcountries on the basis of the country’ stage of development. Although all twelve pillars matterto some extent for all countries, the relative importance of each one depends on a country’sparticular stage of development. The first four pillars make up the basic competitivenessrequirements and are key ( i.e., more heavily weighted) for factor-driven economies, the nextsix pillars are efficiency-enhancers and key for efficiency-driven economies, and the last twocomprise of innovation and sophistication factors and are key for innovation-driven economies.

The country categorization draws on the economic theory of stages of development, whichcan be traced back more than half of a century (e.g., Rostow, 1960), was crystallized a cou-ple of decades ago in a major publication by Michael Porter (1990), and was adapted tothe needs of the GCI more recently (Sala-i-Martin et al. 2007). Countries are categorizedinto three groups. Countries in the first stage of development feature a factor-driven economywhose main competitive advantage factor endowments—primarily unskilled labor and naturalresources. Companies in these countries sell basic products or commodities, tend to have rela-tively low productivity, pay low wages, and compete on price.4 Maintaining competitiveness atthis stage of development requires well-functioning institutions (Pillar 1), good infrastructure(Pillar 2), a stable macroeconomic environment (Pillar 3), and a healthy workforce with atleast basic education (Pillar 4).

More competitive countries feature higher rates of development, increased productivityand higher wages. Such countries are said to be in the efficiency-driven stage of developmentwhere they begin to develop more efficient production processes and increase product qualityin order to remain competitive. Competitiveness is now considered to be increasingly driven byhigher education and training (Pillar 5), efficient goods markets (Pillar 6), well-functioninglabor markets (Pillar 7), developed financial markets (Pillar 8), strong absorptive capacity(Pillar 9), and ability to access large domestic or foreign markets (Pillar 10).5

Countries in the innovation-driven stage depend for competitiveness on the ability of theirbusinesses to sell new and unique products. Wages have now risen and citizens expect higherstandards of living. At this stage, companies must compete by producing new and differentgoods using the most sophisticated production processes (Pillar 11) and by introducing newones (Pillar 12).6

4. Most countries occupy this stage, only a rare few have moved to the third stage.5. This stage corresponds to the investment-driven stage in the original formulation of Porter (1990).6. Porter’s (1990) original formulation also contained a fourth stage of development, the wealth-driven stage.

This followed the innovation-driven stage and contained countries whose major competitive advantage is themanipulation of past wealth. The CGI formulation drops the wealth-driven stage of development, presumablycategorizing those countries into less competitive innovation-driven.


In terms of Porter’s formulation (Figure 2), the factor-driven economy has only partialstrength in the “factor conditions” corner, the efficiency-driven economy has partial strengthin “factor conditions”, “demand conditions”, “firm strategy, structure and rivalry”, and theinnovation-driven economy has full strength in all four corners.

Linkages and the effects of networking are increasingly the focus of academic inquiry intocompetitiveness and innovation. The literature suggests networking may support technologytransfer, access to new markets, risk sharing, pooling of complementary skills, some intel-lectual property protections, and knowledge spillovers (Pittaway 2004). Furthermore, it issuggested that such networking may be crucial to success in high-technology firms, and thosethat do not participate may suffer reduced access to knowledge and technology.

Many of the benefits associated with networking are developed through the accumulationand diffusion of tacit knowledge. In contrast to implicit knowledge, which can be gainedthrough reading a manual or purchasing a patent, tacit knowledge is dependent upon ge-ographical proximity and participation in informal networks. Furthermore, these informalknowledge networks may be crucial for regional competitiveness (Saxenian 1994).7

For example, effective management styles and institutional practices are forms of tacitknowledge. The list would also include the spontaneous and informal interactions that mighttake place between a medical researcher and an aerospace engineer that leads to a new inno-vation in materials science.8 Tacit knowledge is a key source of knowledge diffusion in bothclusters (discussed further in Chapter 8) and multi-national corporations.

A crucial feature of national competitiveness in the 21st century is the presence of multina-tional corporations (MNC). About two-thirds of global trade is believed to occur in intra-firmtrade between far flung subsidiaries of MNC’s (Dicken 2007). One could suggest that the riseof ostensibly stateless multinationals should diminish the importance of the various nation-dependent determinants outlined above. In fact, conditions in the host country are funda-mental to the competitiveness of MNC’s and contribute certain advantages to host countries,including vast distribution networks and intra-market relationships, knowledge and technol-ogy transfer, and substantial innovation.

6.4 Conclusion

Developing national competitiveness is an interdisciplinary task that requires the expertiseand insights of many stakeholders. The preceding chapter reviewed some key strategies andpolicies, yet it is important remember that policymakers do not act in a vacuum, and currentpolitical needs can sometimes trump far-sighted strategies for national development. Whilethe full range of policies that government policymakers can choose to support may be boundby budget pressures, they also have the power to create inspiring opportunities for citizens.

7. Informal networking without any concrete interactions has been termed “local buzz” (Batehlt et al 2004),though there is not abundant empirical evidence to support the benefits of such interactions (Huber 2012).

8. In a significant departure from mainstream economics, some scholars suggest that tacit knowledge transferis predicated by both increasing dynamism and path dependence. This approach, which borrows heavily fromevolutionary biology, appears to explain many key aspects of technological change such as why certain productsof inferior technology but with widespread use dominate the market long after more advanced competitorshave emerged. Furthermore, in this conception the appearance of “mutations”, or radical innovations, holds thepossibility of upsetting the entire system (Metcalfe 1998).


Developing countries seeking to enhance their competitive position would be well advised toconsider the various measures outlined in the Global Competitiveness Index, particularly thefirst four pillars of competitiveness.

Knowing where a future market opportunity may lie can be the key to success and can helpfocus innovation efforts. To this end, government provides a great service when it publiclyannounces its national priorities and most pressing challenges. Such challenges may includethe need to produce renewable energy, find an inexpensive source of clean water, or createand adopt the newest information technologies so the country can join the ranks of the mostadvanced nations. Such goal-setting allows individuals and companies to focus their efforts ona specific product, service, process, or technology that is likely to generate an economic return.After all, a firm that solves a national priority is likely to have a huge government customerat a minimum, and potentially a much broader base of customers. Setting national goals caninspire and spur to action entrepreneurs, scientists and engineers, yielding long-term benefitsvastly larger than the initial investment.


Appendix 6.A Jordan and the GCI

In recent years, Jordan’s position in the Global Competitiveness Index has fallen 21 placesfrom 50th in 2009-10 to 71st in 2011-12. The country has managed slight declines in everyfactor category listed above.

The Global Competitiveness Index 2011-12 found that Jordan excels at a number of factors,including adequate public health, low crime rate, good infrastructure and political stability.However, some significant problems prevent the country from becoming more competitive,including an inefficient government bureaucracy, lack of access to financing, burdensome taxrates and corruption.

Jordan could improve its competitiveness by focusing on several key factors that are cur-rently underperforming:

• Innovation policies: Increasing the quality of scientific research institutions, private andpublic spending on R&D, enhancing university-industry collaboration, and encouragingthe production of patents.

• Labor market efficiency: Increasing participation of women in labor force, increas-ing staff training programs, developing more transparent and legally-sanctioned hir-ing/firing practices.

• Investment: Decreasing trade tariffs to encourage free trade, improving investor protec-tions by closely regulating financial markets and the banking sector.

Beginning in 2007, the Jordan National Competitiveness Observator has published annualreports benchmarking the country’s progress, using over half a dozen different indices andmodels.

Appendix 6.B China’s Solar Industry

The role of government in industry is a hotly debated issue. While too much governmentintervention can negatively affect the free market (as seen in some “closed” economies), someintervention can strengthen the market position of domestic firms. Consider the case of China,one of the world’s most important centers for manufacturing. For years, domestic industrieshave pursued a “cost focus” strategy of producing a wide variety of products at low cost,typically low value-added and labor-intensive manufactures such as textiles.

However, Chinese policymakers and industry leaders now seek to move up the value chainby producing more technologically advanced goods and services. One example of this move-ment is China’s entrance into the rapidly expanding global solar products industry. The coun-try pursues an industry development strategy based on strong government intervention anda bevy of supportive industrial policies. In 2012, about ten years after the country began asustained political and economic effort to develop its solar industry, China was the world’sdominant producer of solar products.

Through state investments in raw materials, technology and production facilities, andaided by fiscal incentives and export assistance, Chinese companies have surged to claim adominant market share in nearly all segments of solar panel production. China’s industrial


policies satisfy national development needs and support domestic companies competing in theglobal market.

A key to the country’s initial success appears to be the timely pairing of an export-focusedbusiness model with massive government subsidies in a number of European nations designedto bolster the use of solar power. The generous subsidies afforded by the German and Spanishgovernments for solar photovoltaic feed-in tariffs in recent years created significant demandfor a wide variety of solar products, which Chinese industry was poised to provide.

A second factor may be related to government support for solar industrial and technologyclusters. Initial evidence suggests that solar firms located in Jiangsu province clusters weregranted certain advantages, including tax waivers, loan guarantees, low-cost land to buildfactories and R&D funding. High-technology companies in other sectors were also attractedto the clusers, creating an environment conducive to productivity.

As illustrated below, approximately 97% of China’s solar photovoltaic (PV) products areexported to the European market, with Germany (46.9%) and Spain (22.65%) accounting fora majority of the global demand in 2007 (see Figure 3). China produces many more solarPV modules than it uses domestically (see Figure 4). In order to continue this rapid growth,observers believe China may need to expand its domestic market in order to match supplywith demand. (Besha 2011)


Figure 6.1: Global demand for solar PV modules (2008)

Figure 6.2: Global production of solar PV modules (2008)


References

Abramovitz, Moses. 1986. Catching up, forging ahead and falling behind. Journal of EconomicHistory 46:385–406.

———. 1994. The origins of the postwar catch-up and convergence boom. In The dynamicsof technology, trade, and growth, ed. J. Fagerberg, B. Verspagen, and N. von Tunzelman.Chentelham, UK: Edward Elgar.

Audretsch, D. B., and M. P. Feldman. 1996. R&D spillovers and the geography of innovationand production. In American economic review, 630–640. 86:86.

Baumol, William J., Sue Ann Batey Blackman, and Edward N. Wolff. 1994. Productivity andAmerican Leadership: The Long View. 4th. The MIT Press.

Bell, Martin, and Keith Pavitt. 1993. Technological accumulation and industrial growth: con-trasts between developed and developing countries. Industrial and Corporate Change 2(2).

Besha, Patrick. 2011. Industrial policy and innovation in China’s solar energy sector. Technicalreport. 2011 Atlanta Conference on Science and Innovation Policy.

Delgado, Mercedes, Michael Porter, and Scott Stern. 2011. Clusters, convergence, and economicperformance. Technical report. Institute for Strategy and Competitiveness, Harvard Busi-ness School.

Dicken, P. 2007. Global Shift: Mapping the Changing Contours of the World Economy. 5th. Guil-ford Press.

Freeman, Charles, and Luc Soete. 1997. The Economics of Industrial Innovation. Boston, MA:MIT Press.

Huber, Franz. 2012. Do clusters really matter for innovation practices in information tech-nology? questioning the significant of technological knowledge spillovers. Journal of Eco-nomic Geography 12:107–126.

Nelson, Richard R. 1995. Recent evolutionary theorizing about economic change. Journal ofEconomic Literature 33:48–90.

Nelson, Richard R., and Nathan Rosenberg. 1993. Technical Innovation and National Systems.National innovation systems: A comparative analysis. Oxford University Press.

Nelson, Richard R., and Gavin Wright. 1992. The rise and fall of American technological lead-ership: the postwar era in historical perspective. Journal of Economic Literature 30 (4):1931–1964.

Pittaway, L., M. Robertson, K. Munir, Denyer D., and A. Neely. 2004. Networking and innova-tion: a systematic review of the evidence. International Journal of Management Reviews 5(6): 137–168.

Porter, Michael E. 1990a. The competitive advantage of nations. Harvard Business Review(Mar.).


Porter, Michael E. 1990b. The Competitive Advantage of Nations. Free Press.

Romer, P. M. 1990. Endogenous technological change. Journal of Political Economy 98 (S5).

Rosegger, G. 1996. Economics and Technological Change.

Rostow, W. W. 1960. The Stages of Economic Growth, Non-Communist Manifesto. Cambridge:University Press.

———. 1990. Theorists of Economic Growth From David Hume To the Present. Oxford UniversityPress.

Ruttan, Vernon W. 2001. Technology. Growth, and Development, New York: Oxford UniversityPress.

Sala-i-Martin, X., J. Blanke, M. Drzeniek Hanouz, T. Geiger, I. Mia, and F. Paua. 2007. Theglobal competitiveness index: measuring the productive potential of nations. In The globalcompetitiveness report 2007-2008, 3–50. Hampshire: Palgrave Macmillan.

World Economic Forum. 2011. The global competitiveness report 2011-2012. Technical report.World Economic Forum.

Part III

Strategy

121

Chapter 7

Alliances / Knowledge-IntensivePartnerships1

7.1 Introduction

The confluence of important developments in the international economic environment duringthe past two-three decades has turned inter-firm cooperation into an important mechanism ofbusiness interaction and market and technology access.2 Particularly in high- and medium-tech industries, the private sector has increasingly used various kinds of cooperative agree-ments such as joint ventures, joint R&D, technology exchange agreements, co-production,direct minority investments, and sourcing relationships to advance core strategic objectives.Called alliances (partnerships) in this paper, such agreements imply deeper and steadier rela-tionships than arm’s-length market exchanges but fall short of complete mergers. They involvemutual dependence and shared decision-making between two or more independent parties.When research and development is a focus of the partnership, universities and other researchinstitutes may also participate.

The proliferation of inter-firm alliances has raised expectations of accelerated long-termgrowth opportunities for developing countries through faster access to markets and technolo-gies and greater learning possibilities. Available evidence, however, shows that, although de-veloping country firms have increased their participation significantly, recorded partnershipsare still overwhelmingly concentrated in developed economies. It also shows that a rathersmall group of newly industrializing countries and economies in transition with significant ca-pabilities and domestic markets have benefited disproportionately more than others. Overall,the opportunities for widespread partnering for developing country economic convergencehas fallen short of expectations. Although indicative, such evidence should be interpretedcarefully. Not only is the underlying data subject to significant bias, the nature of recordedpartnerships has been changing dramatically. Rather than equity-based, the vast majority ofpartnerships during the past twenty years have been contractual agreements, catering to the

1. This Chapter draws significantly on the report “Partnerships and Networking in Science and Technology forDevelopment” prepared by the author for the United Nations Conference on Trade and Development (UNCTAD),Division on Investment, Technology and Enterprise Development (DITE) (2002).

2. See Malerba and Vonortas (2009), Caloghirou et al. (2004), Jankowski et al. (2001), Vonortas (1997).

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CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 123

pressing need for strategic flexibility in high-tech sectors. Strong arguments can be madethat non-equity agreements can play in favor of developing country firms as they require lesscommitment and get closer to informal kinds of cooperation. Numerous cases of transna-tional companies operating in developing countries and emerging economies have shown howcross-border partnering and networking can significantly raise those countries’ technologicalprowess and business competitiveness.

Analysts may, in fact, have overreached in trying to extrapolate from the experience ofdeveloped countries in forming expectations for developing countries. They may have paid toomuch attention to formal forms of partnering—like those mentioned above, involving explicitcontracting among parties—and much less attention to various forms of informal partneringamong organizations and individuals. Anecdotal evidence indicates that informal partneringprobably accounts for a very large share of partnering activity in industry, involving extensivelysmall and medium-sized enterprises (SMEs) in proximate geographical areas.

Formal and informal partnering should be seen as a continuum, where formal enterprisecooperation, clustering and networking are perceived as alternative, and often complemen-tary, modes of operation. Formal partnership requirements—including strategy formulationand significant partner contribution in tangible and/or intangible resources—may be placingthe bar too high for the majority of (mainly small) firms in most developing countries. That,however, leaves a whole lot of other cooperative interactions for these economic agents to pur-sue. It now seems quite probable that more informal partnering through networks and clustersis a way for many firms in developing countries to increase their sophistication and becomestronger and more competitive, thus gradually preparing for more formal partnerships.

For firms that do graduate to formal partnerships, this Chapter expounds a roadmap toharnessing their potential for promoting technological prowess and economic competitive-ness. Key lessons for success include a clear understanding of the firm’s objectives in thepartnership, the negotiation of a suitable agreement with sound dispute resolution and exitclauses, the treatment of the agreement as a “living” document, and the awareness of the im-portance of knowledge and relative capability distribution among partners. For these firms,policy decision-makers and international organizations have important roles to play in termsof spreading the message of partnership opportunities, on one hand, and in terms of creatinga supportive infrastructure, on the other.

Common Types of AlliancesThree types of alliance are particularly common:Equity shareholding Arrangement in which a company becomes a minority shareholder

in its partner through an equity investment. This action is often reciprocated by thealliance partner.

Example: In 1999, Renault and Nissan entered a strategic alliance through a cross-shareholding agreement, whereby each company purchased a minority equity stakein the other. Renault currently holds a 43.4% stake in Nissan while Nissan holds15% of Renault shares. This arrangement ensures that each company will act inthe financial and strategic interests of the other while maintaining its own identityand culture. Activities include joint production of engines, batteries, and other key


components.

Joint Venture Arrangement in which partners agree to contribute resources and equityto develop a new business entity with a specific purpose in mind.

Example: In order to save money on procurement operations, in 2011 DeutscheTelekom (DT) and France Telecom (FT) created a new 50/50 joint venture firmknown as BUYIN. The new company, which is based in Brussels, manages the pro-curement of terminal devices, mobile communications networks, and fixed networkequipment for the two telecom giants. The alliance is expected to save the compa-nies about €1.3 billion over the first three years of operation. Furthermore, DT andFT have expressed interest in expanding the joint venture to other areas such as ITinfrastructure in the future.

Contractual (non-equity) Arrangement that lacks shared ownership or dedicated admin-istrative structures. Cooperation is undertaken through non-equity based meanssuch as licensing deals, technology exchange agreements, sourcing relationships,co-marketing, etc.

Example: Malaysia’s AirAsia and Australia-based Jetstar teamed up in 2010 witha plan to reduce the two budget airlines’ operating costs. Through a non-equityalliance, the airlines agreed to explore opportunities to jointly procure aircraft, co-operate in passenger handling in Australia and Asia, pool aircraft components andspare parts, and jointly acquire engineering and maintenance supplies and services.The airlines expect the alliance to reduce costs, pool expertise and result in cheaperfares.

7.2 Context of Strategic Alliances

7.2.1 Definitions

Alliances refer to agreements whereby two or more partners share the commitment to reach acommon goal by pooling their resources together and by coordinating their activities. Partner-ships denote some degree of strategic and operational coordination and may involve equityinvestment. They can occur vertically across the value chain, from the provision of raw ma-terials and other factors of production, through research, design, production and assembly ofparts, components and systems, to product/service distribution and servicing. Or, they canoccur horizontally, involving competitors at the same level of the value chain. Partners may bebased in one or more countries.

A narrower set of partnerships can be characterised as innovation-based, focusing primar-ily on the generation, exchange, adaptation and exploitation of technical advances. Calledstrategic technology alliances (STAs) herein, these arrangements are of primary concern toboth developed and developing countries as a result of expected direct contribution to na-tional capacity building.

The most basic distinction in partnerships is between formal and informal agreements.Relatively little is known about the latter apart from anecdotal evidence that (a) many firms


routinely partner informally on short-term business endeavors, and (b) informal partnershipsmay account for the vast majority of collaboration. Informal partnerships are unfortunatelyalmost impossible to track down systematically. They fall more in the realm of clusters andnetworks to which we will return in the last section.

7.2.2 International Context

Since the early 1980s, when the first data were put together to map a sudden burst of inter-firm cooperation, it has been established beyond doubt that alliances have become a veryimportant mechanism of business interaction and market and technology access around theworld. A proliferating literature in economics, business and policy has tried to identify andinterpret the important features of cooperation among firms, universities, and other publicand private organizations.3

A set of developments in the international economic environment has underlined the ex-plosion of business partnerships since the late 1970s. Four changes, in particular, seem to bekey:

Globalization Transnational companies have pushed into new product and geographical mar-kets relentlessly.

Technological change The pace of technological advance has accelerated significantly, partlyas a result of increasing competition through globalization. In addition to being anoutcome of competitive pressures, however, technology is an enabler of globalization.Technological capabilities have diffused around the world more widely than ever before.

