Innovation and Incentives
Author： Source： Date：2017-09-01
Editor’s notes: Innovation becomes the key to economic growth. What are other ways to encourage innovation besides subsidies? Professor Mirrlees deciphered the characteristics of innovations and shed light on some incentive options.
Good morning. This is a large audience and it's exciting to think that they might all be interested in innovation. I hope you all are.
Why innovate?
Clearly everyone wants to innovate, every government wants to increase innovation in their economies, and of course I mean cities as well as countries. I seem to hear this in every country I visit that it must be --what they want to do is to become the world leader in innovation. Why? I think it’s, in part just because innovation is exciting but also many economists have claimed that a high rate of innovation is needed for economic growth. And looking at the data of our economic growth all over the world, they have to explain why it continued as rapidly as it did. Many economists have studied this claim that in modern economies, you cannot explain the growth by capital accumulation alone and that it must come to quite a large extent from something called innovation, new techniques of production, finding new ways of doing things that have simply higher productivity. So you don't keep doing the same kind of things, the all of it. You have expansion that is deeper than that. And that’s based on innovation.
Actually this is not very well established because when you look at the data, you find that in some quite long periods, countries where economic growth has been very important like the United States of America may appear to have been no innovation according to the data. But we know perfectly well that there was. So the data is not entirely reliable and indeed the answer to this question depends very much on what you mean by innovation. So I will start by talking a bit about what innovation means. And then, since it's plausible that innovation should be encouraged. That means we don't just wait and let it happen without thinking about the environment in which it might happen, and that could be encouraging in some way. The question is how you can effectively encourage innovation. Of course it will be obvious that the key question here is what kind of character of innovations gets to be encouraged by the different ways you might do it. And that’s going to be my final topic, that is, how it would best be done.
Definition and characteristics of innovation
So what is innovation? I strongly recommended this very interesting book, and I knew that many Chinese have read it. Phelps wrote in this book, the main title of which is Mass Flourishing, which is about innovation and about its thesis that a lot of innovation are what he calls “ grass-root innovation” , as the saying comes from many people doing relatively small things which are new. Within that whole area of thought that emphasizes that innovation is the application of new ideas and requires creativity and imagination. It's a magic definition really. But there is a clear implication that what matters is the kind of increases in productivity economically and in other areas which you would say requires creativity and imagination. That begins to suggest ... I mean, these are the words that he uses a great deal and that many economists (who) have studied industrial development have wanted to emphasize. But of course it isn’t just doing something that has not been done before and that's another possible definition of innovation, that innovation might be something that simply wasn’t there but doesn't require any creativity or imagination to create it. One example is building a new road that connects two towns. That may very well help the economy. There may be very important new development contributing significantly to economic growth. And we would say that's not just a matter of accumulating in capital. You have to think of doing something new that hasn’t been done before, but it’s not an innovation in the character that Phelps wants to emphasize.
In my more mathematical moments, I very well understand that some problem-solving is real routine. What you have to do is to go through a well- understood series of steps in order to try to solve the problem, and that you try many different possibilities and one of them works. None of that requires what I would call really imagination. Mathematicians say that it lacks ideas. Some problem-solving is like that. A lot of what is done by pharmaceutical companies in developing new drugs is working through a lot of possibilities that have been dreamed out by somebody. There's the innovation. But then they have to be checked carefully one at a time that not only one of them but most will have the desired effects and will not have undesired effect. Invention you see is something different from innovation. Some innovations require inventions - electric cars need the batteries and electric motors which have to be invented; and some do not - the creation of a new building which can be very creative and rather wonderful. Beethoven’s Eroica symphony seems to me a rather important example of innovation of a wonderful invention. But there isn’t really an element of invention that exactly contributes to the economic growth. Computers, I think, come within this category.
Some innovations require long development, and some don’t. Nuclear bombs took a very long time to develop. It took quite a while for computers to work in the way we like them to work. But some important innovations happen at once, Picasso’s paintings would be fairly an extreme example, that he could toss off a painting in a few hours, and presumably it wasn’t immediate inspiration. That doesn’t mean that that’s not an important innovation. Indeed these are also economically valuable creations. So don’t just assume that innovations are necessarily going take a long time to work out. But this fact that it may takes a while or not is going to be key when I start talking about important policies. Well, there are, of course, different types of incentive that we might use. I’ve said enough for the moment about letting you the variety of things that we would call it innovations and that are important for economic progress.
Incentives to innovation
Innovation needs ideas, probably big ones, Can we encourage them? If you say what is about ideas, things that come from inspiration? It’s not immediately clear how you can deal with it, perhaps you just have to leave it to the culture of particular country or region, as to whether it stimulates this kind of invention or not. Professor Phelps spends a fair amount of space in describing different cultures where there is very different innovation. Italy is one extreme being relatively of the rich countries not very innovative, well of course said not right, because of all the wonderful artists being produced in Italy, but perhaps they don’t do so much now. And on the other hand, America, which is being highly innovative. So you do get differences that perhaps can be put down to cultural differences.
If the innovation would involve routine problem solving, as the type I was talking about when I describe pharmaceutical companies developing new drugs, simply having to try out a very large number of different, slightly different vaccines to see what happens. Why I encourage that? Is there any particular reason why that would be avoided because of its character as being innovation or new development? These are what we are going to think about. But when we are thinking about it, consider the different kinds of incentives that might be used, you will immediately think of some kind of subsidy, for example, patent royalties, really amount to subsidy, although it’s not a subsidy paid by government, it’s a subsidy paid by consumers of the invented product who pay royalties, because that’s part of the price that they pay for the commodity they buy and then use. Cheap substitutes might be provided that would be a form of subsidy. Places where young people with great ideas can go on work, science parks are, presumably, to some extent, that kind of thing.
But of course there are other kinds of incentives and in thinking about what might be the right and best way to encourage inventions. Think of the possibility that you might instead use prizes as a way of encouraging it. You will understand that I have a particular interest, and this particular way of doing it, and I’m going to be indicating that it seems to me not a particularly good way of encouraging innovation that perhaps is. PL in Britain thought that a good way of doing it would be to use honors, and Britain, of course, has rather a lot of honors, things like knights, and so on. And the point of giving an honor to somebody who has done something you value is that…if you are the government, it doesn’t cost you anything to give somebody the knight’s honor cost-free if indeed it has desired results. Well then on economic ground, that’s the method you should be using. An honor is a prize without monetary value; and some prizes are indeed just honors. But of course that leaves out what people might have in mind, simply advise ministers of the government, standing out and saying we have very good ideas if you want to try to innovate harder. And that's certainly one of the methods people have in mind.
It seems to me that the best method is subsidy. Using money is the best way of doing things, because it doesn't interfere with the value of what’s produced as a result of the innovation as measured by what people are prepared to pay for it. So long as what people are prepared to pay for it is the best measure you can think of the value of what is done. That's the way to do with it, as the argument for using market rewards. Other things like prices, people deal with that and say oh yes this particular piece of work you did is particularly valuable and you get an extra payment for it, even though there will be no evidence of its being more valuable to people who have reasons to value it because they use it themselves.
But of course one problem is that quite often the beneficiaries to an innovation, don’t actually pay for one reason or another, don’t pay enough. And People have suffered and do not make the producer pay. You get a lot of congestion on the roads because you invented the motor car. People who suffer from that congestion and who are late for their appointments don’t, of course, get to give a negative contribution to the value of the motor car. And people who would like planes to be quieter and would certainly have good reasons to value an innovation that makes planes quieter with settings under the flight path of the planes. They don’t manage to get the contribution except when government comes in and the question of permission is raised. So that's bit of problem. It is a problem that not only applies to innovation but seems important for big innovations. Questions like going to mars is not something that you would expect to be justified on the basis that people who pay fares on the spaceship one day will contribute. So it remains a question.