Notion of “core competency” Increasing international competition and faster pace of tech-nological advance have robbed firms of their ability to be self-sufficient in everythingthey want to do. The current management mantra is to do internally what a companydoes best and outsource the rest through partnerships.

Economic liberalization and privatization This process has led to unprecedented interna-tional flows of capital in the form of both foreign direct investment and portfolio invest-ment. Developing countries have managed to increase their share of the intake (but thedistribution among them remains highly skewed).

Such developments have changed the nature of international business interactions thathas supported the development of a score of developing countries since the mid-twentiethcentury. Traditional mechanisms of technology transfer including licensing, the acquisition ofcapital goods, and the transfer of complete technology packages through foreign investmentare being supplemented by many semi-formal and formal new mechanisms for gaining accessto technologies and markets. These new mechanisms entail the formation of dense webs ofinter-organizational networks that provide the private sector with the necessary flexibility toachieve multiple objectives in the face of intense international competition. The result has

3. For literature reviews see, for example, Caloghirou et al. (2003, 2004), Gomes-Casseres (1996), Gulati(1998), Hagedoorn et al. (2000), Hemphill and Vonortas (2003), Vonortas and Zirulia (2011).


been an increasing interdependence on a global scale that few firms interested in long-termsurvival and growth can escape.

The available literature on formal business partnerships and networking has tended to fo-cus primarily on developed countries: their firms have dominated global partnering records,at least as currently accounted for. OECD member countries have accounted for no less thanfour fifths of the activity over the years. More recently the rapidly developing economies ofChina, India, and Brazil have registered significant international cooperative activity, espe-cially large multinational corporations based in these countries. The same firms also dominateinternational trade and investment.4

The vast majority of the recorded alliances are classified as contractual agreements. Con-tractual agreements do not involve equity investment across partners or in the collaborativeactivity (such as in a joint venture). Sectors registering large numbers of partnerships aroundthe globe include pharmaceuticals, chemicals, electronic equipment, computers, telecommu-nications, and financial and business services. Service sectors took an increasing share ofthe total in more recent years. The motives of firms to partner differ among sectors. Cost-economizing (e.g., share costs and risks of a technological development) appears to be moresignificant in capital and R&D intensive sectors such as telecommunication hardware. Strate-gic considerations become important when firms use partnerships to enter new product areas,especially ones with high technological and market risk. In information and communicationindustries a major driving force towards international partnerships seems to be the effort todevelop new global product and system standards. In pharmaceuticals, cost economizing andspeed to market seem to be very important. In the automotive sector, securing resources todevelop state-of-the-art technologies for environmental friendly vehicles, achieving economiesof scale in production, and accessing markets appear to be major drivers. Finally, in the airlineindustry cost savings through investment in common systems of reservations, ticketing, andclient services appear to be the main driving force for international partnering activity.

Specifically, the number of recorded STAs which did not exceed ten per year during the1960s had jumped to about 150 at the end of the 1970s. Sharp increases were recorded dur-ing the 1980s, reaching about 500 deals by the end of the decade. A short respite in the firstcouple of years in the 1990s was followed by yet another increase in new STAs. Annual an-nouncements of STAs fell back to about 500 in the second half of the past decade. However, ourdatabases which have traditionally depended on public announcements of collaborative agree-ments are becoming less and less dependable as alliances have become mainstream strategy inindustry and they are not vigorously reported. Major databases have thus been discontinuedand others have become very problematic.5

A major development has been the contrasting evolution of equity-based STAs (e.g., tradi-tional joint ventures) and non-equity STAs in the past two decades. From almost 100% in themid-1960s, the share of equity-based STAs in the total fell to about 70% in the 1970s, 40%

4. For references to partnering in developing and transition countries see Deloitte (2004), Freeman and Hage-doorn (1994), Ivarsson and Alvstam (2005), Lee and Beamish (1995), Rondinelli and Black (2000), Si andBruton (1999), and Vonortas (1998). A series of publications by UNCTAD review the literature on partneringand networking for national capacity building (UNCTAD, 1999a, 1999b, 2000a, 2000b).

5. All three databases that tracked STAs were discontinued last decade: CATI (University of Maastricht, CORE(University of North Carolina), NCRA-RJV (George Washington University). Tompson’s SDC database is increas-ingly unreliable.


in the 1980s, less than 20% in the1990s, and less than 10% more recently. The gap has beenfilled by non-equity, contractual forms of STAs such as research consortia and joint develop-ment agreements that have provided the main mechanism of inter-firm collaboration in morerecent years. For instance, all countries with significant public R&D programs fund researchconsortia these days, with the most prominent example being the Framework Programmes forResearch and Technological Development of the European Union.

High-tech manufacturing sectors—information technology, pharmaceuticals, aerospace,defense—have gradually developed a dominant position in STAs since the early 1980s. Medium-tech sectors—instrumentation and medical equipment, automotive, consumer electronics, chemicals—have followed. High-tech sectors have strongly preferred contractual STAs, relative to medium-and low-tech sectors.

Turning to STAs with at least one partner from a developing country and/or an economy intransition, one starts from a rather small base but the trend is upward: developing countrieshave increased their participation in technology-intensive partnerships during the past coupleof decades. It is important to notice that important countries for alliances like Israel, the Re-public of Korea, and Singapore have graduated from the developing to the developed countrycategory. The distribution of recorded STAs is very skewed across countries, reflecting theirindustrial and technological sophistication (BRICs heading the list).

Capacity building in East Asia (UNIDO 2006)The Asian Tiger economies of Taiwan, Korea, and Singapore have successfully leveragedalliances to develop their technological capabilities and dramatically expand their GDPsover the past several decades. In each of these countries, the overarching governmentstrategy has been a three-fold process: (1) link domestic firms to the global economy inorder to build indigenous skills and technological capabilities; (2) leverage relationshipswith other nations and international firms in order to form meaningful connections withstrategic value; (3) learn as much as possible about international best practices and state-of-the-art technology, then build on these foundations and improve them.

In each nation, the government has taken a different approach to achieve these objec-tives and develop technological capabilities. These approaches are highlighted below.Taiwan Development of a national technology and innovation system focused on building

up the country’s export oriented SMEs.

• Investment promotion agency (for the identification of suitable industries andtechnologies)

• Science and technology institute (for acquisition, reverse engineering and dif-fusion)

• Export-marketing agency (to provide firms with relevant information on mar-kets)

• Agency to support clustering (to link larger firms to clusters of smaller firms)

Republic of Korea Promotion of large indigenous national firms that could quickly learnfrom and compete with developed country multinational corporations.


• Restrictions on foreign capital (to ensure that FDI, licensing agreements andtechnology exchange hastened the building of technological capabilities at theenterprise level)

• Institutional framework by which the Government allocated performance-based promotional privileges, such as subsidized credit, to a small number ofentities that became large conglomerates.

Singapore Promotion of linkages between indigenous SMEs and the global value chainsof multinational corporations.

• Incentive system and institutional framework to attract multinational firms

• Investment promotion agencies (which searched worldwide for firms and in-dustries to provide investment)

• Agencies responsible for industrial estates

• Export-processing zones

• Licensed manufacturing warehouses

7.3 A Practical Guide

Alliances can significantly expand opportunities for companies interested in accessing marketsand technologies and for governments interested in indigenous capacity building and eco-nomic growth. However, benefits do not flow automatically; nor do partners necessarily gainequally. There is a lot of learning associated with setting up and managing successful part-nerships and room for policy decision making to facilitate them. This section distills lessonsfrom past experience to draw a practical generic guide to negotiating and managing successfulpartnerships. It focuses mostly on partnerships with technological content (RTPs).

7.3.1 Partnership Opportunities and Dangers

Consideration of a business partnership must always start with a careful recount of the strate-gic challenges confronting the firm in question. Management must consider:

• Where does the firm want to go in the future? What are its strategic objectives?

• What are the necessary projected steps—organizational, technological, finance, market-ing, and so forth—to achieve the strategic objectives?

• To what extent do the required resources and capabilities exist internally?

The more tactical challenges for management considering a specific task include:

• What is the exact activity the firm is currently interested in and why can it not be eithercarried out in-house or bought from an external source?


• How is a partnership expected to assist in accessing the requisite resources and capabil-ities that the firm does not already possess?

• What kind of partners is the firm interested in? How is it going to identify them?

• How to successfully negotiate the partnership? What are the specific assets that the firmwill bring to the negotiating table? How much control can it afford to give away?

• How to manage the partnership and learn from it?

• How to set clear objectives for the partnership?

• How to evaluate partnership performance?

• When and how to dissolve the partnership?

From the point of view of the firm, potential benefits from partnering include:

• Access markets; create new product markets

• Share costs of large investments

• Share risk, reduce uncertainty

• Access complementary resources and skills of partners, such as complementary tech-nologies, people, finance; exploit research and technological synergies

• Accelerate return on investments through a more rapid diffusion of assets

• Rationalize the deployment of resources to enhance economies of scale and scope

• Increase strategic flexibility through the creation of new investment options

• Unbundle the firm’s portfolio of intangible assets, and selectively transfer componentsof this portfolio

• Co-opt competition

• Attain legal and political advantages in host countries

More broadly, alliances have such virtues as flexibility, speed, and economy. They can beput together in little time and be folded up just as quickly. They can involve little paperwork.An analogy of partnerships vis-a-vis market internalisation through mergers and acquisitionswould be “love affairs” instead of “marriages”.

Alliances also entail costs. Regardless of strategic goals, inter-firm collaboration alwaysimplies a trade-off between greater access (markets, finance, resources, capabilities) and lessercontrol of strategic decision making, day-to-day management, technological and other kindsof proprietary knowledge. Partial loss of control over strategic decisions, over technology use,and over market position can invite opportunistic behavior by one or more partners resultingin the involuntary loss of important assets, particularly intangible assets such as technologicaland other types of knowledge. Other potential drawbacks from partnering include:


• Increased transaction costs due to (a) increased management needs, (b) diversion ofmanagement attention, (c) employee coaching into the agreement, (d) decisions andresponsibilities that are subject to negotiation.

• Lack of compatibility of the collaborative activity with core firm interests; e.g., lockingthe firm into a product/service standard that may not be in its best interest.

It should be stressed that partners often join a partnership for different reasons. Reasonsfor participation can shift over time, implying shifts regarding the perceived benefits and costsof collaboration. The motivation to enter into a joint relationship must, then, be not onlystrong but regularly reexamined during the lifetime of the partnership.

7.3.2 Partner Choice

The existence of complementary needs, assets, and capabilities among partners is generallyconsidered a prerequisite for maximizing collaboration benefits and minimizing costs. Com-plementarities may be reflected in:

• Expertise in different, but commercially linked, technologies

• Strength in different, but commercially linked, markets

• Specialization in separate parts of the value chain

The trade-off of linking complementary organizations may be higher transaction costs forrunning the partnership. The chance for disagreements, for instance, between partners onmarket strategy, technology designs, and decision-making processes rises. Everything elseconstant, like-minded partners with similar management perspectives, goals and will result infewer conflicts and lower costs of managing collaboration.

A common alliance problem: the wrong partnerThe risks involved in strategic alliances increase substantially when the alliance is codifiedin a written contract, and especially when there is uncertainty about the future or a part-ner’s reliability. For example, when Dow Chemicals signed a $17.4 billion Joint VentureFormation Agreement with Kuwait’s state-run Petrochemical Industries Company (PIC) in2008, everything seemed to be on track for the creation of a new leading global plasticsmanufacturing company known as K-Dow. Shortly after the 50-50 joint venture deal wasinked, however, PIC’s parent company, Kuwait Petroleum Corporation, reneged on theagreement with concerns over the ensuing global recession.

The breakup of the joint venture agreement had severe consequences for Dow, whichhad expected $7.5 billion in revenue from the sale of several chemical plants to PIC. Priorto the debacle, Dow had agreed to acquire a rival firm, Rohm and Haas, with the fundsit had planned on receiving from the joint venture deal. Not only did the failure of theventure lead to a drawn out legal battle between Dow and PIC, but Dow is also facing alawsuit from Rohm and Haas for failing to honor the acquisition deal.

Sources: Sieb, C. (2008). “Kuwait decision to quit joint venture puts Dow Chemical’sExpansion in Jeopardy.” The Times, December 30, pp. 39; Westervelt, R. (2009). “Dow


launches arbitration proceedings against PIC,” Chemical Week, 171, p. 7.

7.3.3 Partnership Negotiation6

Negotiation is one of the most important aspects of partnerships. Depending on the objectives,experience, and complexity of the deal, partnership negotiation can be a difficult process.Reported negotiation length varies from a few weeks up to two years. Several issues areextremely important and tend to dominate the negotiation phase:

• Control of the partnership, including its equity structure and veto power over variousaspects in managing the partnership (appointment of key personnel, dividend policy,technology use, export markets, quality standards, supply sources, etc.)

• Conditions surrounding technology transfer. This is the most frequently mentioned itemin partnership contracts following control

• Dispute resolution

• Terms of partnership termination.

Common negotiation problems include:

• Valuation of the assets brought by each partner to the partnership

• Transparency

• Conflict resolution procedures—explicit rules and/or trust relationships

• Allocation of management responsibility and degree of management independence

• Changes in ownership shares as partnership matures

• Exit policy

• Dividend policy

• Measurement of performance

Managing alliances: Eli Lilly’s corporate strategyIn 1999, Eli Lilly established the pharmaceutical industry’s first “Office of Alliance Man-agement” which was established specifically to implement and guide alliances once agree-ments are made. Eli Lilly’s management recognized that most unsuccessful alliances faildue to implementation issues, personality conflicts and other non-technical factors. TheOffice of Alliance Management addresses these issues and works closely with partnersto ensure strategic, operational, and cultural alignment to optimize resources and meetalliance goals. This office is part of a larger framework of Eli Lilly’s alliance building strat-egy, which also includes offices geared towards identifying opportunities and negotiatingagreements with partners.

6. The section draws considerably on Miller et al. (1995).


Source: Gary Stach, (2006) “Business alliances at Eli Lilly: a successful innovationstrategy”, Strategy & Leadership, Vol. 34 Iss: 5, pp.28 - 33

Fairly common relationship problems include:

International strategy-related problems A particular type of conflict in cross-border alliancesmay occur when a multinational corporation (MNC) with a global strategy forms a part-nership with a local partner pursuing more narrowly defined goals. Global strategiesfrequently require the MNC to incur costs in one country in return for profits in an-other. Local partners may thus be placed at a disadvantage. Given that relationships canshift over time, this may become a problem during the course of the partnership. Suchproblems can include the following:

• Export rights. Exporting sometimes represents a fundamental difference betweenindustrial and developing country partners. A MNC may not want the partnershipto freely export products to markets already be served from other manufacturingpoints in its system. The developing country partner will be of a different opinionas it will typically view exports as a natural avenue of expansion.

• Tax issues. The optimization process undertaken by the MNC will cover its world-wide burden. If the partnership exports products through the TNC system, transfer-pricing strategy will not necessarily be in the interest of the local partner.

• Dividend, investment policies. The global investment programs of the MNC mayaffect its preference of dividends over reinvestment in the partnership. Again, thelocal partner may have diverging views.

• Partner size. Large size differences may introduce difficulties during rapid expan-sion periods of the partnership due to their different resource base. Size differencesmay also have operational implications that can cause problems (e.g., the largerfirm not taking the partnership seriously enough).

Ownership and control problems Long-term, strategic partnerships may need operationalmanagement with considerable independence from either partner. Problems may arisefrom changes during the lifetime of the partnership. A possible change involves the man-agement in one of the partners that may affect this firm’s attitude towards the specificpartnership. In addition, one needs to consider possible disagreements over time regard-ing changes in product lines, raw material sourcing, technology transfer and utilization,and so forth.

Cultural problems These involve both the social cultural backgrounds of companies basedin different countries and the corporate culture that characterizes each company. Bothtypes of cultures condition how people view their environment and how they interpretissues. Complaints concerning arrogance, business practice, corruption, and so forthhave not been unknown to partnerships.

Problems related to changes over time The changing environment within which the part-nership operates alters partner relationships and can cause stress.


• Experience in a partnership results in learning. Learning can modify how one viewsthe contributions of the partner. Learning should happen from all sides and in-volves better market understanding and improved capabilities. Learning boostsself-confidence and raises expectations for partner contribution. The result some-times is dissatisfaction. Moreover, dissatisfaction is frequently the result of differ-ential rates of learning that make a firm feel falling behind its partners.

• Unforeseen changes in circumstances making parts of the agreement obsolete. In-troducing the necessary modifications may be difficult, even in the case that allsides agree.

Common alliance problem: differential rates of learningLooking to expand into the Japanese marketplace in the 1970s, General Foods Corporationentered a partnership with Japanese food giant Ajinomoto. Ajinomoto offered its mar-keting expertise and knowledge of local business practices in Japan, and General Foodsagreed to disclose its advanced processing technology for products such as freeze-driedcoffee. After several years of successfully partnering together, Ajinomoto’s managementbegan to feel that the alliance was unnecessary because Ajinomoto had internalized theadvanced processing technology and was no longer learning from its American partner.General Foods, however, was not as successful learning about the Japanese marketplaceand still needed Ajinomoto’s expertise. When the collaboration deteriorated and eventu-ally disbanded, General Foods was left disappointed.

Source: Barlett et al. (2008) Transnational Management: Text, Cases and Readings inCross-Border Management. 5th ed. New York: McGraw-Hill.

7.4 Conclusion

The proliferation of partnerships during the past three decades has raised expectations ofaccelerated growth through faster access to markets and technologies and greater learningpossibilities. There is evidence that inter-firm partnerships can be an extremely useful tool toassist developing country firms in their efforts to catch up. Partnerships can accordingly assistcountries speed up the process of establishing competitive indigenous industries. Partnershipscan also play a major role in mobilizing the necessary resources and technological expertise toupgrade lagging infrastructure.

The evidence of formal collaborative agreements captured by large databases is, however,still concentrated in certain geographical areas and sectors. This has been interpreted to implythat the expectations of widespread catch-up opportunities through partnerships have not yetmaterialized (Freeman and Hagedoorn, 1994). We have argued elsewhere against that suchinterpretation on two grounds. First, partnerships alone cannot be expected to bring devel-oping economies on par with industrialized economies. They are but one of many factors en-abling firms to enhance competitiveness and supporting rapid rates of economic growth. Sec-ond, intensive international inter-firm collaboration is a relatively new phenomenon where,


with few exceptions, developing countries have made their presence felt only the past 10-15years. In other words, it is simply too early to tell.

It is also possible that analysts have tried to extrapolate too much too fast from the expe-rience of developed countries, missing important flags. Going back to the basic dichotomy be-tween formal and informal partnerships, the available empirical information has overwhelm-ingly been on the former. In contrast, we have a lot of anecdotal but little systematic infor-mation on the latter. Available anecdotal evidence strongly indicates that informal partneringprobably accounts for the lion’s share of partnering activity in industry. It involves firms andall other kinds of organizations, but it involves especially small enterprises in proximate geo-graphical areas.

In fact, we have developed various terms to capture aspects of more informal modes ofinteraction. We talk about clusters. We talk about districts. We also talk about networks. Eachterm means something different, but they also share considerable ground: the willingnessand ability to interact closely with the surrounding environment, with peers, with buyers andsuppliers—by and large on an informal basis. An expanding literature has, in the past fewyears, tried to amass evidence of such interaction and of policies that promote it in developedand developing countries.7 Various programs have been implemented by development agen-cies around the world to promote clusters and networks (UNIDO, 2001). The next Chapterdeals with them directly.

Formal and informal partnering should be seen as a continuum, not unlike the way en-terprise cooperation, clustering, and networking are portrayed next to each other in UNCTAD(2000a, vol. I). Then, the question is not anymore whether partnering helps developing coun-try firms to grow competitive. The question rather becomes which kind of partnering maybe more appropriate—or more prevalent—at different stages of development and in differentsectors.

Available data on formal partnerships show that the vast majority of them involve par-ticipants from developed countries (Section 2). An increasing, but still minority of cases in-volves participants from few countries in the upper echelon of NICs, few countries in transi-tion with significant industrial capabilities, and few developing countries with large domesticmarkets and/or relatively low-priced resources (increasingly semi-skilled and skilled humanresources). Little else remains. While part of this skewed distribution undoubtedly reflectsdata collection bias, it would be difficult to attribute everything to bias. Simply put, formalpartnerships have not appeared able to reach most developing country firms. Not until now,at least.