Well the beneficiaries will pay by subsidizing. I think that it is indeed a reasonable question. It is not immediately obvious that innovation should be or inventions should be given particular encouragement. The price may not measure the full benefits of course. The problem of copying is well known. And when I say the problem of copying I mean that you didn't have patent protection and intellectual property protection, and then people would quite legitimately copy quickly. And the person who is the original creator would not get benefits from his work as well because other people have produced perhaps even better copies than he has produced himself. The problem of patenting may make things expensive for the poor, which is often raised in face of a series of cases. When you think of a particular example where AIDS drugs is barely made available to many of the poorest people suffered from HIV in Africa for example. Is that the problem of the patent system? No, I think it's the same problem that food and clothes are expensive for the poor, just as these drugs which we rightly regarded as very important problems. The problem is being poor and ought to be tackled by doing something about poverty. Now it seems to me this is not the occasion to go into the tricky question that patenting may possibly be excessive, and that copyright certainly is, the period in which people get copyright is really very hard to justify.
It is not clear whether there should be any other subsidy, but there is a big issue here, uncertainty. Innovations like other investments, have uncertain consequences, It seems part of the definition of the innovation. You don’t know what is going to come of it. Actually sometimes this may not be true, you may think of something which you realize when you have thought of it is bound to be a great success. A lot of people want it, it might be a drug that you understand straightaway will do the right job. Perhaps penicillin was close to that. So uncertainties may not necessarily be all that great, and usually with innovations they are particularly risky. New drug development is indeed a striking case. Because I am told by people that know something about these things that drug companies do have to work through a large number of possibilities before they find one that works. So the uncertainty in coming out with the one possibility is very great.
It is believed that most people, including most entrepreneurs are quite risk-averse. Not be overstated, but the evidence for this is that the average return on risky assets is greater than on others. So people are prepared to take considerable sacrifices on the average returns in order to avoid great risk. On the other hand I found evidence that amongst the very rich, they seem to have very risky and uncertain wealth which jumps around all over the place from year to year, and even from decade to decade, and don’t seem to make an average return that is greater than ordinary people’s average return from savings accounts. So this is generally the belief that I think is probably right for most people, but it’s not totally sure. Clearly in claiming that most entrepreneurs are quite risk-averse, I am ignoring the fact that many entrepreneurs do like to gamble. Gambling, of course, is, on the face of it, very clearly a very strange thing for a risk-averse person to do. But most of these believe that people gamble for the excitement, not because they happen to be risk-loving. So the answer of this uncertainty is you want insurance should ensure innovation. Innovations have all from long development times of quite substantial expenditures in earlier years and no returns for many years. That’s also a bit like big investments which may not be innovations. The innovator would like to borrow to pay for the development costs, paying off the loan only if the innovation is sufficiently successful. Interests should be sufficient to compensate the lender for unsuccessful loans. Assuming that there isn’t much case for overall subsidy beyond what we’ve already mentioned, so you wouldn’t want the lenders, even the lenders are the government to be making a loss over the long run.
What I am describing, is the operation of venture capitalists, also the private equity firms operate to some extent in this way. Countries vary greatly in the supply of this kind of finance. The lender should take account of what we call moral hazard, just what the economists who got the Nobel Prize this year had been working on. This is one of the things I’ve worked on, that the borrower may not work well enough unless the terms of finance provide the right incentives. That might mean paying a proportion of profits. And this is what we want to underline and urge, (that) is the very important shift and reform you should want if you want to encourage innovation by providing insurance. What the innovator pays should be a proportion of its profits and not fixed interests, because fixed interests just put them in an unnecessarily risky position. And dealing with moral hazard is important to get plenty of information about the borrower and its plans, as well as to construct the contract so that if things only go moderately well, he doesn’t have to pay too much. I suggest with innovations we might think of application for funds, the way we in universities think of research grant applications such as peer review. This is something that banks were only partly doing well and lead out times to banking crisis, the big crisis we have gone through. Well there isn’t time now to get into that. The cost of doing good assessment may be substantial, and limit possibilities of innovation, but it’s essential.