Formal partnerships require strategy formulation and partner contribution, whether in fi-nancial resources, intangible assets, market familiarity, market access, etc. Frequently, therequired level of strategy sophistication and resource commitment is considerable. It is, thus,quite possible that these requirements raise the bar too high for the mass of (mainly small andunsophisticated) firms in the majority of developing countries. Hence, it could be argued, therelatively slow trickling down of partnering to the majority of developing countries.

Still, this leaves many other interactions for these agents to pursue. It seems quite probablethat informal partnering through networks and clusters is a way for many relatively disadvan-

7. See, for example, Casas and Luna (1997), Casas et al. (2000), Humphrey and Schmitz (1995), Levitsky(1996), Perez-Adelman (2000), and Vonortas (2002).


taged developing country firms to become stronger, more competitive, and to meet the mini-mum capability prerequisites in order to graduate to formal partnerships. Governments maybe wise to try addressing most small firm problems related to size and competitive positionthrough networks (often more vertical, supplier-buyer relationships) and clusters (regional,more horizontal, agglomerations).

For firms that do graduate to formal alliances, the following are key lessons for success:

• Clearly understand the strategic objectives of the firm.

• Clearly determine the firm’s needs from the partnership.

• Negotiate a suitable agreement.

• Treat the partnership agreement as a “living” document.

• Understand that the comparative advantages of partners at the outset of the agreementmay change over time.

• Be aware that technology transfer is one of the most sensitive and contentious issues.Create clear provisions for a framework of technology use in the partnership.

• Partnership agreements must contain sound provisions for dispute resolution and, in theevent of irreconcilable differences, the exit mechanism to be employed in terminatingthe partnership.

• Monitor and review the partnership throughout its lifetime.


Appendix 7.A Petrobrás Subsea Boosting Technology Devel-opment

Over the last several decades, Brazil’s Petrobrás has evolved successfully into a global leader indeep sea drilling techniques by using strategic alliances to help it absorb external knowledgeand generate unique solutions. Particularly, the alliance strategies that it employed during the1980s and 1990s played a crucial role in its development of subsea boosting technologies.

Subsea boosting refers to technologies that increase the flow rate of wells in deep seaoil fields. This has been an important area of concern for Brazil since most of its recentlarge oil discoveries have been found under these conditions. Before Petrobrás utilized subseaproduction, it was limited to using a Floating Production System (FPS) which was subject toproblems including limited depth capabilities and setbacks due to poor weather.

Petrobrás’s development of Subsea Multiphase flow Pumping Systems (SBMS) showcaseshow it navigated these challenges to join the select club of firms that operate subsea productionsystems. It began with little to no knowledge of the technology, but was able to join anindustry project to research SBMS technology, led by Scottish pump manufacturer Weir Pumps.Petrobrás’ role in the project was limited due to its lack of experience, but it was able to use thisexperience to monitor the progress in SBMS technology and understand new developmentsthat occurred.

The project ultimately failed, but Petrobrás succeeded in gaining a much deeper knowledgeof the hurdles facing the technology and which competing avenues held promise. This knowl-edge helped Petrobrás take the next step and establish a technological cooperation agreementwith German pump manufacturer Borneman, with the goal to develop a prototype systemthat was suited for utilization in Brazil’s offshore fields. It took a much more active role inthis project and contributed extensively to a testing campaign that identified and ultimatelysolved the bottlenecks in the system. By 1997, Petrobrás was ready to put the innovation intoproduction. At this time, Petrobrás ended its relationship with Borneman and entered a newjoint industry project in which Westinghouse, Leistritz, and a host of other suppliers wouldtake part in delivering the system to Petrobrás. The decision to shift away from Bornemanwas purely an economic choice. Petrobrás had already acquired the technological know-howit needed to implement the system and became more concerned with system costs than tech-nology development.

The experience of Petrobrás in its development of SBMS systems highlights how it useddifferent modes of partnering at different stages of development in order to attain the max-imum benefit at each stage. In the first stage, it was mainly concerned with learning aboutopportunities, and the joint industry project served as an entry point to monitor progress inthe sector while minimizing costs to the firm. From here, Petrobrás was able to develop itsown technology through a technology cooperation agreement and ultimately mastered thistechnology. Finally, it commercialized this technology through the use of industry collabora-tion in order to reduce its costs. Although the Petrobrás experience is special due to the greatamounts of capital available to the company, it illustrates how partnering is a fluid endeavorwith requirements that change and evolve as a firm progresses towards its objective. Source:Furtado, André Tosi and Adriana Gomes de Freitas, 2000


Appendix 7.B Tata-Fiat Joint Venture

The challenges of developing a successful joint venture are exemplified by the partnershipbetween the Italian automaker Fiat and its Indian partner, Tata Motors. In 2007, the companiescreated a joint venture firm to produce engines, transmissions, and complete automobiles atplants in India. With a strong relationship previous to the agreement, the JV firm seemed likea natural progression for two companies with similar values and objectives. Fiat already hada presence in India for several decades, and established a wholly-owned subsidiary, Fiat India,in 1995. However, the Indian subsidiary struggled in the following decade, leading companyexecutives to believe the company could not ‘go it alone’ in the Indian market. They felt thatFiat needed a committed partner to identify appropriate products and prices for the Indianmarket, build an effective distribution network, and commit to a long-term arrangement. TataMotors, on the other hand, was in a position to benefit from Fiat’s technical expertise andglobal business network.

In 2005, the two companies began a dialogue on how they could mutually benefit fromcooperation. Through high-level discussions, Fiat and Tata executives soon realized that thecompanies had much to gain from one another. The meetings soon led to a Memorandum ofUnderstanding, which solidified their intent to “analyze the feasibility of cooperation, acrossmarkets, in the area of passenger cars that would encompass development, manufacturing,sourcing and distribution of products, aggregates and components.” A year later, the twocompanies signed an agreement for a dealer sharing network in India, with Tata Motors man-aging the marketing and distribution of two Fiat models, the Palio and Palio Adventure. Soonthereafter, the head of Tata Motors, Ratan Tata, was appointed to the board of directors ofFiat, signaling a new era of cooperation between the firms. This increasing level of integrationset the stage for the fifty-fifty joint venture, which was agreed upon after a long negotiationprocess involving aspects such as asset values and exit clauses. The agreement seemed at firstto be a golden opportunity for both firms.

Four years later, the alliance between Fiat and Tata is still in operation, with over X vehi-cles produced by the joint venture since its inception. However, as of 2011 the partnershiphas yet to break even and has been on shaky ground in recent months. Fiat’s product line hasstruggled to gain ground in India, with many analysts pointing a lack of Fiat model variety,and a poor perception of Fiat in India generally as the source of strains. Still, the challengesassociated with the partnership may run deeper than product lineup and marketing failures.Many cultural differences exist not only on a corporate level, but on a national level as well.The future of the Fiat-Tata alliance is still uncertain, but one thing has become clear: exec-utives from both firms must work together to improve Fiat’s image and appeal in the Indianmarketplace if the venture is to succeed in the long-run. Sources: Ariño, áfrica et al., 2008;Chaudhari, Yuga, 2011

Appendix 7.C Vodacom-CWN Joint Venture

The importance of cultural congruity can be highlighted by the troubled relationship betweenSouth African telecommunications firm Vodacom Group, and the Democratic Republic of theCongo’s Congolese Wireless Network (CWN). In December 2001, the two companies formed


a strategic alliance with Vodacom’s purchase of a 51% stake in CWN, and the subsequentestablishment of a new telecommunications firm in the DRC, known as Vodacom Congo. Inthe early 2000s, Vodacom had already established a strong customer base in South Africaand expanded internationally into the nearby African countries Lesotho, Mozambique, andTanzania. However, its largest competitor was involved in 15 African countries and some partsof the Middle East. The DRC represented one of the fastest growing markets in Africa, andhad high potential for further expansion. These factors made it a prime target for Vodacom’sexpansion plans.

There existed several challenges in the DRC marketplace such as political instability, eco-nomic uncertainty, existing rivals within the country, and the difficulty of securing a licenseto operate. With these issues in mind, Vodacom executives decided a partnership was thebest route to take. From CWN’s perspective, Vodacom offered desperately needed techno-logical expertise. The marriage between the two firms and the resulting joint venture wasinitially successful, with Vodacom Congo growing from CWN’s initial 20,000 customer base in2001 to 2.6 million in 2007, becoming the DRCs largest telecom company. However, culturaldifferences plagued the alliance from the outset, and perceptions of inequality tarnished therelationship between South African and Congolese employees. There was an unequal distribu-tion of income, opportunities, and decision-making power between employees. Furthermore,the South African staff was criticized for arrogance and disrespect. According to interviewswith Congolese employees, South African managers routinely ignored dress codes, made noeffort to learn the language, and did not mingle with Congolese colleagues at social functions.These tensions soured the mood between workers over time and fostered a workplace withlittle mutual respect.

Although top executives realized this problem and made attempts to improve the institu-tional structure of the firm, animosity remained between workers. Over the following yearsthe company lost ground to competitors, falling to the number three operator by 2010. Thefinal nail in the coffin may have been Vodacom’s proposed cash injection of $484 million intoVodacom Congo, which would have significantly diluted CWN’s shares in the company andcaused objections from its staff. The confrontation set the stage for Vodacom’s decision to sellits shares in Vodacom Congo and exit the DRC market, a process which is still ongoing as ofNovember 2011. In the end, this case represents a failure of understanding and respect amongcultures, contributing to the downward slide of a potentially successful venture.

The case illustrates that, even in ventures involving two developing countries, feelings ofmistrust and disrespect can develop if significant attention is not given to preventing theseissues. This effort cannot be made on a piecemeal basis, as the issues are interrelated andno single component can be dealt with in isolation. Reforming the management policies andstructures of a partnership must be accompanied by social and cultural efforts as well. Sources:Gomes, Emanuel, Marcel Cohen, and Kamel Mellahi, 2011; Malakata, Michael, 2011.

Appendix 7.D Indus Towers Joint Venture

A recent example of a successful joint venture in the telecom industry is the story of the Indiantower management company Indus Towers. Indus Towers was established in November 2007through a joint venture between Bharti Airtel, Vodafone Essar, and Idea Cellular, with the goal


of reducing passive infrastructure costs for each company. Over the past decade, the Indiantelecom industry has been undergoing extraordinary growth, with some experts forecastingan 80% penetration rate by as early as 2017. Early competition in this industry was intenseand marginal revenues were very low compared to other countries, which led to challengeswith capital investment in new tower infrastructure. At the beginning of 2007, only 25% ofwireless towers in India were shared between telecom operators. This system was inefficientfor operators because firms were building towers in overlapping areas that could easily beserviced by a single tower.

Bhati Airtel and Vodafone Esser, the two largest private telecom-services providers in India,realized they could cooperate on tower development while remaining competitive in their corebusinesses of providing telecom services. Together, they decided to jointly establish an inde-pendent firm to construct and manage towers throughout the two firms’ common operatingregions. Idea Cellular, the third largest telecom operator in India, was also offered a smallershare in the new firm and eagerly accepted based on the expansion prospects it could provide.

Negotiating and implementing the terms of the joint venture included several challengesthat needed to be resolved by the parties involved. Determining how to value the assetsthat each company contributed was an early area of friction, which was resolved through theestablishment of a point system where towers were rated based on attributes such as locationand size. The companies then contributed capital for new towers such that the point valueswere equal among each partner. Other early issues included network downtime, the lack ofa standardized data sharing platform, and conflicts between strategic company objectives. Inthe face of these challenges, Indus Towers was able to find solutions in large part due to equalrepresentation on the management board and a shared understanding of the challenge thatneeded to be solved.

Over the past four years, Indus Towers has grown into an efficient vehicle to operate towersthroughout the country and has successfully evolved into an independent tower company.Today, Indus Towers is the largest telecom tower company in the world with a portfolio ofover 110,000 towers and plans to add 5,000 more each year until 2015. Sources: Gulati,Ranjay et al., 2010;


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Chapter 8

Clusters / Science Parks / KnowledgeBusiness Incubators

8.1 Introduction

As information and communications technology (ICT) grew more advanced during the 1990s,some observers predicted that geographic location would cease to be a determining factor ineconomic development. In the old economy, factories had to be near raw materials like coalor iron ore. In the new economy, business would be global, with workers across the globeengaging with one another via mobile devices and the Internet. Instead, the last 20 yearshave shown that location still matters. While some services (e.g. call centers) have beenoutsourced, they’ve been outsourced to particular places, like Bangalore in India, where manycompanies compete for business within a geographically restricted space.

With this realization, economic development is now focused on creating local and regionalagglomerations with a specialty, often aimed at the high-technology sector which is perceivedto have high growth and export potential. This chapter focuses on these agglomerations,called clusters, and two related policy options for encouraging hi-tech growth, Science Parksand Knowledge Business Incubators. Despite the fact that many parks and incubators remainlimited in scope, policy makers sometimes view such subsidized initiatives as the first seedsor stages of an economic continuum leading ultimately to the emergence of a vibrant hi-techcluster with many profitable private firms.

8.2 Clusters

In the second quarter of 2011, the Silicon Valley Region of the US State of California captured39% of the roughly $7.5 Billion in US venture capital funding in that quarter. In a nationas vast as the United States, how did one relatively small geographic region, far from thefinancial and political centers of the US East Coast come to play such an important role intechnology and innovation? The answer is that Silicon Valley is a phenomenally successful hi-tech industrial cluster. Promoting cluster formation remains a common yet elusive goal amongtechnology and industrial policy makers across the world.

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CHAPTER 8. CLUSTERS / SCIENCE PARKS / KNOWLEDGE BUSINESS INCUBATORS 144

8.2.1 What is a Cluster and why are they desirable?

Just as moving people from a dispersed rural setting, to a dense urban one increases interac-tion and economic efficiency, so does concentrating businesses and specialists in one regionincrease their productivity and innovation. Michael Porter offers this succinct definition ofclusters:

Geographical concentrations of interconnected companies, specialized suppliers, ser-vice providers, firms in related industries, associated institutions (for example universi-ties, standards agencies, and trade associations) in particular fields that compete but alsocooperate (Porter 1998)

More generally, clusters are agglomerations of people, firms, institutions, and other eco-nomic actors working in a similar field who interact in a relatively small region. While thischapter focuses on hi-tech clusters, such as in the fields of biotechnology and informationand communication technology, low-tech clusters can also be extremely important economicdrivers.

Indeed economic dynamism and innovation are precisely the qualities that attract pol-icy makers to aid cluster-formation. High paying jobs, high economic growth, market domi-nant companies with export potential, and the prestige of being an international technologicalleader, are just some of the reasons hi-tech clusters are so valued. A cluster can become aglobal center for the activity performed there, drawing investment from across a nation andthe world. Examples of such dominant clusters range from financial services (Manhattan,City of London); shipping (Athens, Singapore); fashion (Milan, Paris); film and entertainment(Hollywood, Mumbai). Hi-tech clusters include electronics and software like Silicon Valleyor biotechnology like Route 128 in Boston. Often hi-tech clusters draw on the talent of topuniversities in the previous examples, Stanford and UC Berkeley and MIT and Harvard respec-tively.

Clusters are often described geographically, but it is not merely the proximity of relatedfirms and institutions which makes them successful. It is the social interaction between eco-nomic actors which help to drive innovation. A university may contain a brilliant scientist, afirm may retain a skillful lawyer or engineer, and a banker may possess access to great sumsof capital, but if they never meet and discuss the ways that each may help the other a newinnovative company is unlikely to be formed. In successful clusters, such collaboration andentrepreneurialism is profitably fostered.

Does an Innovative Cluster need to be High Tech?For almost all developing countries it would be foolhardy to literally create “The NextSilicon Valley”. It is not necessary to go after a leading edge high tech field such as soft-ware, biotechnology, or advanced materials to be innovative. Applying new technologiesto older industries and encouraging an environment of collaboration, competition, en-trepreneurship while extremely difficult, can boost the competitiveness of a region. Oneexample is the Sinos Valley region of Brazil, which has grown from a regional center ofshoe production into a major global exporter of shoes. Firms there have developed strong


ties between firms, suppliers, and international retailers; this has dramatically increasedthe efficiency and scope of production (Nadvi 1995).

8.2.2 Why do Industries Cluster?

When many businesses of the same type gather in one region, information sharing betweenfirms, competition, and specialization spur development. A virtuous cycle develops wherepeople seeking to be at the forefront of their field choose to live in the leading cluster andlarge talent pools in turn attracts more businesses. Workers then are even more likely to moveto such an area because they are confident of finding employment and so on. Specializedfinancial institutions, tailored to a particular industry emerge, making business transactionseasier. Increasing rates of return and positive externalities are key features of clusters (Breschiand Malerba 2005).

Michael Porter’s Diamond Model

Figure 8.1: The Diamond ModelPorter popularized the Diamond Model as a way to analyze a region’s strengths and

weaknesses. Factor conditions refer to a region’s inherent properties, such as skilled la-bor, access to capital, natural resources, and institutions. Demand conditions describe thestructure of a region’s home market. If the region’s home market contains many sophisti-cated consumers of a technology, the region will be at an advantage because of the rapidmarket feedback they can receive. The web of supportive and related industries can alsoplay a key role for the emergence of a cluster. Companies with active and engaged suppli-ers are more likely to innovate. Firm strategy, Structure, and Rivalry defines how firms ina regional cluster will relate to one another. Collaborative, open relationships can speedthe transfer of knowledge among market participants, but rivalry can also spur innovation


through competition. The government can influence all aspects of market environmentthrough its use of regulations, subsidies, taxes, education policy. Finally chance can heav-ily influence the developmental trajectory and cannot be fully controlled by either firmsor the government (Porter 1998).

Clustering also occurs because of the characteristics of four different kinds of knowledgerelative to spatial proximity. These knowledge types are sometimes simplified as “Know-what”,“Know-why”, “Know-how”, “Know-who”. The first, “Know-what,” refers to an up to date un-derstanding of the state of the field. Both with regard to technology and changing businessconditions; a firm grasp of formal and informal business and science news and facts. Know-what is needed to understand what direction companies should be moving in and is criticalfor strategic planning.

Analytical or scientific knowledge makes up “Know-why” which can be thought of as expla-nation of the works of nature. Both “Know-what” and “Know-why” are codifiable, that is, theyrefer to knowledge amenable to being written down, codified, and transmitted. Thanks tomodern communication technology, codified knowledge can be transmitted around the worldin a matter of seconds. Imagine a racing automobile; there is a great deal of information whichcan be transmitted about its qualities, specification, and care. This information can be foundin blueprints, owner’s manuals, cost invoices, and in detailed engineering test data. However,one would be hard pressed to take all this data and put together a championship Formula Oneracing team from even the most intelligent and athletic group of people unfamiliar with autoracing.

This is because a third kind of knowledge the “Know-how” is also critical. Tacit knowledge,also referred to as “learning through doing”, is not easily transferred over long distances. Suchknowledge, like the ability of a mechanic to instantly diagnose an unusual engine problem ora driver to know exactly how much to engage the clutch when approaching a hairpin turncannot be appropriated through reading a book. Tacit knowledge is said to be “sticky” notmoving fast or far from those who have it. Many industrial processes involve a great deal oftacit knowledge. Only by working side by side or closely collaborating can individuals fullymaster the ability to efficiently complete certain tasks.

Finally, “Know-who” refers to who knows how to do what, that is, information linking indi-viduals and organizations to particular pieces of knowledge. Put differently, networking is theintimate knowledge of which individuals are truly important as innovators and institutionalgatekeepers. Reputations can be difficult to judge from afar. Media sources may report onscientists who are the most interesting to readers or “colorful” while ignoring those in the fieldwho are truly driving progress. Similarly in government or corporate bureaucracies, some-one who holds a certain high rank or title may not actually be the key to an organization’smanagement.

Location makes a significant difference for the application of all four types of knowledge.While tacit knowledge and networking are most obviously tied to geography, it turns outthat much of analytical knowledge is as well. A study of research cited in patents revealsthat papers from nearby universities are more likely to be cited than papers from universitieslocated farther away (Fagerberg, et al. 2005).


The Importance of Small and Medium Enterprises (SMEs) in Clustering and Innova-tionThe common perception of a “high-tech” company remains a large wealthy corporationwith gleaming research labs full of expensive equipment. And it’s true that such companiesdo invest a great deal of money in research and development, employ many scientists andengineers, and produce very complicated, state of the art products. But fundamentally,innovation is a profoundly disruptive process. For many corporations, game-changingtechnologies are a threat to a good business model. Small companies, especially start-ups,have little vested interest in the status quo and therefore are more likely to bring to markettruly innovative products.

8.2.3 Agglomeration vs. Innovative Clustering

Cities have long contained districts which cater to a specific type of industry. Sometimes thisoccurred because of deliberate policy—grouping all butchers and abattoirs in one block to sep-arate the process of animal slaughter from the rest of the city. Often though, and especially asmodern industry began to emerge, clusters formed organically as tradesmen grouped togetherto leverage economies of scale and to more effectively compete for business. A history of theoriginal industrial revolution in Britain testifies to the importance of such clustering,

Very shortly other ’external economies’ developed. Once a pool of skilled labour grewup in a mill town that added to the ’inertia’ of location. It made it more worth the whilefor expansion to occur in the same locality. A factory-trained labour force, of semi-skilledwomen and adolescents, was also an immense local advantage by the second genera-tion. Another very important external economy was the convenience of specialized serviceindustries—such as the bleaching firms, the machine-making shops, machine-servicing fa-cilities which grew up in the shadow of the mills. All these things exercised a ’centripetal’pull on the cotton industry. . . (Mathias 1969)

However, industrial clustering should be differentiated from simple agglomeration. Whilenot a cut and dry distinction, one key difference is the degree of backward and forward link-ages between firms. Some regions, perhaps because of easy access to a vital natural resourcetend to specialize in the production of a particular good. While such groupings may contributeto certain positive externalities such as a deep talent pool, they may not on their own lead toan innovative or competitive environment.

Local Living Conditions—Amenities as a strategy for talent attractionWhile the greatest force which pulls skilled workers to a cluster is the promise of con-tinuous employment because of the large number of specialized local firms, secondarylocational traits can help to lure employees towards an emerging cluster. Bangalore sitson a plateau, unlike other major Indian cities which are located near the ocean or in trop-ical lowlands. The pleasant climate is a real advantage. Boulder, Colorado, a fledglingtech hotspot, is located on the front range of the Colorado Rockies. The scenic views and


opportunities for outdoor recreation represent a significant recruiting tool, as employersseek to attract highly educated, and highly mobile workers. Universities, too, serve toenhance the appeal of an area. Cultural events such as concerts, lectures, and art exhibitsthat universities often sponsor provide opportunities for recreation and intellectual stim-ulation which may be otherwise lacking in industrial towns. Developing countries withsignificant foreign diasporas seek to attract their citizens back home with similar incen-tives. For top performers they offer high-quality housing, personal attendants, drivers,and recreational facilities along with plum administrative positions.

Linkages are crucial, especially between SMEs. One of the advantages of a large corpora-tion is the degree of communication that can occur within a company. Bureaucratic politicsaside, employees of the same large company are essentially working towards the same goal.But SMEs are often in direct competition with one another. Strong communication that leadsto innovation separates an innovative cluster from a stagnant agglomeration.

Backward linkages are the connections between businesses and their suppliers. Forwardlinkages are the ties between businesses and their customers. The more information that flowsup and downstream, the more innovative and responsive a company can be. Knowing thata battery supplier is close to a breakthrough in lightweight battery research and also havinga market survey which shows that joggers dislike the heavy weight of current music players,could put a company in a good position to develop a new model music player developedspecifically for the jogging market. Without the information the company might continue toproduce the same heavy music player mindlessly until it was forced to adopt the new batteryby its competition.

Cities: People Magnets in Flat WorldThomas Friedman popularized the concept of the "flat world" in which information andcommunication technologies combined with widespread political and economic reformsover the last 20 years have changed nature of international trade and competition. Whilepreviously nation-states and then multi-national corporations were the main drivers ofglobalization, Friedman argues that individuals are now competing on a global scale.Furthermore new technology means that the best and brightest from all over the worldcan compete without needing to move to a “leading” country to be successful (Friedman2005).

Richard Florida also views people as the key to public policy surrounding innovation.In contrast to Friedman though, he argues that people’s talents aren’t likely to be fullyexpressed unless they can live in close contact with other skilled people. Florida looks tocities as the engines of economic growth, and says that while the world may be flatteningfor 2nd and 3rd tier cities and workers in manufacturing; 1st tier cities with a high degreeof innovation are pulling even further ahead. He calls these cities “spiky” because oftheir high degree of economic and innovative activity in contrast with the surroundingcountryside.

Florida points out that people look for different amenities in cities at different timesduring their lives. Young people are looking for lots of economic activity and a large po-


tential mating pool. Middle-aged workers tend to want safe neighborhoods and excellentschools for their children. Top knowledge workers want to live in diverse cities that acceptcreative individuals and their sometimes non-conformist behavior (Florida 2008).

8.2.4 Case Studies in Cluster Formation

Silicon Valley

Much of the enthusiasm for clusters is linked to success of the first, modern high-tech clus-ter, Silicon Valley. Despite advances in other regions throughout the US and the rest of theworld, this area south of San Francisco, California still attracts the best and brightest mindsin engineering, software, and web development. Silicon Valley did not emerge as the techpowerhouse it is today overnight. In fact, the San Francisco Bay region has been an importantcenter for innovative radio and electronic research since the early 20th Century.

Silicon Valley’s name though, is a hint at the key driver of large scale growth. The develop-ment of the transistor or semiconductor, a key ingredient of which is silicon, was central to theregion’s success. The Dean of Engineering at Stanford University, Frederick Terman, helpedcreate the Stanford Industrial Park in 1951. Companies, including many founded by Stanfordgrads moved onto this real estate to be closer to the research being done at the University andto have better access to promising young engineers.

Beginning with the seminal Shockley Semi-Conductor Laboratory in 1955, a series of spin-offs and startups led to rapid innovation in the high-tech electronics field. These early firmswere heavily supported by procurement from the US government, especially the military whichused the hardware in aircraft, missiles, and other advanced weaponry. Activity was acceleratedby the spin-off culture. Partially a result of the region’s existing business culture, it was alsoaided by the state of California’s ban on non-compete contracts. In many states employees arebarred from starting work on new projects that could directly compete with their former em-ployer. In California, without such restrictions, there are stronger incentives to take advantageof business opportunities provided by technological advancement.

Technical expertise and an entrepreneurial culture weren’t the only factors contributingto the Valley’s rise. As early as the late 1960’s, Venture Capital firms and boutique law firmsbegan to do business in the area. These specialized legal and banking services made it easierfor first time businessmen to make the leap from employee to owner. As the number of peoplewith start-up experience grew, there were more opportunities for mentoring relationships todevelop. Experienced investors guided their protégés in business development. Strong sociallinks were formed between entrepreneurs, stimulating the flow of information about techno-logical developments and investment opportunities.

Some of the drivers of Silicon Valley’s growth have remained constant; a cooperative, col-laborative, and entrepreneurial business climate, a strong talent base of scientists and engi-neers, regional pride and rivalry, and close university-industry relations. Others have devel-oped later and aided growth or have faded away, such factors were; government procurementcontracting, venture capital infrastructure, specialized legal firms, high intra and inter-nationalimmigration, cheap land values (Kenney 2000; Hospers, et al. 2009).


Bangalore, India

Bangalore in the state of Karnataka, India was once known primarily as a resort for retiredpersons. Today it is the third most populous city in India and the center of the country’stelecommunication, defense, computer, and IT industries. With a fast growing and dynamiceconomy, Bangalore attracts skilled engineers from across India and transnational corporationshoping to utilize this talented, skilled workforce at lower cost than in the West.

Bangalore’s success stems in part from two structural components which are similar toSilicon Valley. The first is presence of large companies working for the Indian governmentworking to develop high tech products for telecommunications and defense. The second is thelarge number of quality post-secondary educational institutions which are sited in Bangalore.The decision to concentrate such activities in Bangalore was made years ago when India main-tained a highly regulated domestic economy. As trade liberalization began in the late 1980sand early 1990s, exposure to imported goods produced by foreign manufactures increased thelevel of completion among firms to produce higher quality products. Businesses owners in theregion are tightly linked through a variety of ties, including college alumni and business clubs.

The opening of a Texas Instruments plant in Bangalore in 1985 was a watershed moment.Since then, many other foreign technology companies, including Google, Microsoft, IBM, andOracle, have invested in Bangalore, often in one of two hi-tech, industrial parks, ElectronicCity and Whitefield. Many foreign companies view Bangalore as a cost effective locationfor research and development. Indian hi-tech companies specializing in IT, engineering, andmanagement consulting have seen rapid growth. Wipro and Infosys are the second and thirdlargest ICT Indian ICT companies and are headquartered in Bangalore. From 1995-2005 theICT sector has grown to over 70% of Bangalore’s total exports. In 1995 Bangalore’s ICT sectoraccounted for less than 0.25% of India’s total exports, by 2005, that figure had reached 6%.Bangalore stands as a prime example of how to leverage its strengths, English speaking, highskilled, low cost labor to attract foreign companies and in turn foster the development ofinnovative and globally-successful domestic firms (Van Djik 2003; Grondeau 2007).

Silicon Wadi (Israel)

Over the past 20 years, Israel has established itself as a world leader in a variety of ICTbusinesses. This success stems from a variety of factors, including deliberate governmentpolicy. Israel’s human capital provides its main competitive advantage. Israel’s commitmentto education, especially in computer science and engineering as well as an influx of scientistsand engineers from the former Soviet Union in the early 90s, have provided a strong pool ofpotential knowledge workers. These workers have strong networks with one another becauseof the small number of Israeli Universities and compulsory service in the IDF.

Israel spends a sizable portion of its budget on military R&D and in the 1960 and ‘70s madesignificant advancements in secure networking and encryption technologies. This in-countryresearch placed Israel in a strong position when the internet began to mature and a need forsuch technology became apparent. As new firms began to grow, a need for stronger venturecapital markets was identified. In response, the Israeli government set up a special venturecapital program called Yozma in 1993, which promised to match private investment in Israelitechnology companies. Since then it has seeded 10 VC Funds with $20 million each giving


them a 40% Government share and 60% private. Eventually in all but one case, these seededfunds, the government share was bought out by private investors. Today, total venture capitalunder management in Israel stands in excess of $10 Billion with around $1.5 billion investedannually (Wylie 2011; Engel and del Palacio 2011). The Israeli government started a numberof incubators but after poor initial performance these were privatized and have since becomemore successful.

Like other developing clusters, Israel has successfully leveraged its nationals living abroad.Significantly, it has recruited Israeli engineers and entrepreneurs working in the US to developstrong links with Silicon Valley. Today, Silicon Wadi boasts the highest number of non-UScompanies listed on the NASDAQ exchange and many American firms operate subsidiarieswithin Israel (Bresnahan 2004).

8.2.5 Can Governments Stimulate Cluster Growth?

Every city planner, regional politician, and national economic official hopes to emulate thesuccess of Silicon Valley or one of the other dynamic regional clusters mentioned above. Buteach example hints that “blank slate” innovative industrial development is not a simple, fast,or easy process. Various strategies have been used to stimulate “cluster-like” economic devel-opment across both the developed and developing world. The good news is that some policiescan improve the performance of local firms and spur innovation. The bad news is that thereis no “out of the bottle” solution for creating high-tech innovative clusters. Most cluster-baseddevelopment policies have been at best mildly helpful. At worst they use up resources thatcould better be used elsewhere and produce no discernible impact (Braunerhjelm and Feld-man 2006; Colombo and Delmastro 2002)

Knowledge or Skills? Spillovers from UniversitiesScientists and engineers at leading research universities spend their time advancing thefrontiers of knowledge. But do technology businesses really co-locate with universities inorder to access state of the art research? The degree to which knowledge really “spillsover” from universities is variable, but even the universities with the most successful tech-transfer offices can only commercialize a tiny fraction of their research. Instead businesseslook to universities as a source of talented workers with specialized skills. By staying closeto these rich talent pools, tech businesses are assured access to a steady stream of facultyand graduates equipped with latest knowledge and expertise.

8.3 Science Parks and Incubators

This section examines two related strategies for promoting innovation and regional economicdevelopment. Science Parks or Research Parks are mixed-use real-estate developments builtclose to Universities which seek to encourage Industry-University knowledge transfer. BusinessIncubators are also often located near universities (sometimes within science parks) and offer


incentives such as low-rent property and networking opportunities to encourage spin-offs fromuniversity research and the establishment of new firms by entrepreneurs.

8.3.1 Science Parks

Taking Stanford’s pioneering park as an example, many universities began building scienceparks and encouraging private industry to open branch research offices on or near campuswhere they would have easy access to talented graduates. The goal was increased knowledgespillovers and product commercialization. Science parks were envisioned as a location wheregovernment, industry, and the university could collaborate and share ideas. This collaborationwould hopefully result in entrepreneurship and human capital development, which could serveas kernel for developing a regional agglomeration of knowledge workers. Another impetus forcreating science parks was desire to garner greater benefit from science research. In the UnitedStates, a great deal of public research funding is funneled through University departments.The rationale for basic research was partially predicated on the assumption that such researchwould lead to economic growth. As public science funding came under budget pressure inthe 1970s and 80s and as the US faced economic competition from Europe and Asia, ScienceParks began to be seen as method for increasing technology transfer. Since the emergenceof the first science parks in the United States during the 1950s, the concept has proliferatedwith over 400 parks worldwide. In North America today there are 174 research parks whichcollectively employ over 300,000 workers and occupy over 47,000 acres (Battelle 2007).

Korean Clustering: Grappling with TraditionFor the last half century of Korean economic development, young clever workers havesought corporate positions in the chaebols (large conglomerates). These leading compa-nies were considered national champions and employment at a chaebol carried great socialprestige. Entreprenuership was seen skeptically, an indication that someone had failed tomake the cut at a larger firm. However, as the Korean government has recognized the eco-nomic potential of small, innovative startups (and the limits of older industrial policies),the authorities have taken steps to encourage dynamic technology clusters.

One such example is Daedeok Innopolis located in Daejeon, Korea, south of Seoul.Daedeok Innopolis started as a science park called Daedeok Science Town in 1973. Despitehaving the advantage of being collocated with KAIST, Korea’s leading research university,and significant government and corporate support, the science park was not particularlysuccessful in stimulating the formation of new hi-tech firms. The government has strug-gled to turn the science park into a self-sustaining cluster. Since the 2005 renaming of thescience park, Daedeok has begun to see improved performance, between 2005 and 2009sales increased from $2.5 to $12.3 Billion. Additionally it added 13 new companies tothe KOSDAQ, an impressive number since previously the park had only produced 11 intotal. However, the challenge of altering Korea’s traditional business culture will remain.Tax rules have been changed to allow new family businesses to enter the tax system moreeasily and bankruptcy laws have been altered to make the consequences of failure lessdire (Watson 2011).


Figure 8.2: Science Park Characteristics (Battelle 2007)

At their start, Science parks were essentially real-estate developments aimed at attract-ing high tech firms. Local municipalities or Universities used the prospect of cheap land andtax incentives to encourage high tech industry to move to the research park. One of the pri-mary reasons for the creation of science parks in the developed world has been the relativeresiliency of universities in the face of economic decline. In many regions which have expe-rienced de-industrialization, universities remain one of the few functioning large institutionsand so attempts at economic rejuvenation are centered around the university. A similar logicprevails in developing countries, which are attempting to build an innovative environmentfrom scratch. In either case, ties to a university lend credibility to such developments andimply a longer-term commitment by policy makers.

Ciudad del Saber (City of Knowledge): RedevelopmentAs Panamanian officials prepared to take control of the former US-controlled region calledthe Canal Zone, they looked for ways to utilize the buildings and other infrastructurethat were being abandoned by the Americans. Ciudad del Saber (CDS) was establishedby a private, non-profit organization in 1999, at the site of Fort Clayton, a former USmilitary base. CDS houses a variety of affiliates within its properties including businesses,educational programs, and international organizations and NGOS. The park focuses on5 major “work areas”: Information Technology, Biosciences, Environmental Management,Human Development, and Business Management and Entrepreneurship. CDS also housesan onsite business incubator. Some of the main draws for the park are its reliable accessto electricity and telecommunications, a business friendly tax policy, and proximity to


Panama City and a nearby tropical ecosystem region called the Panama Canal Basin. CDShas become a UN hub (housing many UN agencies servicing Latin America), and currentlyhouses 27 academic affiliates, 59 business affiliates, and 53 NGOs/IOs.

The sophistication of science parks has increased since their initial development. Initially,land and access to skilled graduates of the university were the main draws for business tomove into the parks. As it became apparent that these loose ties were ineffective in promotingrobust development, policy makers began to recommend a more activist approach to parkadministration. Stronger ties between faculty members and park tenants were encouraged.Business assistance services became more common. The focus began to shift from recruitmentties with large corporations to promoting the establishment of start-up companies. Effortsto increase the number of innovative small businesses led to the incorporation of businessincubators into many science parks, a subject which will be discussed at further length lateron.

Hsinchu Science and Industrial Park Taiwan: A Success StoryBeginning in the 1960s and 70s, Taiwan began to be seen as a low cost manufacturingdestination for basic electronics for foreign firms, and local SMEs began to make imitationproducts. In 1980 the Taiwanese government decided to invest in a science park neartwo well-regarded technical universities. Additionally, the organization exemplifying thenational effort to research semi-conductors, ERSO (Electronics Research and Service Or-ganization) was moved into the park. The park hosted many small emerging computerand electronics companies that were augmented by the government’s policies for seedingventure capital funds. Rather than backing individual companies (picking winners andlosers) the government sought to create a competitive local environment with incentivestilted towards the creation of IT companies.

One key to the park’s success was luring back Taiwanese scientists and engineers whohad been living and working in Silicon Valley. These individuals were offered substantialincentives, such as 49% government investment in any firm they started within the parkand management positions within companies and park administration. These returneesbrought with them knowledge about how to start and run hi-tech companies and alsofounded the first private VC funds in Taiwan. The science park augmented the knowledgebase of local companies which were already aggressively expanding. The park served tofunnel knowledge from the universities and abroad into the private sector. From 1988 tothe pre-recession height of 2007, annual sales from the science park grew 2300% from489.86 Billion NT to 1.14 Trillion NT (US$ 37 Billion) (Bresnahan 2004).

Proximity between industry and universities does not automatically result in collabora-tion. Science parks may succeed on some level, but there is little hard empirical evidenceto suggest they stimulate new economic growth. They do provide a conducive environmentfor communication and coordination between industry, government, and academia. The mosteffective parks are deeply integrated into the communities where they are located. They must


acknowledge the occasionally competing goals of various local stakeholder groups.These goals include providing jobs for local workers, corporate access to university R&D,

regional development, and enhancing university prestige and revenue from technology trans-fer. Policy makers must also realize their own bias looking at “success stories”. In certain cases,universities and their industrial relations have played a key role in producing self-sustainingclusters, but many other factors are responsible for regional economic development.

Realistic time horizons must also be kept in mind. Even successful science parks such asResearch Triangle in North Carolina have taken over 50 years to become fully established.An attractive campus with several prestigious sounding businesses grouped closely togethermay make Science parks an attractive option for policy makers seeking an impressive lookingend product, but they are unlikely to rapidly contribute to economic growth and development(Bresnahan 2004).

8.3.2 Knowledge Business Incubators

Widely used by local governments to encourage general entrepreneurship, business incubatorswhich specifically focus on high-tech sectors are a sort of inversion of the science park model.Whereas science parks try to attract businesses to co-locate and hopefully collaborate withuniversities, business incubators seek to encourage spin-offs and start-ups. Incubators try tocreate a welcoming environment for entrepreneurship by lowering startup costs and providingconsulting services.

Technological MIDI: BrazilThe southern Brazilian city of Florianopolis has sought to encourage the development of ahi-tech innovative economy but faces difficulty because of its distance from the commer-cial and financial hubs of São Paulo and Rio de Janeiro. The local technology businesscouncil ACATE, founded Technological MIDI in 1998 with the aim of incubating up to 10companies. In 2001 they expanded the facility to house a total of 14 companies.

MIDI offers many of the same services as other incubators including rent at 50% ofmarket rate, access to business and financial networks, business consulting, and tax relief.Its close ties to the local business community and the national government are helpful aswell. It is registered to receive federal subsidies under Brazil’s so-called “IT Law”, whichencourages domestic IT innovation. By 2007, companies which had graduated from theincubator had achieved sales of US$ 13.9 Million and employed 385 people. This successearned the incubator the best technology incubator award in 2008 from the Brazilianinnovation and entrepreneurship association ANPROTEC.