Thank you very much.
James Mirrlees is the 1996 Nobel Laureate in Economics. He is the Distinguished Professor-at-Large at the Chinese University of Hong Kong.
Speech delivered at the opening plenary of the 3rd Dameisha Forum. Opinions expressed here belong to the author and do not necessarily represent the position of SZIDI.
Good morning. This is a large audience and it's exciting to think that they might all be interested in innovation. I hope you all are.
Why innovate?
Clearly everyone wants to innovate, every government wants to increase innovation in their economies, and of course I mean cities as well as countries. I seem to hear this in every country I visit that it must be --what they want to do is to become the world leader in innovation. Why? I think it’s, in part just because innovation is exciting but also many economists have claimed that a high rate of innovation is needed for economic growth. And looking at the data of our economic growth all over the world, they have to explain why it continued as rapidly as it did. Many economists have studied this claim that in modern economies, you cannot explain the growth by capital accumulation alone and that it must come to quite a large extent from something called innovation, new techniques of production, finding new ways of doing things that have simply higher productivity. So you don't keep doing the same kind of things, the all of it. You have expansion that is deeper than that. And that’s based on innovation.
Actually this is not very well established because when you look at the data, you find that in some quite long periods, countries where economic growth has been very important like the United States of America may appear to have been no innovation according to the data. But we know perfectly well that there was. So the data is not entirely reliable and indeed the answer to this question depends very much on what you mean by innovation. So I will start by talking a bit about what innovation means. And then, since it's plausible that innovation should be encouraged. That means we don't just wait and let it happen without thinking about the environment in which it might happen, and that could be encouraging in some way. The question is how you can effectively encourage innovation. Of course it will be obvious that the key question here is what kind of character of innovations gets to be encouraged by the different ways you might do it. And that’s going to be my final topic, that is, how it would best be done.
Definition and characteristics of innovation
So what is innovation? I strongly recommended this very interesting book, and I knew that many Chinese have read it. Phelps wrote in this book, the main title of which is Mass Flourishing, which is about innovation and about its thesis that a lot of innovation are what he calls “ grass-root innovation” , as the saying comes from many people doing relatively small things which are new. Within that whole area of thought that emphasizes that innovation is the application of new ideas and requires creativity and imagination. It's a magic definition really. But there is a clear implication that what matters is the kind of increases in productivity economically and in other areas which you would say requires creativity and imagination. That begins to suggest ... I mean, these are the words that he uses a great deal and that many economists (who) have studied industrial development have wanted to emphasize. But of course it isn’t just doing something that has not been done before and that's another possible definition of innovation, that innovation might be something that simply wasn’t there but doesn't require any creativity or imagination to create it. One example is building a new road that connects two towns. That may very well help the economy. There may be very important new development contributing significantly to economic growth. And we would say that's not just a matter of accumulating in capital. You have to think of doing something new that hasn’t been done before, but it’s not an innovation in the character that Phelps wants to emphasize.
In my more mathematical moments, I very well understand that some problem-solving is real routine. What you have to do is to go through a well- understood series of steps in order to try to solve the problem, and that you try many different possibilities and one of them works. None of that requires what I would call really imagination. Mathematicians say that it lacks ideas. Some problem-solving is like that. A lot of what is done by pharmaceutical companies in developing new drugs is working through a lot of possibilities that have been dreamed out by somebody. There's the innovation. But then they have to be checked carefully one at a time that not only one of them but most will have the desired effects and will not have undesired effect. Invention you see is something different from innovation. Some innovations require inventions - electric cars need the batteries and electric motors which have to be invented; and some do not - the creation of a new building which can be very creative and rather wonderful. Beethoven’s Eroica symphony seems to me a rather important example of innovation of a wonderful invention. But there isn’t really an element of invention that exactly contributes to the economic growth. Computers, I think, come within this category.