Key features of incubators are temporary leases in business rental property offered at belowmarket rates, professional business managers, and structured networking opportunities withventure capitalists.


Services Provided by Business Incubators• Provision of a facility to house client firms, including office space, business services

and access to laboratory and other technical resources needed for prototyping, test-ing and analysis for technology-based clients

• Agreement among stakeholders on the objectives of the incubator, including short-term and long-term expectations about tenants’ growth and maturation

• Experienced incubator managers who can design and deliver customized services toaddress the unique needs of client firms

• Design or use of long-term financial support strategies that draw on locally availableinvestment sources, client fees, and downstream equity or royalty returns

• Reliance upon a supportive community infrastructure to facilitate access to thewidest possible range of financial, management, marketing, technical, legal andinformation resources needed for tenant training, networking, market analyses, reg-ulatory compliance and product development (Johnsrud 2003).

Business incubators have become even more widespread than science parks, not the leastbecause of the fewer resources needed to establish one. Incubators carry additional appeal be-cause of how far along they are in the continuum from basic research to marketable product.The primary rationale for high-tech business incubators is that small, innovative companiesare the most likely to create transformative technologies which will benefit society at large,potentially leading to the creation of new industries especially in advanced economies. Begin-ning entrepreneurs have difficulty evaluating the market potential of innovative technology,and even less understanding of the necessary steps towards commercializing a product. Thisexperience gap is a serious barrier to universities that are encouraging their faculty members(academics typically lack business experience) to spin off new firms. Since such businessesare inherently risky and unproven, they suffer from a lack of investment, resulting in a marketfailure. Governments seek to correct for this failure by subsidizing the establishment of suchfirms (OECD 2006). Incubators attempt to bridge this gap in three key ways, by providinginfrastructure, business support, and access to networks.

Infrastructure

New businesses face substantial hurdles in acquiring office space, support staff, parking, stor-age, telecommunications, and other basic overhead requirements. Business incubators helpnew businesses by simplifying this tedious and time-consuming phase of establishment. By of-fering package deals at below market rates, firms find themselves at an immediate advantage.The act of renting a real office (rather than maintaining a virtual office or working out of ahome) confers added legitimacy to new firms at time when this image is especially importantfor attracting investment. Business incubators typically house multiple firms. These firms areable to share the costs of the various services such as a receptionist, audio/visual equipment,


printers and faxes, and insurance. Interactions between tenants can stimulate further growthas synergies between complementary firms can develop.

Business Support

The level of business support varies widely by incubator but can include help with composingbusiness plans, mentoring or coaching from more experienced managers, training sessions,accounting services, IT support, legal assistance, as well as other options.

Equity StakesIncubators that are started by the public sector tend to be focused on economic develop-ment and increasing local employment levels. As a consequence they tend to ask littlefinancially in return from the entrepreneurs they host. However there are private incuba-tors as well. Some private companies require an equity stake from the firms they incubate.

Leading private sector incubators, Y-Combinator and Techstars require around a 6%equity stake from their startups. This cuts both ways, entrepreneurs trade away some oftheir value, but this incentivizes incubators to work harder since they will share in thefinal success of the start-ups. According to the National Business Incubators Association,24% of US tech incubators require some sort of equity stake (Bass, 2012).

Access to Networks

Of course the main barrier start up business face as they attempt to expand is access to capital.Often this is because entrepreneurs lack contact with venture capitalists and angel investors.Incubators can arrange for their tenants to network with prospective investors. This could bein the form of events where founders make pitches to investors or business lunches with localleaders to gain social capital.

Other Types of IncubatorsAccelerators Rather than allowing for slow growth like more traditional incubators, busi-

ness accelerators aim to rapidly bring entrepreneurs from the initial idea phase for-ward to a solid business plan and a prototype or website. They often try to connectbudding firms to venture capitalists or angel investors. Examples include Ycombina-tor and TechStars.

Virtual Incubator Some firms already have office space or infrastructure in place butneed help with other aspects of business development. Virtual incubators use theinternet to connect entrepreneurs with management counseling and other serviceswithout having to move to a central shared location.


8.3.3 Assessments of Effectiveness

The word “incubator” is key. Business incubators aim to “graduate” companies from the in-cubator and into the regular market once they become established. Successful operation ofa knowledge business incubator require solid selection criteria and robust standards for firmexit. By being selective about which firms they choose to house, incubators can increase thechances of success. Similarly being clear about when firms must exit provides certainty andencourages firms to expand quickly to become profitable enough to survive outside the incu-bator.

Incubator ExamplesICEHOUSE (New Zealand) As part of an effort to increase the number of hi-tech SMEs

in New Zealand, the ICEHOUSE business growth program was founded in 2001.Its stated purpose was to launch 350 firms to meet a national goal of 3000 newSMEs. Partners for ICEHOUSE included the University of Auckland Business School,BNZ, HP, NZTE, Gen-i, Ernst & Young, Paul Diver, Grafton Consulting Group, andMicrosoft. The ICEHOUSE incubator is linked to New Zealand’s largest networkof angel investors and has a monthly event where 25 entrepreneurs can attend aseminar explaining how to launch a start-up and have the opportunity to meet withincubator staff about joining ICEHOUSE. The incubator offers 3 basic levels of ser-vice, market validation, business plan development, and full incubation. ICEHOUSEprimarily aims to incubate companies with an intellectual property component witha high growth potential in an emerging market. Since 2001 it has launched 75 com-panies and attracted $50 Million in angel investment. It was ranked as one of thetop 10 technology incubators in the world by Forbes magazine in 2010.

Y-Combinator One of the most successful tech accelerators was founded in 2005. Y-Combinator takes selects prospective entrepreneurs through 3-month “bootcamps”designed to quickly launch promising companies. After the three month period,entrepreneurs pitch their ideas to a group of investors and venture capitalists at apresentation called “Demo Day”, an event which has become extremely influential.

Applicants are rigorously screened, but Y-Combinator seeks to invest a small amountof money across a large number of companies. Those accepted into the program aregiven approximately $18,000, business training, and access to Y-Combinator’s net-work of experienced entrepreneurs and investors. The budding companies cede a6% equity share to Y-Combinator in exchange for their service. To date, this accel-erator has launched 380 companies, including notable internet businesses such asDropbox and Reddit (Y-Combinator url 2012).

It is critical for policy makers and the managers of a business incubator to be clear aboutthe objective of the operation. There is a wide range of potential incubator sponsors includingmunicipalities, universities, government agencies, non-profit agencies, who may all seek dif-ferent end goals. This includes privately owned business incubators whose goal is to achieve


a profit. This can sometimes come at the expense of local economic development. If the goalof a knowledge business incubator is to spawn numerous high technology companies to stim-ulate growth, this must be explicit. Managers may choose to allow successful businesses toremain on site too long because of the steady revenue from rent and fees. Similarly, they mayallow unrelated businesses to rent what is essentially subsidized office space. These practicesconsume resources that could be used by desired technology startups. Knowledge businessincubators are a cost-effective way of stimulating the creation of high tech businesses and fos-tering a local culture of innovation. However they must be carefully managed and focusedon their specific objectives. Innovation and quality should be more highly prized than simplyfilling space within the incubator (Lalkaka 2002; Almubartaki, et al 2010).

8.4 Conclusion

The process of creating self-sustaining hi-tech clusters cannot be fully controlled by govern-ments. While there is no well-defined recipe for this type of economic development, certainingredients may be helpful. These include strong links between research and development atuniversities and emerging industries, access to capital markets, and a local culture of compe-tition and collaboration. Policies such as the creation of science parks and knowledge busi-ness incubators can help foster technology transfer and entrepreneurship but are unlikely tostimulate self sustained economic growth in the absence of other factors. They cannot alonemake up for deficiencies in local systems of innovation. Without stable macroeconomic en-vironments, strong labor and capital markets, respectable intellectual property protection, areasonable research and development base, rule of law, and other basic requirements, anentrepreneurial high tech business culture is unlikely to take hold (Fagerberg, et al. 2005;Asheim, et al. 2006).


Appendix 8.A Middle East and North Africa: Hi-TechEntrepreneurship Efforts

Governments throughout the Middle East and North Africa have increasingly turned their fo-cus towards science and technology to diversify their economic base, increase employment,and in the case of countries with petroleum reserves, prepare for the day when oil and gasprofits decline. Most countries have established science parks, which often serve as the basefor business development, networking, and incubator programs. A recent development hasbeen the creation of online networking sites aimed at connecting prospective entrepreneurs,mentors, investors, and organizations. Techwadi and Wamda are two examples of such net-working ventures.

Wamda Serves as an online knowledge and networking hub to aid MENA entrepreneurs.Currently, it hosts information about starting businesses in the region as well as successstories and tutorials. Its Wamda fund invests in early stage companies at the $50-75Krange and eventually it plans to launch an accelerator program as well.

Techwadi Aims to connect ICT professionals of MENA origin working abroad, especially in Sil-icon Valley. The goal is to link these experienced individuals with regional developmentagencies and potential entrepreneurs to facilitate knowledge flow and best practicesfrom the leading clusters back to emerging MENA ICT centers.


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Chapter 9

Small Firms / Entrepreneurship

9.1 Introduction

Over the past several decades, small firms and entrepreneurial activities have emerged as vitalaspects of innovation and economic growth worldwide. As more firms transition away fromthe vertically integrated business models of the twentieth century, the traditional sources ofcompetitive advantage—economies of scale in production, management, finance, and R&D—continue to decline in terms of their significance to innovative activity. Instead, the growth ofthe knowledge-based economy is engendering a new system in which small and medium-sizedenterprises (SMEs) and entrepreneurship are the driving forces of social and technologicalchange. These activities are closely linked with transformational breakthroughs, knowledgetransfers, open innovation, and other developments that drive the “creative destruction” ofless efficient ways of doing things. Policymakers, especially in the developing world, mustaddress the growing importance of this phenomenon if their innovation policies are to reachtheir full potential.

The speed at which new ideas diffuse in today’s global economy creates challenges thattraditional large businesses are unequipped to address. In order to be competitive in thetwenty-first century, firms must constantly work to identify trends and opportunities, reactquickly to changing market conditions, and take risks involving the use of new unproven busi-ness techniques. As discussed in Chapter 2, technological innovation can be described in termsof technology lifecycles, whereby rapid improvements in new technologies diminish over timeuntil an even newer technology finally overtakes them as the dominant design, signaling a newtechnology lifecycle. During these transition periods, large firms tend to remain committed toestablished practices, opting for incremental improvements in current business techniques.Conversely, small high-tech firms and entrepreneurs act as the “disruptors” of the system,pushing the industry standards to the new paradigm. As globalization continues to reduce theaverage lifetime of new technologies, this function is becoming ever more important.

Notwithstanding the importance of technological innovation to competiveness and growth,small businesses and entrepreneurs are driving innovation through a variety of other meansas well. Indeed, innovative activity involves much more than science and technology, and thewealth of information available in today’s world has placed a premium on the creative use ofthis information. The wider range of actors in the global economy, and increasing complexity

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of relationships needed to maintain competitiveness, are creating the need for innovation infirm organization as well as in how firms interact with external organizations. Additionally, thetransition to a service-based economy has placed a greater emphasis on the non-technologicalbusiness aspects of firms in many developing and developed nations. Altogether, these factorsare redefining the role of small firms in the global value chain, and are creating opportunitiesfor small firms to innovate while older and larger firms have more difficulty modifying theirtraditional methods of operation.

In general, the role of government in relation to SMEs and entrepreneurship should be toestablish the institutional, organizational, and regulatory conditions necessary for a healthy“enterprise culture.” Government actions alone will not create this atmosphere, but their ac-tions can either facilitate or destroy it (UNIDO, 2004). This role has often been compared tothat of a gardener working to create the conditions necessary for their crops to flourish. Firstof all, the weeds must be pulled from the landscape before the seeds can be planted. Theweeds are analogous to impediments to enterprise: high taxes; complicated regulations; bu-reaucratic corruption; and barriers to competition. Next, the soil must be prepared by tillingthe land and adding fertilizer. The quality of soil represents the quality of institutions andorganizations necessary for entrepreneurial activity. Aspects such as intellectual property andentrepreneurial universities fall into this category. After creating the foundations for growth,the final step is to select the layout and diversity of crops. Research priorities, along withdevelopment and demonstration programs, are set by identifying market demands and com-mercial comparative advantages. If a government acts as a prudent gardener of innovation,society will be more likely to reap the rewards of a prosperous entrepreneurial society.

9.2 Overview of SMEs

Although there is no universally accepted definition for an SME, they are generally understoodto be “non-subsidiary, independent firms which employ fewer than a given number of employ-ees” (OECD, 2005). The legal definition of an SME varies by country as well as by industry, butthe maximum number of employees in an SME generally ranges between 200 and 500. Manycountries make further distinctions between micro, small, and medium-sized enterprises. TheEU, for instance, defines a small business as having no more than 49 employees and a microbusiness having no more than 9 employees (UNIDO, 2004).

Across the globe, SMEs account for the vast majority of all firms and usually account forthe bulk of jobs in a country’s economy. In particular, micro-firms consisting of less than 10employees constitute at least three-quarters of all firms in most countries, and are responsiblefor about 20% to 30% of total employment in most developed country economies (OECD,2009). In developing economies, micro-firms likely play an even more important role. InOECD countries, SMEs on the whole constitute about 99 percent of all firms, around two-thirds of total employment, and over half of total value added in the economy (OECD, 2010).Figures 9.1 and 9.2 below show the breakdown of firms by size in OECD countries as a shareof total firms and total employment, respectively.

In addition to birth rates and death rates, another important factor distinguishing SMEs istheir rate of growth. OECD defines “high-growth enterprises” as firms that have annualizedgrowth in employees greater than 20% over a three year period, and have at least 10 em-


Figure 9.1: Share of enterprises by size class (number of employees), 2006 (EIP, 2010)

Figure 9.2: Share of employment by size class (number of employees), 2006 (EIP, 2010)


Figure 9.3: Share of high-growth firms by sector, 2006 (EIP, 2010)

ployees at the beginning of the measurement period (OECD, 2009). High-growth enterprisesare seen by analysts as a source of entrepreneurial vitality, and are promoted as importantdrivers of economic growth and job creation. Figure 9.3 shows the number of high-growthenterprises—broken down by the service and manufacturing sectors—as a percentage of allfirms in selected OECD countries.

An especially important subset of high-growth enterprises is firms that are less than fiveyears old. These young high-growth firms—often referred to as “gazelles”—represent less than1 percent of all firms in most countries throughout the world, but are responsible for a muchlarger percent of new jobs created and economic growth. Encouraging the success of gazellefirms is a critical aspect of innovation policy in most developed countries. As will be discussedin the next section, however, an effective policy regime will address all types of SMEs and notjust the gazelles.

Lastly, two other useful metrics that provide insight into the health of the SME environmentare birth and death rates. Birth rates refer to the number of newly created enterprises with atleast one employee, as a share of all firms in an economic unit of analysis. Similarly, death ratesrepresent the number of firms that cease to exist as a share of all firms. Birth rates and deathrates are useful to gauge how friendly conditions are for entrepreneurship in an economy.Generally, these rates tend to be much more turbulent in smaller firms than in larger ones,and are also higher in the services sector as opposed to manufacturing. Surprisingly, OECDdata has shown little difference in birth and death rates between low- and high-tech industries(OECD, 2009).

9.3 Types of SMEs

Although SMEs generally face similar challenges regarding financing, marketing, and other is-sues where asymmetrical information comes into play, innovative activity varies widely across


Figure 9.4: Arnold Staircase—Hierarchy of company types (Arnold and Thuriaux, 1997)

the SME landscape depending on a firm’s goals and characteristics. SMEs are represented bymany different types of enterprise, ranging from high-tech electronics and advanced materialsmanufacturers to small independent service providers, such as barbers and cafe owners. Asmall percentage of these SMEs invest heavily in R&D and are highly innovative, while manyothers do not engage in formal research at all. That said, analysts have developed varioussystems to categorize SMEs by their technological and innovative capacity. One common cate-gorization is the “Arnold Staircase” shown in Figure 9.4 below. The diagram is used to describecategories of enterprises with varying levels of R&D competence and their core characteristics.

Another common classification is the “SME Research Staircase,” which separates SMEs de-pending on the level of technological activity. At one end of the scale are basic SMEs whichundertake little or no R&D at all. These firms are by far the most common, representing about70% of all SMEs in the EU. On the other side of the spectrum, the most innovative SMEs arethe technology pioneers, which are involved in leading-edge research and technological break-throughs. These firms only make up 3% of the SME population in the EU, but are responsiblefor the majority of technology-based innovation and job creation.

Classifying firms into different categories based on technological capacity is useful to un-derstand the wide variety of SMEs in existence, and can inform policies for maximum ef-fectiveness in each type of SME. Highly innovative and high growth potential firms demanddifferent modes of support than low research intensity firms which constitute the majority ofSMEs. Science, development, and innovation (STI) support policies should focus on the spe-cific needs of each group of companies and moving them up the “SME Research Stairway,”aiming at helping SMEs develop an innovation capability.


Figure 9.5: The SME Research Stairway (EURAB, 2004)

At the high-tech end of the scale, the major challenge for policymakers is how to catalyzethe technological breakthroughs and major innovations that can drive economic growth andtransform the economy. At the other end of the spectrum, government action may be bestfocused on facilitating the absorption of knowledge and transfer of ideas between firms, net-works, and industries. Although most SMEs are not involved in breakthrough innovation, theystill play an important role in the restructuring of global value chains and improvement of in-dustry best-practices through non-technological innovation and incremental improvements. Ineither case discussed above, SMEs serve a critical role for economic growth in a knowledge-based economy.

9.4 Entrepreneurship in the twenty-first century

Across developed as well as developing countries, of chief importance to a healthy and vibrantSME sector is an appropriate environment for entrepreneurial activity. Entrepreneurship maybe defined in a number of ways, and in a broader or narrower scope depending on the context.The European Commission defined entrepreneurship generally as “the mindset and process tocreate and develop economic activity by building risk-taking, creativity and/or innovationwith sound management, within a new or an existing organisation” (European Commission,2003). Whatever the definition of entrepreneurship, it is widely understood throughout theworld that increased entrepreneurial activity can satisfy important policy goals including jobcreation, economic growth, and alleviation of poverty.

Entrepreneurship is undertaken by people in all societies, for a variety of reasons and un-


der a myriad of circumstances. Indeed, the desire to solve problems and improve one’s qualityof life is a fundamentally human trait, but certain environments foster entrepreneurship morethan others. Social values, culture, government policies, political systems, available technol-ogy, economic conditions, customs, and laws all influence the prevalence of entrepreneurshipin a society. Additionally, entrepreneurship is heightened during times of need, crisis, and op-portunity. The business activities that are engendered during these situations, however, havevastly different objectives and carry unequal prospects for achieving national priorities such asjob creation and growth.

As the discussion above indicates, entrepreneurs can be broadly categorized by the objec-tives of their innovative activities. One common form of entrepreneurship is that of necessity,due to lack of other means of income. Often times, the entrepreneur of necessity is merelysearching for a way to get by, and is not as concerned with high-growth or large profits.

A second type of entrepreneur, however, starts an enterprise because they perceive a gapin the market which they view as an opportunity to make a profit. These entrepreneurs findniche sectors where improvements are needed and create marketable solutions. In the rapidlyevolving economy of the twenty-first century, there is boundless potential for opportunity-driven entrepreneurs with technological skills and creative minds.

A third category of entrepreneurship which has garnered widespread attention in recentyears is based on solving societal problems such as health or environmental issues, but notnecessarily with the goal of large monetary rewards. So-called social entrepreneurs are moti-vated by altruistic ideals and are blurring the lines between making money and offering charitywork. The potential for growth in these firms may not be as high as in purely opportunisticentrepreneurship, but their role in solving societal problems can provide valuable benefits tothe economy and improve overall quality of life in a society.

In addition to the major types discussed above, a new subclass of entrepreneurs can also bedistinguished, which has arisen to exploit the opportunities provided by the emerging knowl-edge economy. Characterized by their creativity and mastery of new technologies such as socialmedia, so-called knowledge entrepreneurs are responsible for some of the most dynamic andsuccessful businesses in the twenty-first century (Cooke and Porter 2008).