Some innovations require long development, and some don’t. Nuclear bombs took a very long time to develop. It took quite a while for computers to work in the way we like them to work. But some important innovations happen at once, Picasso’s paintings would be fairly an extreme example, that he could toss off a painting in a few hours, and presumably it wasn’t immediate inspiration. That doesn’t mean that that’s not an important innovation. Indeed these are also economically valuable creations. So don’t just assume that innovations are necessarily going take a long time to work out. But this fact that it may takes a while or not is going to be key when I start talking about important policies. Well, there are, of course, different types of incentive that we might use. I’ve said enough for the moment about letting you the variety of things that we would call it innovations and that are important for economic progress.
Incentives to innovation
Innovation needs ideas, probably big ones, Can we encourage them? If you say what is about ideas, things that come from inspiration? It’s not immediately clear how you can deal with it, perhaps you just have to leave it to the culture of particular country or region, as to whether it stimulates this kind of invention or not. Professor Phelps spends a fair amount of space in describing different cultures where there is very different innovation. Italy is one extreme being relatively of the rich countries not very innovative, well of course said not right, because of all the wonderful artists being produced in Italy, but perhaps they don’t do so much now. And on the other hand, America, which is being highly innovative. So you do get differences that perhaps can be put down to cultural differences.
If the innovation would involve routine problem solving, as the type I was talking about when I describe pharmaceutical companies developing new drugs, simply having to try out a very large number of different, slightly different vaccines to see what happens. Why I encourage that? Is there any particular reason why that would be avoided because of its character as being innovation or new development? These are what we are going to think about. But when we are thinking about it, consider the different kinds of incentives that might be used, you will immediately think of some kind of subsidy, for example, patent royalties, really amount to subsidy, although it’s not a subsidy paid by government, it’s a subsidy paid by consumers of the invented product who pay royalties, because that’s part of the price that they pay for the commodity they buy and then use. Cheap substitutes might be provided that would be a form of subsidy. Places where young people with great ideas can go on work, science parks are, presumably, to some extent, that kind of thing.
But of course there are other kinds of incentives and in thinking about what might be the right and best way to encourage inventions. Think of the possibility that you might instead use prizes as a way of encouraging it. You will understand that I have a particular interest, and this particular way of doing it, and I’m going to be indicating that it seems to me not a particularly good way of encouraging innovation that perhaps is. PL in Britain thought that a good way of doing it would be to use honors, and Britain, of course, has rather a lot of honors, things like knights, and so on. And the point of giving an honor to somebody who has done something you value is that…if you are the government, it doesn’t cost you anything to give somebody the knight’s honor cost-free if indeed it has desired results. Well then on economic ground, that’s the method you should be using. An honor is a prize without monetary value; and some prizes are indeed just honors. But of course that leaves out what people might have in mind, simply advise ministers of the government, standing out and saying we have very good ideas if you want to try to innovate harder. And that's certainly one of the methods people have in mind.
It seems to me that the best method is subsidy. Using money is the best way of doing things, because it doesn't interfere with the value of what’s produced as a result of the innovation as measured by what people are prepared to pay for it. So long as what people are prepared to pay for it is the best measure you can think of the value of what is done. That's the way to do with it, as the argument for using market rewards. Other things like prices, people deal with that and say oh yes this particular piece of work you did is particularly valuable and you get an extra payment for it, even though there will be no evidence of its being more valuable to people who have reasons to value it because they use it themselves.