Entrepreneurship ExamplesNecessity Entrepreneurship After being laid off from a lighting and housewares manu-

facturer in 2008, Jeff Shay of Portland, Oregon decided to open his own consultingfirm rather than brave the rocky job market. With 15 years of engineering and man-agement experience under his belt, Shay used his skills to land consulting contractswith small and medium-sized manufacturing firms that were interested in sustain-able business practices (Tozzi, 2010).

Opportunity Entrepreneurship One of the most successful start-up firms in recent mem-ory is the photo sharing firm Instagram. When it was created in 2010, foundersMike Krieger and Kevin Systrom set out to design a fast and fun way to share digitalphotos. The service’s ease of use and interesting features soon led it to grow wildlyin popularity. In April 2012, the firm was purchased by social media giant Facebookfor approximately $1 billion (Stern, 2012).


Social Entrepreneurship In order to improve the speed and effectiveness of emergencyaid responders, Assaf Shafran of Israel founded his social venture, IsraeLife, to pro-vide a smart-phone based dispatching system to first responders like firemen andEMTs. The firm began as a non-profit enterprise, but moved to a profit-based modelonce Shafran realized it would be more effective at accomplishing his original goal.The venture has raised $2.5 million in private capital since 2008 and has since ex-panded into the US (Moran, 2011).

No matter the industry, achieving success as an entrepreneur is a difficult task that few areable to accomplish. A growing body of evidence suggests that successful entrepreneurs haveseveral common characteristics that set them apart from most ordinary people. First, psycholo-gists who have studied the topic assert that entrepreneurs are excessively confident and refuseto submit to failure even when the odds against success are overwhelming. The refusal to callit quits can be an advantageous trait in that the chances of a successful outcome are improvedwhen one follows through on every possible opportunity. At the same time, however, it meansthat unrealistic goals will often not be achieved. On a related theme, successful entrepreneursare often extremely attached to their firms, sometimes spending all their waking hours work-ing to develop their businesses. Although this close personal attachment obviously improvesthe chances of business success, it also may cloud an entrepreneurs’ judgment when difficultchoices need to be made concerning firm control and equity investments from third parties.One last important trait that defines entrepreneurs is a high tolerance for risk. Without a risk-taking mindset, small business leaders would be unable to make difficult decisions regardinguncertain future trends in markets, technologies, and consumer preferences.

9.5 Challenges to growth in SMEs

The challenges facing SMEs can be categorized as those resulting from a lack of ability on thepart of the entrepreneurs and those resulting from the business operating environment. Per-sonal ability plays a critical role in the eventual success or failure of a small firm. Entrepreneurswith low levels of education or training, a lack of management skills or experience, or insuf-ficient knowledge of new technologies are unlikely to succeed in the increasingly globalizedeconomy. Additionally, even the most talented managers will fail if their firms lack access tofinance or information regarding the latest market trends. Strategic linkages to larger firms,access to global distribution channels, and adequately priced inputs for business operationsare other critical elements for entrepreneurial success in SMEs (Stevenson 2010).

Due to the smaller scale of their operations, SMEs also suffer many challenges that largerfirms are not as exposed to. For instance, SMEs commonly experience “limited managerialresources, immediate time pressures and lack of in-house expertise are barriers in accessingexternal resources” (Boldrini 2011). Moreover, small firms may lack the operational breathingroom needed to make longer term strategic decisions, such as pursuing available businessskills support services. Often times, entrepreneurs are “unaware of the benefits available andsecondly they are more concerned by immediate survival than long term benefits” (ETF 2001).

Entrepreneurs can only develop ventures when they are able to make stable predictionsabout the possibility of a return on their investment. Markets with significant levels of uncer-


tainty about the future economic climate will see underinvestment as a hedge against uncer-tainties. Uncertainty may include a number of issues such as “access to resources and otherinfrastructural needs, features of the intended market, and whether others can unfairly ap-propriate value from the entrepreneur’s activities (i.e., through corruption and other criminalactivities)” (Webb 2010).

The level of uncertainty associated with a particular market or industry is affected by boththe formal and informal institutions that guide investment and entrepreneurship within aneconomy. On the formal side, incentives for economic opportunities are established by taxes,subsidies, and other forms of government intervention in the marketplace, along with the legaland regulatory framework in place. On the informal side, the norms, values, and beliefs ofthe society define opportunities that are deemed legitimate and may be desired by a sizeablegroup. Together, appropriate formal and informal institutions can mitigate uncertainties andfacilitate entrepreneurship.

One of the most important variables that an entrepreneur will evaluate when making busi-ness decisions is their ability to obtain low cost credit. As many small businesses lack estab-lished credit histories, private sector financial institutions may be reluctant to make loans.Barth et. al. found that “Firms using international accounting standards have easier accessto cheaper credit. This reflects these firms’ advantages in competing for foreign bank loans.Likewise, firms with external auditors also encounter fewer financing obstacles” (2011).

However, in the case of the Middle East, even if enterprises are able to adopt internationalbusiness standards, they can still suffer from “the higher level of public ownership of banks, thelack of competition and restrictive lending practices [that] are among the major problems” inthe Middle East region. In Lebanon, for example, 3% of beneficiaries account for 75% of totalprivate sector credit (Stevenson 2010). Despite the fact that many small businesses around theworld are self-funded initially, access to financing at critical moments of growth is absolutelyessential. A successful firm will not expand if they are unable to secure affordable loans andwithout expansion profitable products and markets will be left under pursued.

9.6 Approaches to policy

At the most basic level, in order to facilitate entrepreneurship a government “must establishconfidence in property rights, promote education, guarantee access to capital markets, safe-guard stable macro-economic conditions and make sure that the necessary physical infrastruc-ture is in place” (Wennekers 2005). Many different areas of policy influence enterprise, andsuccessful small business policy is often more about removing barriers than adding complexity.

Policies to cut red tape and facilitate investment have a broad impact, but may be diffi-cult to achieve. A major challenge is formulating a system in which “value is created throughproduct innovation, as opposed to unproductive or destructive forms in which value is cre-ated for customers at the expense of competitors (e.g., rent-seeking through market poweror political power)” (Mcmullen 2011). Indeed, government support of certain industries orfirms may prevent the entry of new players and stifle the competition necessary to developinternational viable enterprises. Eliminating unproductive forms of regulation is another sub-stantial challenge in the development of an environment supportive of the creation of SMEs.Entrepreneurs around the world commonly report high taxes for small businesses, complex


business registration, and cumbersome regulations as being the most significant stumblingblocks to their growth (Aegis Survey, 2012). Simplifying the process of starting and growing abusiness immediately improves the risk/opportunity trade-off for all potential entrepreneurs.

The availability and flexibility of labor is also a major constraint on the growth of firms.Strict employment regulations can limit job creation, reduce flexibility of the workforce, andconstrain R&D investment (OECD, 2004). While there needs to be some rules in place toprotect workers’ rights, excessive intervention can undermine the price signals sent by labormarkets and hamper investment. Instead, policy needs to be developed through collaborativeengagement with unions and employers in order to establish consistent and achievable stan-dards for labor contracts while maintaining flexibility for businesses to increase or reduce staffbased on market needs.

An essential element of policy for SME development is encouraging a culture of entrepreneur-ship. Indeed, an entrepreneurial culture is one of the most important aspects of an innova-tive ecosystem. Governments must closely engage with media outlets, business networks,research communities, and directly with the general population to communicate the benefitsof entrepreneurship and the opportunities it creates. Unsurprisingly, entrepreneurship trainingmakes individuals more likely to launch new ventures and report higher levels of satisfactionand economic success.

While this training can be delivered through academic communities and institutions whichhave entrepreneurship programs, it is also important to develop informal learning networks.Appropriate policy should have an understanding of the stakeholders involved and may coor-dinate the actions of different public and private actors. For instance, the EU includes a policycommitment to teaching entrepreneurship at all levels of education. Additionally, many coun-tries have adopted specific “learning-by-doing” schemes where students are able to developskills as they create and run micro-businesses.

Another important component of human capital development, particularly in developingcountries, is the concept of “brain circulation.” Strategies have been developed in many de-veloping countries that promote the repatriation of educated diaspora in order to increase thetalent at home. Individuals returning from abroad with specific knowledge and technical pro-ficiencies are important conveyers of knowledge to local firms and workers. These individualsare often returning from educational stints in developed regions like the US and Europe, andare able to harness their international networks in addition to the skills they have learnedwhile abroad. It is very common for these individuals to exploit these advantages to beginsuccessful entrepreneurial ventures once they have returned to their home countries.

Germany’s EXIST ProgramIn order to increase the number of knowledge-based start-up companies and improve theclimate for entrepreneurship at universities and research institutions, Germany recentlyestablished the EXIST program through its Federal Ministry of Economy and Technology.The program consists of three pillars to accomplish its goals.

The first is the Culture of Entrepreneurship pillar, which provides the tools for en-trepreneurship among university students and faculty. It does so by providing grants touniversities to help them establish the infrastructure for providing skills and support for


technology and knowledge-based ventures. The second pillar is the Business Start-upGrants pillar, which provides funding to help students and researchers turn their ideasinto business plans. Grants cover a range of associated expenses including living costsfor up to 12 months, costs of material and equipment, funding for coaching, and evenchild support coverage. The third pillar is the Transfer of Research pillar, which providessupport for specific challenges to high-tech, knowledge-based firms at the pre-start-upand start-up stages. One such challenge for entrepreneurs is proving the technologicalfeasibility of a new technology or idea, which the program supports through subsidizingresearchers’ wages and materials for this purpose. Once in the start-up stage, the programprovides additional funding and support for product design and prototype development.

Sources: ; OECD, 2010.

9.7 Developing programs to support innovative SMEs

Innovation does not exist in a vacuum, and accordingly there needs to be a continual dialogbetween industry, academia and government focused on iteratively developing policy in re-sponse to observed outcomes. Any support program must include the flexibility to supportentrepreneurs as they adapt to new opportunities and threats rather than rigidly require ad-herence to a plan. This necessitates a deep integration between the public managers, privatefinanciers and funded ventures.

The EU Research and Technological Development Framework Programme (RTD-FP) andthe US Advanced Technologies Program (ATP) illustrate two different approaches to govern-ment led innovation. The RTD-FP is a multi-year funding program that brings together allresearch initiatives under one roof. By developing a long-term roadmap, it is able to shapethe priorities of different actors and facilitate inter-organizational cooperation, which maystrengthen linkages between sectors and improve the efficiency of commercial, academic andpublic research expenditures. By contrast, ATP drives innovation by funding competitions andproviding grants to speed up the development and dissemination of high-risk emerging tech-nologies, where funds are awarded based on merit. This system allows flexibility for newdirections of innovation and affords more creativity to entrepreneurs, but lacks a comprehen-sive research agenda.

Private accelerators and incubators also play an important role in promoting SMEs in manydeveloped countries. In the US, numerous organizations such as KickStarter and Y Combinatorhave blossomed in cities across the country and support countless aspiring entrepreneurs.These companies provide funding and support services to entrepreneurs in exchange for someform of compensation.

Technology Incubator: Y CombinatorAs Y Combinator demonstrates, the seed development of entrepreneurial talent is an ac-tivity that can be undertaken by the private sector in addition to government and angelinvestors. Y Combinator is a for-profit company that developed a model for startup fund-ing where they offer support to aspiring entrepreneurs in exchange for a small percentage


of equity in the firms they support. Generally, company founders receive a combination ofmentoring and seed funding in the range of $30,000, as well as access to a shared workspace. For this support, Y Combinator is paid in the form of firm equity, usually in the 5-10percent range. While there is a very high level of risk involved—most start-ups fail withinthe first year of operation—the direct cost to the company is low enough that they areable to remain profitable. At the regional level, technology incubators like Y Combinatorhelp entrepreneurs build professional networks and discover new opportunities for futureenterprises, meaning even failures may lay the groundwork for later growth.

Other actors that contribute to high-tech SME development are so-called “innovation in-termediaries,” which are not directly involved in technical aspects of research, but organizenetworks for potential collaborators to build relationships. These intermediary actors cancome from industry as well as the public sector. In addition to serving as networking hubs,they provide “help in defining and selecting the needs of the client in relation to innovation,support in decision-making related to innovation, help in finding advice and funding, and sup-port in the implementation of business and innovation strategies” (Diaz-Puente 2009). Theyalso serve as important channels for knowledge transfer and lateral technology transfer thathelp all firms in a sector improve their global competitiveness.

Overall, SMEs are critical aspects of every innovation system and are central to all ofthe other topics discussed throughout this policy guide. More often than not, the reason theseventures are unsuccessful is due to a lack of funding or failure to pay off debts. Although brieflydiscussed in sections of this chapter, the next chapter delves further into the financing aspectof SMEs and discusses the policy instruments used to facilitate credit for high-risk ventures.


Appendix 9.A Comparison of SME initiatives in three Euro-pean countries

In Finland, “the government-run Tekes Foundation provides grants and loans to small andmedium-sized businesses seeking to develop specific ICT applications. Its funding is targetedat projects which produce new know-how or bear high technological and commercial risks.” Inaddition, to direct funding the Tekes Foundation also coordinates technology programs which“promote development in specific sectors of technology or industry, and to commercialize theresults of the research work. The technology programs are planned in cooperation by Tekes,enterprises and research institutes.” (Carayannis, 2005)

The Finnish attempt to spur innovative research can be contrasted with attempts to in-crease the uptake in the use of available technology by firms. In Spain, for this purpose,Technological Diffusion Centers (TDC) were created by the federal government in cooperationwith regional councils. In a population of 40 million, 77 TDCs were created, “37% of whichwere linked to local entities—regional agents that operate at sub-regional or local levels andwork on the development of a limited area within the region (e.g. town and city halls or lo-cal associations)—and 47% were linked to business associations. A third group of specializedTDCs (16%) were linked to foundations, non-entrepreneurial associations and universities,and are specialized in dissemination, promotion and assistance in a given topic or technol-ogy.” (Diaz-Puente 2009) The continuing high levels of unemployment in Spain indicates theextent to which even well designed programs are slow to demonstrate results and can be over-shadowed by macro-economic factors such as constraints to lending and an expensive laborpool.

In the United Kingdom, rather than try to promote a particular industry or change theoperation of firms, there has been a focus on building partnerships between government andcommerce to reduce the barriers for firms. This policy has taken the form of a Regulation andSmall Business Policy Directorate, which in consultation with business develops “evidence forregulatory burdens and priorities for their reform.” This consultative process takes place alongwith the “‘Think Small First’ initiative [which] introduced some flexible exemptions to certainlegislative provisions for small businesses, for example providing that (a) companies below fiveemployees were exempted from the stakeholder pension, (b) union recognition was deemednot necessary for companies below 20 employees, and (c) certain accounting standards weremade applicable only to firms with more than 50 employees.” (OECD 2004) Recognizing thatmultiple stakeholders must be involved is a critical lesson from the U.K.

In all three cases, the policies benefit from explicit designation of concrete goals and abroad engagement of the private sector which links existing networks of academics, businessesand non-governmental organizations. Government is uniquely positioned to act as a convenerof other actors, and leveraging this ability will generate the most efficient returns.


Appendix 9.B Small Business Administration and SME incu-bation in the U.S.

The Small Business Act of 1952 created the Small Business Administration (SBA) with thegoal to “aid, counsel, assist and protect, insofar as is possible, the interests of small businessconcerns.”

In pursuit of these goals the SBA has been organized around three main areas of support.First, it is authorized to license Small Business Investment Corporations as private entities thatuse their own funds and money borrowed with an SBA guarantee to invest in SMEs. TheseSBICs were the forerunners of modern venture capital firms and developed much of the expe-rience needed to be able to accurately model the returns from investment. Secondly, the SBAfunds Small Business Development Centers in partnership with state and private organizationsat hundreds of academic centers and entrepreneurial hubs. These centers are critical for thedevelopment of networks of entrepreneurs and improving the overall human capital capacityof regions. The final area of support is through direct financial support including loans andresearch grants.

The main vehicle for awarding grants is the Small Business Innovative Research (SBIR)program, which was initiated by congress and requires that each federal agency set aside 20%of its external research budget for the purpose of meeting federal research priorities throughgrants to small businesses. The initial legislation split the funding into two phases. PhaseI awards support firms as they assess the scientific and commercial potential of their ideas.Phase II awards support further development of the proposed research, with the ultimate goalbeing a commercializable product, process, or service. Once a project moves through Phases Iand II of the SBIR program, the hope is that it will have sufficient market traction to completelyrely on external funding for subsequent operations.

Appendix 9.C SME credit financing in Korea (Korea Technol-ogy Finance Corporation)

In 1989, the Republic of Korea established a credit guarantee program called the Korea Tech-nology Finance Corporation (KOTEC) to facilitate credit access to high-tech SMEs. In Korea,SMEs account for 88 percent of total employment and are highly dependent on public creditguarantee programs (Hyung, 2009). Previously, the Korea Credit Guarantee Fund (KCGF) hadbeen established in 1976 as a credit program to relieve the credit pressures for SMEs in Korea.KOTEC was subsequently established in 1989 to provide this service specifically for SMEs inhigh-tech fields (Oh, 2011).

Throughout the 1990s and early 2000s, KOTEC’s guaranteed loans consistently underper-formed and carried an average default rate above 8 percent. However, in 2005, policymakersimplemented a new system of risk assessment that was specifically geared towards understand-ing the specific uncertainties associated with high-tech firms. The new technology appraisalmethod, known as the Kibo Technology Rating System (KTRS), evaluated future variablessuch as technology development and commercialization potential, profitability forecasts, andmarketability.


Figure 9.6: KOTEC Loan Program Statistics (KOTEC 2011)

Through close cooperation with Korean Universities and employing a staff of more thanthree hundred science and engineering experts in eight different technology areas, the newtechnology appraisal scheme has yielded positive results for KOTEC’s loan guarantee portfolio.The figure below shows the outstanding loan guarantees and contributions from governmentas well as private financial institutions from 2004 to 2008.

After the implementation of the new technology assessment methodology, governmentleverage needed to maintain the outstanding loan amounts decreased significantly due togreater private sector confidence and investment. KOTEC’s credit guarantee program illus-trates how financing for high-tech SMEs can be accomplished in an efficient manner whilereducing risk to the public (Oh, 2011; Hyung, 2009).

Appendix 9.D Fostering entrepreneurship in Chile (Start-UpChile)

Chile is often held up as a model of economic liberalization and has recently been at theforefront of targeted interventions into promoting small business growth. These include anexpansion of the tax credit businesses can earn for paying for new capital expenses that isspecifically targeted at small firms. Marshall (2010) shows that there has been a positiveimpact of capital investment as a result of the tax credit. He also discusses the possibility ofachieving an economically similar impact by reducing corporate tax rate for firms that exhibitthe mix of profitability and scalability that is desired.

More recently, Chile has created a competition called Start-up Chile which provides US$40,000 equity-free seed capital, as well as immigration assistance, to dozens of teams everyyear who are selected by a competition. In addition to strengthening existing innovation hubs,the goal for the project is to have 1,000 participate in the program by its culmination in 2014.In 2011, 87 startups from over 30 countries were selected from 330 applications.


The recent rounds have a length of 24 weeks, and have already created promising firmssuch as Taggify which recently attracted an additional US$ 750,000 from the GoC venture cap-ital firm. Taggify’s business model of offering contextual ads to web properties is competitivewith innovation from the United States. Chile also gains by promoting immigration and beingable to target small funds at the initial stages of innovation, which historically are the mostdifficult for entrepreneurs to secure. While a large number of ventures are likely to fail, thesmall individual prize sizes mean only a few successes could validate the entire program.

More importantly, the imported entrepreneurial talent who do succeed will be providinga service in exposing a network of individuals who by virtue of working in a start-up venturewill more likely launch subsequent ventures. The key takeaways are that start-up Chile isonly a viable option because of the underlying favorable climate for business developmentand creation. Without a well-regarded framework for enterprise featuring low taxes and aneasy registration process, greater incentives would have been required to get entrepreneurs toemigrate (Marshall, 2010).

Appendix 9.E Lessons in business support services fromMalaysia

Beginning in the 1970s, Malaysia began to take steps to improve the competitiveness of its do-mestic SMEs. The Bank Pembangunan Malaysia Berhad was created to provide training in softskills for entrepreneurs, as well as to allow enterprises to lease shared manufacturing space.In addition, the Credit Guarantee Corporation helped firms with limited or no collateral toobtain loans (Bin Yusoff 2010). This early start set the country on a path to export led growth.Recently, the country has begun to pivot in an attempt to move higher up the production valuechain.

Malaysia benefits from having an integrated policy decision making process. In the 9thMalaysia Plan which covered 2006-2010, the government took concrete steps to leverageSMEs for additional growth in two discrete areas: partnerships to enable firms to integrateinto global outsourcing networks; and entrepreneurship skills building programs. Recognizingthe importance of making international links and developing a reputation as an efficient loca-tion for private outsourcing, the government undertook “collaborative ventures among MNCs,government-linked companies (GLCs) and SMEs to facilitate technology transfer and skills de-velopment and marketing” (Habaradas, 2008). It is critical that these international programsbenefit domestic capacity if they are to be a sustainable building block to future growth.

Previous development plans have also provided matching grants for companies looking topurchase new hardware and software to improve business processes (Lee, 2007). By encour-aging technology and knowledge diffusion via global firms, Malaysia is able to strengthen thequality of domestic human capital and lay the groundwork for new start-ups with the abilityto compete on an international footing. In concert with these joint ventures, assistance toentrepreneurs such as “advisory and outreach services, have been expanded to equip SMEswith new and improved management and business practices, methods in production, qual-ity improvement, marketing and distribution” (Habaradas, 2008). The lessons from Malaysiaillustrate the importance of a comprehensive plan for SME improvement that is integrated


within the larger economic development strategy (Habaradas, 2008; Lee, 2007; Bin Yusoff,2010).


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Chapter 10

High Risk Finance

10.1 Introduction

The benefits of innovation have been widely discussed in earlier chapters of this book. Thesebenefits to society and spillover effects of innovation provide strong arguments for governmentsupport of research and development, especially considering the market failures that accom-pany many forms of innovative activities. While government-funded research is an importantcomponent in an innovative economy, particularly at the more basic levels, most innovation inadvanced economies is funded by the private sector. Within the private sector a large portionof research is conducted by established companies, while a smaller but arguably more innova-tive amount of research is conducted by small, knowledge-intensive companies. This Chapterfocuses on the challenges of financing a subgroup of these companies, knowledge-intensivestartups, which have historically been a significant source of new innovations and job growth.

Knowledge-intensive startups begin with an entrepreneur with an idea that s/he believesbrings something new and original to the marketplace. These startups are responsible foran outsized share of innovation in developed economies compared to their small size andrelative weight in research and in the economy as a whole. Though they have the potentialto be highly successful, they also have a high rate of failure. It is for this reason that they areconsidered high-risk investments. Many of them will fail, in fact, but successful survivors canmake high returns for their investors. They also create substantial benefits for the economyand the public. In the U.S., startups have been responsible for virtually all new job creationover the past 30 years (Kane, 2010).

High-risk financing bridges the gap between an individual with a great idea and a viablecompany with a new product on the market. Often, those with new and innovative ideasdo not have the resources to develop a new product on their own, including both funds andthe necessary set of business organization and management skills. This is especially true insectors that require highly specialized knowledge and resource-intensive development suchas biotech or information technology. High-risk financing fulfills a good part of this need andmakes innovation by individual entrepreneurs and small businesses possible. This chapter firstdiscusses how small startup firms are financed in developed economies and then examines thespecific challenges to promoting high-risk financing in emerging markets.

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CHAPTER 10. HIGH RISK FINANCE 184

10.2 Types of financing

10.2.1 Debt and Equity

There are two main types of financing that are typically available to startup companies. Thefirst is a loan, where a bank (or another lender) provides financing for a given term thatmust eventually be paid back by a business with interest. The other type of financing isequity financing where an investor provides money for a startup in exchange for shares ofthe company. Often this equity-based financing is invested and managed by angel investorsor venture capital firms, which specialize in developing small innovative startup companies.There are both benefits and drawbacks for each type of financing, which means that a startupcompany should carefully assess its circumstances before choosing a type of financing. Banksdo not tend to concern themselves with the day-to-day management decisions of companies;their main interest is making sure that the loan is repaid on time. This preserves the autonomyof the management of a company, but it also has the potential to drain a company of financialresources, which must go toward loan payments, diverting capital from being reinvested intothe new company (Ben-Ari and Vonortas. 2007). During the early stages of new innovativecompanies, which usually have few or no sources of revenue and require large initial capitalinvestments to develop their products, loan payments have a high opportunity cost. For thisreason, loans are usually most appropriate for companies that already have steady revenuestreams. For startups that are in their nascent stages and are focused on developing their firstproducts, equity investments will tend to be a better option.

Equity investments usually place less financial strain on a business during its early stages;however, they often come with greater strings on management decisions (Hall and Lerner,2009). Investors, through acquiring partial ownership of a company, can place restrictionson management decisions. The interests of entrepreneurs and the investors may not alwaysconverge. Entrepreneurs may choose to pursue strategies that bring in more funding such asissuing shares to more investors, while current investors may wish to limit those options inorder to maintain the value of their current investment. This divergence has the potential tocreate friction between entrepreneurs and investors. However, input and direction from in-vestors can often be helpful to a new company. The management of a small startup companymay consist of entrepreneurs who may be more competent in an area of technical expertisethan business management. For these individuals, guidance from investors can be very impor-tant to the success of the company.

10.2.2 Equity Investors Provide Useful Expertise

Though entrepreneurs may not enjoy relinquishing control to investors, venture capitalistsprovide managerial expertise that, in general, improves the performance of startups (Hall andLerner, 2009). Most venture capital funds employ compensation schemes for their managersthat depend heavily on the performance of the fund’s portfolio. This encourages fund man-agers to strictly monitor progress at a new company, particularly in the early stages when acompany has developed very few assets that can be liquidated in a bankruptcy. However, somestudies have not found a correlation between incentive pay and fund performance (Gompersand Lerner, 1999).


The primary method of control employed by investors is releasing funds in short stages. Ifperformance is poor or a venture capital company wants to enforce a change in a companythat it has invested in, it will withhold funding. Venture capital firms will usually grant greaterautonomy to companies that are performing well and place underperforming companies ona tighter leash by providing small installments of funding or even by taking over the man-agement of the company. The funding duration is also usually very short when a company isnew and its assets are intangible, such as knowledge retained by employees. Once an assetbecomes more tangible, for instance through the acquisition of a patent, venture capital com-panies will lengthen funding cycles (Gompers, 1995). When assets are tangible, the “salvagevalue” of a company increases since the assets can be sold on the market if a company fails.This, in turn, decreases the financial risk to investors.

This “hands on” approach that most venture capitalists adopt is one of the reasons thatventure capital tends to outperform other types of funding. Venture capital, according to somestudies, encourages greater innovation over typical investing. One study found that venturecapital funding will create three times as much patenting activity as an equivalent amount ofcorporate R&D (Kortum and Lerner, 2000). Innovative firms that receive venture capital alsotend to bring products to market more quickly (Hellman and Puri, 2000).

10.2.3 Investors Hindered by Information Asymmetries

The differing levels of knowledge between entrepreneurs and investors, otherwise known asinformation asymmetries, can also create tension and raise the price of capital. Entrepreneurstend to know their product (or potential product) better. As they are intimately involvedwith the development process of the product, they have a better grasp of the timeline for acompleted product and whether it will be viable on the market. Investors usually have lesstechnical expertise in the field than the entrepreneur, which creates an information asymmetryor “trust gap”. This trust gap can create communication challenges in the relationship betweeninvestors and entrepreneurs, as entrepreneurs attempt to keep their investors informed aboutprogress in product development and the timeline for return on their investment. Investorsmay even question the quality of the information since entrepreneurs have an interest in pre-serving funding sources and may bias information in a way that benefits them.

This trust gap also makes initial investment decisions more difficult for investors. Sinceentrepreneurs have a better understanding of the potential product and the probability ofsuccess, investors will be at a disadvantage. Providing too much information to investors alsoposes risks to entrepreneurs. Disclosing a new idea in too much detail may allow others tosteal or copy it. The low quality of information that faces investors during investment decisionsincreases the risk of investing in a project with low potential for future returns and thereforewill raise the cost of capital for investments in innovative companies across the board (Halland Lerner, 2009).

These information asymmetries and high failure rates are more pronounced in innovativestartups compared to new businesses in more established fields. This raises the price of exter-nal capital for innovative companies over what other startups would pay. For this reason, thecheapest option for funding R&D is using internally sourced capital, such as existing revenuestreams or retained revenue (Hall and Lerner, 2009). New startups do not have this option,so they must use the more expensive externally sourced capital. This in turn places greater


demands on future performance in order to pay for the more expensive capital.

10.3 Stages of Investment

It is rare to find one investor who will fund a new startup from beginning to end. Some cor-porations do this internally with new startups that are wholly owned by the corporation, butin the case of individual entrepreneurs and small startups, new funding comes in stages. En-trepreneurs are also not limited to one type of funding. Some companies will mix and matchequity and debt-based financing at different stages of the company’s development dependingon the needs of the company at the time (Ben-Ari and Vonortas, 2007). Each step in develop-ing a new product—from idea, to research, to prototype, to a marketable product—requireslarger amounts of capital. Advances in product development must be synchronized with newinfusions of capital. When this does not happen, funding gaps threaten the survival of startupcompanies.

The initial funds for the very early stages of developing a concept into a business (knownas the seed stage) will likely come from an individual’s own finances or from a group of closelyrelated people.1

This amount of money is variable depending on personal wealth, and in most cases inthe US, does not exceed a few hundred thousand dollars. To get beyond the seed stage,entrepreneurs require outside investors that are willing to make small investments in volatileearly-stage companies. In most cases, these investments come from wealthy individuals knownas angel investors who invest a small percentage of their wealth into high-risk ventures.Should the company prove successful, some angel investors will continue to fund the com-pany into the post-seed startup stage. Once funding requirements reach into the $1-2 millionstage, the investments are starting to become large enough to attract the attention of venturecapital funds.

Venture capital funds are different from angel investors in that they are not personal in-vestments; rather they are most often limited liability corporations where the money frominvestors is controlled by professional managers. Venture capital funds have been graduallyshifting their focus, investing in less risky, later-stage companies that require higher amountsof funding (NVCA, 2011). In 1995, investments in seed companies represented 15% of ven-ture capital investments. By 2010, this number has shrunk to 7% (NVCA, 2011). Part of thiscould be due to the higher management costs of monitoring multiple small investments versusfewer larger investments.

Another reason could be that venture capital funds have become risk averse. The changein venture capital fund trends has created a gap between the seed stage and startup stage,leaving fewer funding options for companies attempting to break beyond the seed stage. Angelinvestors, perhaps in an attempt to help plug this gap, have gradually shifted into post seedfunding. In 2002, 47 percent of angel investments went to seed companies, while 33 percentwent to post seed companies (Sohl, 2003). By 2010, this had shifted substantially: 31 percentof angel investments went to seed companies, while 67 went to post seed companies (Sohl,2011). This trend has also been observed in Europe, where seed funds now make up a small

1. Known as the three F’s: friends, family, and fools


Figure 10.1: Angel and Venture Funding

fraction of venture capital fund investments (EVCA, 2010). Whatever the cause of this shift, ithas left seed and early-stage companies with less opportunity to receive external funding.

Inventive Private Sector Solutions for Financing in the UKWhile government support is often essential for overcoming funding gaps where there arehigh risks that discourage private investment, new investment methods for private capitalmay play a part in making those funding gaps easier to overcome. In response to the globalcredit crunch, several UK firms are experimenting with ways to provide capital to newbusinesses. A business called Crowdcube is banking on a concept called crowdfunding,where an entrepreneur presents a business plan to a website with thousands of potentialinvestors and each investor is able to review the business plan and decide how muchhe or she wants to invest. This results in a large number of people each making smallinvestments in a new business. This is in contrast to the traditional angel or venturefinance model where a dedicated team of a few individuals reviews a new business andmakes a large investment.

By allowing individual investors to review the business plan on their own time, itavoids the lengthy and costly review process that takes place with traditional equity fi-nance. It also allows a greater number of individuals to make small investments in newbusinesses who might not otherwise be able to and it spreads the risk for potential fail-ures. Individual investors may not have the skill of dedicated angel and venture investorsin reviewing business plans and picking successful winners; however, providing a way forthem to participate in financing a new business may bring significant amounts of newcapital into play. ( )

Another UK company focuses on providing crowdfunding through debt rather thanequity. Instead of lots of investors making small equity investments in different businesses,Funding Circle’s model allows lots of lenders to make small loans to new businesses.Funding Circle first reviews the risks involved for a potential borrower and then allows itsmembers to provide loans through an auction. Each potential lender bids an interest rateat which he or she is willing to provide a loan, and then the lender with the lowest interestrate will be selected to make the loan. Just as in CrowdCube’s model, Funding Circleencourages lenders to make at least 20 small loans to spread the risk around. (


)Both of these companies use a crowdfunding model that provides a new set of benefits

and risks to the marketplace. By democratizing finance, more people with less means willbe able to invest and potentially profit from new startups. However, most investors willbe at a greater risk for losses since they will not have the experience to evaluate whatbusinesses might be successful and the information available on a website may not be asgood as what angel and venture investors receive when they invest in a company. This is ainventive way of investing that, if it proves to be successful, may open new doors for bothprivate investors and entrepreneurs.

10.4 Exiting

The ability to recoup investment is of crucial importance to investors. The goal of an equityinvestor is not to become a business owner. Rather, the primary goal is to buy shares in acompany with potential, support it and help it grow, and then profit off of the investment byselling shares after company value has increased. Equity investors tend to be patient, but theywill eventually want to sell their equity to realize their profits, which can then be rolled overinto new investments.

10.4.1 Acquisitions vs. Initial Public Offerings

An exit from an equity investment can take shape in three forms: a sale (or takeover byanother company), an initial public offering (IPO), or bankruptcy. Selling the startup to alarger company or another group of investors is one of the most straightforward ways torecoup investment. Often small investors such as angel investors take a company through theseed stage and then sell their equity to a larger investor that can provide additional fundsto continue to grow the company. A larger company may also purchase a startup for itsintellectual property or product line. A purchasing company might want to buy a patent toimprove an existing product or to prevent a competing product from coming to market.

While acquisitions are common, estimating the value of a privately held company is dif-ficult for a purchaser. In contrast to an initial public offering on a stock market, the pur-chaser cannot benefit from a market valuation of the company. The buyer must resort to othermethods such as making comparisons to similar publicly traded companies. Stakes in privatecompanies are also less liquid than publicly traded companies, making it more difficult forpurchasers to sell their equity. The risk associated with purchasing a private company that isilliquid and difficult to value results in a sale price discount that is often ad hoc (Das et al.,2003). The benefit of exiting through an acquisition is that it avoids the costly and administra-tively cumbersome requirements to which publicly traded companies must adhere. Prior to anIPO, a company must list itself on a stock exchange and comply with the requirements of theparticular exchange, such as minimums for market capitalization, share issuance, and histori-cal earnings. A publicly-traded company must also comply with public reporting requirementsand accounting standards that vary from country to country and are typically much more


Figure 10.2: Venture Capital Exits

burdensome than the requirements for privately-held companies. The added burdens of IPOsmean that private sales are often the only feasible option for small and early stage startups.

An initial public offering allows owners to tap funds from a large number of investors. Dur-ing an IPO, a company will list itself on a stock market and make a number of shares availableto the public for purchase. This allows a company to raise a large amount of funds quicklywhich do not have to be repaid to the investors purchasing the shares; however, it subjectsa company to a number of constraints faced by publicly traded companies, such as complexaccounting and reporting requirements, shareholder relations, and greater information disclo-sure (as discussed above). Despite this, an IPO is the preferred method of exit for a venturecapital fund because it usually yields the highest return on investment. Unlike a takeover orprivate sale, where shares and ownership are transferred immediately, venture capital fundsretain their shares for an average of a year after the IPO (Megginson and Weiss, 1991). Animmediate sale during the IPO would signal that the asking price for the stock is too high andthat the company is overvalued. Venture capital funds hold on to their shares and their boardpositions to signal stability in management and confidence in the stock.

In contrast, IPOs are rarely used as a means of exit by angel investors. In 2010, IPOsaccounted for less than 7 percent of exits for angel investors. The majority of exits, 66%,were through mergers and acquisitions (private sales) while the remaining 27% were divestedthrough bankruptcy (Sohl, 2011). The early stage focus of angel investors means that com-panies are usually not mature enough for a public offering when an angel investor is readyto exit. Private sales are also better suited for early stage companies because the intangibleintellectual assets are not likely to be well understood or valued by the public. Experiencedinvestors, such as venture capital funds, will more likely provide greater value in a private saleas they have a higher capacity to understand the value of the knowledge-based assets.

10.4.2 Bankruptcy

Bankruptcy is the least desirable option for exit. While bankruptcy can be viewed as a failure,it does not represent a total loss for investors. Most companies have some salvage value thatwill allow investors to recoup a portion of their investment when the assets are liquidated.For professional investors, bankruptcies happen in a minority of cases. Even following the


financial crisis when business bankruptcies peaked in the US in 2009, bankruptcies remainedin the minority, accounting for 40 percent of investment exits for angel investors (Sohl, 2010).For small businesses in general, around 70% survive the first two years and 50% survive forfive years (SBA, 2011). On average, the percentage of business angel investments that haveended in bankruptcy has remained below the average for small businesses in general. Thisindicates that there may be two factors that distinguish success rates for angel investor-backedcompanies from that of small businesses in general. The first is that angel investors are morelikely to invest in businesses that are more likely to succeed. The second is that angel investorsprovide valuable advice and direction that help businesses succeed.

10.4.3 The Cost of Failure Matters

The process of creating innovations entails trying new things that have unknown outcomes.There is inherently higher risk in this process, making some bankruptcies unavoidable. Thiscan discourage entrepreneurs from taking a chance in the first place. Making it possible forpeople to recover from a failed business will help mitigate this risk. The easier it is to obtainfunding for a new project after a failure, the more likely an entrepreneur will abandon aproject that has a lower chance of success (Landier, 2006). If decreased access to future capitalmakes failure too costly, entrepreneurs will tend to commit themselves to lower performingprojects for longer periods of time. Though this tends to decrease the failure rate of firms, italso diverts capital toward lower performing projects and away from those with the highestchances of success. Consequences must adequately discourage reckless use of funds withoutdiscouraging risk-taking altogether.

10.4.4 Ease of Exit

The ease of recouping investment is a very important factor in determining the level of ven-ture capital investment in a country (Black and Gibson, 1998). A key reason for the highlevel of venture capital funding per GDP in the US is due to its robust IPO market (Black andGilson, 1998). A well-developed IPO market provides the best means for extracting as muchprofit as possible from an equity investment. This provides investors with a greater degree ofconfidence that they will be able to profit on their investment once they decide it is time tosell. Venture capital tends to lag behind in emerging markets due to the lack of an establishedequity market and therefore a market for IPOs. They also in general lack the liquidity throughwhich such a market could be developed, largely due to the lack of pension fund investments(Mani and Bartzokas , 2002). Developing an equity market is a large challenge for an emerg-ing market. This leaves room for some innovative solutions from policymakers and businessleaders that will provide alternative avenues for venture capital funds to maximize the returnon their investments once they decide to exit.

10.5 Challenges for Emerging Markets

Up until now, this Chapter has examined how high-risk financing takes place in well-developedmarkets with a strong base of innovative businesses and high-risk investors. These markets are


not without their own problems, as shown with the gaps in financing for startup companiesand the shortage of investors willing to support companies at the seed stage. Emerging marketsalso face broader problems that are highly connected to the development of legal institutions,courts, open business environments, government transparency, and good governance. Thepremise that factors like corruption, poor public institutions, and the weak rule of law hurtinvestment potential is the basis for several World Bank efforts, such as the Doing Businessreport. These issues are frequently discussed in literature on emerging markets and otherdevelopment-related resources, but they are particularly relevant when it comes to high-riskfinancing.

Investors do not like risk. They despise uncertainty. Investors only choose to take on riskif they believe the potential reward outweighs that risk. The technology and market risksthey undertake in a knowledge-intensive startup are already quite significant but it is whatthey consider within their sphere of influence. Any factor that increases risk beyond thatlevel, especially where it takes the elements of uncertainty—such as in terms of the broadersocioeconomic context—discourages investment if it is not counterbalanced by an increase inpotential return. In any market, risk does not lie in the quality and viability of an innovationalone, but also in environmental conditions.

One risk that any market faces is cyclical market downturns. A company that would nor-mally thrive in a booming market might need to shut its doors during a downturn if demandfor its product dries up or capital flees for safe haven investments. Emerging markets haveother environmental conditions that are not present (or are less prevalent) in developed mar-kets, and investors considering investing in emerging markets will be faced with added risk asa result.

10.5.1 Intellectual Property Rights

As discussed in Chapter 5, intellectual property protection is critical for innovative, knowledge-based firms. A company must be able to exclude others from using its research and inventionsor else it will not be able to capture all of the value from its intellectual property. When acompany is unable to exclude others, most commonly accomplished by enforcing a patent,another company can profit from using an invention without bearing any of the costs of theinvention’s development. The creator of the invention then becomes an unwilling subsidizerof a competitor.

A country must have enforceable intellectual property rights to protect the money andresources a company invests in research and development, or else investors in the companywill not want to run the risk of having a knowledge-intensive company’s most valuable asset,its intellectual property, stolen by a competitor. This both devalues the assets of knowledge-intensive companies and lowers the potential for profits. Weak property rights increase riskand discourage investment.

10.5.2 Taxation

Capital gains taxes directly affect the rate of return that equity investors achieve from theirinvestments (European Commission, 2002). Targeted breaks in capital gains taxes for angeland venture financing can increase returns and help offset the costs of the increased risk of


investing in early stage companies. The United States saw a meaningful increase in earlystage angel investments after it introduced temporary but steep cuts in capital gains taxesfor individuals investing in certain types of companies with less than $50 million in assets(Schonfeld, 2011). Like the U.S., the UK has provided tax breaks to individuals investingin small businesses in an attempt to get capital flowing again following the credit crisis. TheEnterprise Investment Scheme will cut the tax burden on seed stage investments by 50 percentand will eliminate capital gains taxes completely on some types of business investments for ashort time period (HM Revenue and Customs).

10.5.3 Consistent and Impartial Rule of Law

Investors also depend on stable and predictable regulation and its fair implementation. Reg-ulations must change from time to time to keep up with a changing environment and makeuse of best practices that have proven their effectiveness in other countries; however, dramaticchanges impose costs on businesses and also increase uncertainty about how to comply witha new law and how it will be enforced.

The law must also be applied evenly and predictably. Laws that are rarely enforced provideopportunity for selective enforcement. When a law is rarely enforced, it encourages non-compliance and weakens the rule of law. As businesses slacken their compliance with the law,it leaves them vulnerable to unpredictable judgments from bureaucrats, who might have othermotives for enforcing a law (such as extracting a bribe, or assisting “favorite” parties). Thisalso leaves businesses guessing about which laws they must comply with.

The ability to obtain licenses is also important for a business and can relate to many areasof work such as construction, handling chemicals or substances, and using certain types ofequipment. Delays in obtaining a license can hurt a business through slowing work, idling re-sources, and ultimately increasing the time it takes for a product to reach the market. Demandsfor illegal facilitation fees in order to obtain a license more quickly pose unpredictable costsfor businesses and damage trust in a government’s ability to govern fairly. Any unpredictabilityin regulation and enforcement increases risks to businesses and creates an environment thatis unattractive to investors.

An effective and impartial court system is also necessary for a healthy business environ-ment. The ability to recoup an investment is a primary concern of any investor. Whether it isan investor trying to enforce a contract with a company or a bank attempting to obtain loanrepayments, an effective court system is needed to protect an investor. Delays in adjudicationdraw out legal disputes and increase uncertainty for businesses. Foreign investors also needto be sure that in a legal dispute, a court will treat a foreigner and a local national equally(legal impartiality). If a court system is seen as slow or corrupt, an investor would view thisas a potential liability.

While changes in the business environment are never easy, because they require reformsin the private sector, the bureaucracy, law enforcement, and cultural practice, they are nec-essary to attract both international and domestic investment. For international investors, thereputation of a country and the experience of other investors are influential in an investor’sdecision-making process. For domestic investors who know the local landscape and are wellinformed about local factors that may increase the risk of an investment, the investment po-tential in foreign markets also comes into play.


Capital is becoming increasingly mobile, and investors will attempt to seek out an in-vestment that yields the best return for the least amount of risk, regardless of whether theopportunity is at home or abroad. Capital flight is often seen as a vote of no confidence ininvestment opportunities in a country’s economy, while strong capital inflows generally in-dicate investor optimism. A country must reduce risks posed by corruption, a weak rule oflaw, informality, and poor public institutions in order keep capital from fleeing its borders andto attract new capital from abroad. Considering the very significant risks of funding an in-novative, knowledge-based business, any added risks regarding the business climate and theenvironmental conditions discussed above could kill the potential for high-risk investment.

10.6 Approaches for Supporting Financing

Given the increased risk (or even uncertainty) that investors may have toward taking a stake ina company in an emerging market, a government may need to intervene by subsidizing financ-ing or absorbing some of the risk of the investment. These sorts of programs are commonlyfound in developed markets in North America and Europe since these governments have longrecognized the valuable role of small businesses and startup companies in creating job growthand have invested public funds to support their development.

The earliest instance of such public support may be the American Research and Develop-ment Corporation set up in Massachusetts under the heavy tutelage of the State governmentin 1946. Because most of these financing support programs have taken place in developedcountries, the literature available for supporting risk financing in developing countries is thin.For this reason, the programs presented here took place mostly in developed economies; how-ever, the mechanisms that these programs used to boost investment should be more broadlyapplicable.

Publicly Funded Venture Capital in U.S. StatesSeveral U.S. States have devoted public money to venture capital funds to help promisingnew businesses grow and create jobs for their residents. One of the first examples ofthese state funds is the Massachusetts Technology Development Corporation (

), established in 1978 by the state legislature to invest innew technology-based enterprises.

An independent board comprised of experienced venture capitalists manages the fundand uses money from the legislature to invest in firms seeking $2-3 million in funding.By targeting funds in this range, the MTDC plays a crucial role in bridging the fundinggap that exists between angel investors and venture capital funds. Over the lifetime ofthe fund, the MTDC has invested around $83 million into 133 companies that currentlyemploy 7,500 people and maintain yearly payrolls that amount to $612 million (Kirsner,2011). In addition to creating jobs, the fund has been a good business decision for thestate: it has an average internal rate of return of 16.5% that allows the MTDC to reinvestin new firms without added state support (MTDC, 2011).

The State of Connecticut formed its venture capital fund, Connecticut Innovations in1989 ( ) and through its return on investments, Con-


necticut Innovations has operated without further financial infusions from the state since1995. The fund operates as an independent corporation with a board that is appointedby the governor and the legislature. Connecticut Innovations’ investments range from$15,000 to $1 million, providing funding to a wide variety of businesses in different fund-ing stages.

The fund has leveraged private sector investments in excess of $1 billion and has ledto the creation of 5,000 jobs in the state. The State of Maryland created the MarylandVenture Fund in 1993 to target early stage seed companies. The fund has brought in 62.5million in revenue over the life of the life of the fund while only costing the state $41million to run. Since 1993, 23 of its investments have either gone public with IPOs orhave been acquired by a larger firm (Maryland, 2011).

There are also many other states that have publicly funded venture funds,which vary substantially in terms of size and focus (

). Apart from direct investments, states also use a variety of othermeans to encourage private investment in early stage companies such as providing eco-nomic incentives, assisting the development of angel networks, and providing investoreducation. A more in depth explanation of these programs can be found in this documentfrom the National Governors Association (

).

Yozma: Israel’s Big BetOver the past 20 years, Israel has experienced one of the most dramatic transformationsfrom a financially constrained economy with low levels of innovation to a dynamic andhighly innovative economy with the highest R&D expenditures as a proportion of GDPin the OECD (OECD, 2011). In order to achieve this, the government undertook a boldeconomic liberalization scheme to shift more capital into the hands of private investorsand underwrote the venture investments of experienced foreign venture capital funds inIsraeli startups so that domestic investors could learn from the best. In 1993, the Israeligovernment invested $100 million into a program called Yozma, “initiative” in Hebrew,that matched investments of foreign venture capital funds in Israeli businesses. Yozma pre-negotiated buy out prices for the government’s shares in an investment so that the venturecapital fund could buy out the government if the investment was successful (Gilder, 2009).This sweetened the deal for foreign investors since they would be able to assume theprofits from the government’s shares if the startup started turning a profit without bearingthe risks of losses from those shares if the investment failed.

This was a bold and potentially risky strategy since it shifted the rewards for successto the private investors and placed a greater the burden for losses on the governmentand tax payers. But it also brought experienced foreign investors into the Israeli marketto make investment decisions on Israeli firms and teach local investors how the best VCfunds operate. After the success of the first $100 million in drawing foreign VC investors,the program grew to $210 million to take advantage of the international interest (HighTech Industry Association). These measures helped form local venture capital funds, but itwas not until the early 2000s that reforms channeled enough funds into these companies


that risk financing in Israel really took off. A series of privatizations and reforms to statepension funds shifted capital away from state bureaucracies and into the hands of privatecitizens and investors.

These venture capital funds created in the 1990s through Yozma became an avenue forinvestment for these new streams of capital (Gilder, 2009). The Israeli government’s beton bringing foreign venture capital firms into the country has paid of tremendously: from1991 to 2000, venture capital investment grew from $58 million to $3.3 billion (Gilder,2009). From 1997 to 2007, Israel’s share of GDP devoted to research and developmentjumped from 2.97 percent to 4.76 percent. This number has since declined a bit sincethe global economic crisis, but it still remained the highest in the OECD in 2011 at 4.25percent (OECD, 2011). Israel’s venture capital spending per capita is the highest in theworld at $142, around twice the amount in the United States (Vilpponen, 2011).

10.6.1 Research and Development Subsidies, Microfinance, and SmallBusiness Support

Germany, both through its federal and länder governments, supports innovative companiesthrough subsidies for research and development. While these subsidies do not specificallytarget high-risk financing, by subsidizing some of a company’s costs, the lower operating costsshould make a company less risky and should make any private investment in a companygo further. An analysis of the effectiveness of the R&D subsidy on innovation found that itdid increase innovation in the companies that took part in the program in general (Schneiderand Veugelers, 2010), but it did not increase innovation at Young Innovative Companies (anEU definition for startups that spend more than 15% on R&D and are less than 6 years old).An increase of innovation on average for companies receiving the subsidy might be sufficientreason to continue the program, but the authors suggest that a more targeted program mightbetter address the specific needs of a startup.

Evaluations of business support programs in Italy provide support for the notion that tar-geted support is more effective. While Italy’s programs do not focus specifically on innovativeor new technology based firms, they do provide an opportunity to evaluate the differencesbetween automatic and selective support. In a study of several of Italy’s business support poli-cies, those programs that used a selective review process to award funding resulted in greaterbusiness growth and job creation than those programs that distributed funds through an au-tomatic qualification process (Colombo et al, 2008). Further, younger firms grew and createdmore jobs than established firms. The study found that selective funding was most effectivewhen it was paired with firms that were both young and innovative.

There are a couple of reasons why a selection process might yield better results. While thestatistical model used in the study attempts to compensate for selection bias (ie. those that aremore qualified are more likely to be selected for funding, and because they are more qualified,they are also more likely to succeed as businesses), it may still be a factor in the firms’ success.When a firm wins funding, it also may act as a mark of approval for the business. Becausegovernment program managers have evaluated the company on a number of criteria, thismay signal to investors that the company is a worthwhile investment when it is successful inthe selection process. In this way, the selection process is acting to mitigate the information


asymmetries that often discourage investment in new innovative businesses.Conversely, microfinance, which attempts to encourage entrepreneurship on a very broad

scale, is not likely to be effective at supporting innovative companies. Microfinance institutionsrequire a large customer base, because the value of an individual loan is so small. They do notspecifically target innovative firms, nor do they necessarily target firms at all. In many casesmicrofinancing is often used for smoothing cycles in consumer spending in poor populations,such as using the financing as a stopgap measure when funds run out.

Though microfinancing may be of substantial value in helping provide resources to peoplein times of hardship, it does not tend to encourage entrepreneurship or more small businesses(Dichter, 2007). Because it has a minimal impact on small business formation and growth, itseffect on highly innovative small businesses, a small subset of businesses in general, would beeven further diluted.

Additionally, administration costs for microfinance have to be kept to a minimum becausethe small values and the high volumes of the loans require a highly efficient loan distributionsystem in order to keep administrative costs from eating away at profits, or in most cases formicrofinance loans, to minimize losses. This prevents an MFI from providing the type of busi-ness training that is considered highly effective in fostering well-functioning small businesses.While microfinance may have a place in development, it is not an effective tool for providingfinance to innovative businesses.

A successful example of a research subsidy mechanism is the Small Business InnovationResearch (SBIR) program in the US ( ). Theprogram requires that agencies that spend over $100 million annually on R&D to devote 2.5percent of their budget to SMEs with fewer than 500 employees. The program was initiallyconceived with a three stage funding process. The first stage provides up to $150,000 for 6months to study the feasibility and potential of an R&D project.

The second stage provides up to 1,000,000 for a year to continue the R&D efforts basedon the results of stage I. Stage III does not provide any funding, instead the agencies orcommercial entities that will benefit from the R&D are expected to pay for the research fromnon-SBIR funds if they see merit in the research (SBIR, 2011). A critical reform to the programin 1995 allowed for an expedited review process for stage II if a company was able to obtainoutside matching funds. They also receive bridge funding of $30,000 to $50,000 betweenstages I and II to prevent any funding gaps in the interim. This resulted in the programattracting younger companies that are in the most need of stable capital.

A study revealed that the SBIR found that the program resulted in good public benefitsthat would not have resulted from private funds, had support from government grants notbeen present. It found overall that the program was socially valuable and a good use of publicfunds (Link and Scott, 2000). While developing countries may not be able to take the sameapproach due to small research budgets, the important feature in improving the performanceof this program was minimizing gaps in funding. For funding projects that are taking place instages, minimizing gaps is an important part of program design.


Public Support Programs for High-Risk Financing in FinlandFinland has developed a publicly-funded system of institutions designed to support newstartups and help carry them over the valley of death. Though these institutions overlap inseveral areas, each institution plays a role in supporting young companies at a particularfunding gap. The system provides the potential for a startup to rely on government supportor government-facilitated support starting at pre-seed business planning and continuingall the way until the company has moved beyond early stage development and is of a sizethat is more attractive to private venture capital.

This approach involves a strong role for the government, but seems to work well inFinland, which has a high number of high tech innovative companies and spends thesecond highest amount of its GDP on R&D in the OECD. Finland has also achieved oneof the highest venture capital expenditures in Europe at roughly $60 per capita. Forcomparison, the U.S. spends $67 per capita (Wagner and Laib, 2011), and estimates forventure capital expenditures across the entire EU reach as low as $7 per capita (Vilpponen,2011).

Figure 10.3: Finland’s High-Risk Financing Institutions

Sitra, the Finnish National Fund for Research and Development, is a fund directed bythe Parliament that engages in a wide range of activities from investing in venture fundsto individual business finance. Sitra in recent years has focused its efforts on the earliestpre-seed stages of a new business. Sitra, in partnership with Tekes, provides hybrid grant-loan support up to 40,000 euros to entrepreneurs. This funding helps an entrepreneurpurchase consulting services to create a business plan and evaluate the feasibility of acompany’s R&D goals (Maula and Jääskeläinen, 2007).

Tekes, The Finnish Funding Agency for Technology and Innovation, is primarily gearedtoward supporting new knowledge-based enterprises through research and developmentgrants and loans, but also provides up to 80 percent of the startup capital, up to 100,000Euros, for new businesses through unsecured loans. This type of loan can help overcomeone of the most difficult points in the valley of death through providing necessary fundsat the earliest stages of a company when private capital is scarcest. Further, Tekes pro-vides technical assistance to potential applicants and provides loan support for developingbusiness models (Maula and Jääskeläinen, 2007).

Finnvera is Finland’s Export Credit Agency, which, in addition to helping secureFinnish companies against the risks of internationalizing and expanding exports, engagesin venture capital investments and the support of SMEs. Finnvera supports innovative


knowledge-based startups through a subsidiary called Avera which makes direct invest-ments in companies without private partners. Avera targets its funding to bridge thegap between R&D funding and venture capital funding. Avera funding frequently followsTekes funding to sustain businesses that are attempting to commercialize a product and at-tain private sector venture funding. The size of the investment, up to 500K Euros, is largeenough to act as bridge funding to move a company beyond the seed stage (Finnvera).

Finnish Industry Investment Ltd. started out as primarily as an indirect investor in newcompanies through making equity stakes in venture funds. Its purpose was to partner withprivate equity and encourage the creation of new venture capital funds in order to boostthe involvement of private capital in early stage financing. After encountering difficulty inconvincing private investors to co-invest with a government controlled entity in venturecapital funds, FII began investing directing with private investors in new companies ona matching basis. When making co-investments with private investors, FII typically letsthe private sector partner lead on the investment and does not accept a board seat in thecompany. About half of FII’s funds are invested in venture funds and half are investeddirectly in companies (Finnish Industry Investment).

Finland’s public support of young innovative startups features significant governmentsupport at the early stages, but then shifts government involvement to encouraging privatecapital formation and investment once a company moves beyond the seed stage. Thisfocuses government support where market failures are the greatest, but it also relies ongovernment officials picking winners and losers among applicants for support. The successof this model depends on the experience and capabilities of the government institutionsimplementing these programs.

10.7 Conclusion and Recommendations

In presenting recommendations for promoting high-risk financing, it is important that we notput the cart before the horse. In emerging markets, angel investors and venture capital fundsare limited primarily by a lack of what investors “perceive to be promising entrepreneurs andhigh-potential firms suitable for investment” (OECD, 2004). Quoting from an OECD reporton promoting innovative SMEs, “the most fundamental requirement for facilitating fundingfor innovative SMEs is to create an economic and institutional environment that is conduciveto entrepreneurship and innovation” (OECD, 2004). Developing opportunities for investmentmust precede any effort to stimulate high-risk financing.

The recommendations below will focus on investors investing in domestic markets. Early-stage investors need physical proximity to monitor their investments, making foreign invest-ment into seed companies and early-stage startups less likely. Foreign investment aimed atexpanding a later-stage company that already has revenue streams is a more likely possibility.It might also make a foreign investor more confident about investing in a developing marketsince the firm has already proven that it can flourish against the added challenges in such amarket. Investors need less encouragement to invest in successful companies, so these recom-mendations will focus on developing small businesses that have not yet proven themselves.


Support companies at the seed stage: The riskiest stage of investment is at the very earlypre-seed stage when an idea for a company is just taking shape. The seed stage suf-fers from a dearth of investment and represents an opportunity for government supportto help deserving companies bridge the gap. Government money should be used toleverage private funds so that the impact of public investment is maximized. Potentialmethods for doing this are matching requirements, loan guarantees, subsidies, and taxcredits.

Mitigate the costs of failure: By making it possible to recover from failure, entrepreneurscan learn from their mistakes and try again. Government programs that subsidize fund-ing for startups should develop appropriate penalties for failure that balance the needto make failure costly enough to provide disincentives for reckless borrowing with theneed to make sure that an entrepreneur can recover from a failed business.

Make sure everyone plays by the same rules: Government policies should attempt to cre-ate a level playing field so that businesses can prosper and fail not on the basis of fa-voritism, their connections, or their willingness to pay bribes, but on their ability tocompete. True competition can only take place when everyone plays by the same rules.Enforce the rule of law consistently and equitably, and vigilantly protect intellectualproperty rights.

Provide training and require monitoring and mangament assistance: Capital alone will notmake a business successful. Part of the value of angel investors and venture capital fundsis the management assistance and monitoring that they provide. Combining debt-basedfinancing with the management and oversight typically found in equity-based financingwill make loans a more productive method for financing startups.

Be selective and choose which companies to fund on merit: Programs that distribute fundsbased on a review-based meritocratic selection process are more successful than thosethat provide funds based on criteria that confer automatic eligibility. This helps en-sure the efficient use of public funds by directing funds toward only the most promisingfirms and by limiting bankruptcy losses. The vetting process before funds are awardedhelps decrease the information gap and risk that investors face when they are decidingwhether to invest.

Systematize seed and venture capital financing: Entrepreneurs need to know what to ex-pect when they start a business and how they are going to obtain funding at each stagealong the way. Systematize financing by organizing institutions and private investors sothat the methods for financing are clear at each stage of development. This will make fi-nancing easier and more practicable for both entrepreneurs and investors alike and avoidad hoc arrangements that can make transactions more cumbersome and unpredictable.


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