But of course one problem is that quite often the beneficiaries to an innovation, don’t actually pay for one reason or another, don’t pay enough. And People have suffered and do not make the producer pay. You get a lot of congestion on the roads because you invented the motor car. People who suffer from that congestion and who are late for their appointments don’t, of course, get to give a negative contribution to the value of the motor car. And people who would like planes to be quieter and would certainly have good reasons to value an innovation that makes planes quieter with settings under the flight path of the planes. They don’t manage to get the contribution except when government comes in and the question of permission is raised. So that's bit of problem. It is a problem that not only applies to innovation but seems important for big innovations. Questions like going to mars is not something that you would expect to be justified on the basis that people who pay fares on the spaceship one day will contribute. So it remains a question.
Well the beneficiaries will pay by subsidizing. I think that it is indeed a reasonable question. It is not immediately obvious that innovation should be or inventions should be given particular encouragement. The price may not measure the full benefits of course. The problem of copying is well known. And when I say the problem of copying I mean that you didn't have patent protection and intellectual property protection, and then people would quite legitimately copy quickly. And the person who is the original creator would not get benefits from his work as well because other people have produced perhaps even better copies than he has produced himself. The problem of patenting may make things expensive for the poor, which is often raised in face of a series of cases. When you think of a particular example where AIDS drugs is barely made available to many of the poorest people suffered from HIV in Africa for example. Is that the problem of the patent system? No, I think it's the same problem that food and clothes are expensive for the poor, just as these drugs which we rightly regarded as very important problems. The problem is being poor and ought to be tackled by doing something about poverty. Now it seems to me this is not the occasion to go into the tricky question that patenting may possibly be excessive, and that copyright certainly is, the period in which people get copyright is really very hard to justify.
It is not clear whether there should be any other subsidy, but there is a big issue here, uncertainty. Innovations like other investments, have uncertain consequences, It seems part of the definition of the innovation. You don’t know what is going to come of it. Actually sometimes this may not be true, you may think of something which you realize when you have thought of it is bound to be a great success. A lot of people want it, it might be a drug that you understand straightaway will do the right job. Perhaps penicillin was close to that. So uncertainties may not necessarily be all that great, and usually with innovations they are particularly risky. New drug development is indeed a striking case. Because I am told by people that know something about these things that drug companies do have to work through a large number of possibilities before they find one that works. So the uncertainty in coming out with the one possibility is very great.
It is believed that most people, including most entrepreneurs are quite risk-averse. Not be overstated, but the evidence for this is that the average return on risky assets is greater than on others. So people are prepared to take considerable sacrifices on the average returns in order to avoid great risk. On the other hand I found evidence that amongst the very rich, they seem to have very risky and uncertain wealth which jumps around all over the place from year to year, and even from decade to decade, and don’t seem to make an average return that is greater than ordinary people’s average return from savings accounts. So this is generally the belief that I think is probably right for most people, but it’s not totally sure. Clearly in claiming that most entrepreneurs are quite risk-averse, I am ignoring the fact that many entrepreneurs do like to gamble. Gambling, of course, is, on the face of it, very clearly a very strange thing for a risk-averse person to do. But most of these believe that people gamble for the excitement, not because they happen to be risk-loving. So the answer of this uncertainty is you want insurance should ensure innovation. Innovations have all from long development times of quite substantial expenditures in earlier years and no returns for many years. That’s also a bit like big investments which may not be innovations. The innovator would like to borrow to pay for the development costs, paying off the loan only if the innovation is sufficiently successful. Interests should be sufficient to compensate the lender for unsuccessful loans. Assuming that there isn’t much case for overall subsidy beyond what we’ve already mentioned, so you wouldn’t want the lenders, even the lenders are the government to be making a loss over the long run.
What I am describing, is the operation of venture capitalists, also the private equity firms operate to some extent in this way. Countries vary greatly in the supply of this kind of finance. The lender should take account of what we call moral hazard, just what the economists who got the Nobel Prize this year had been working on. This is one of the things I’ve worked on, that the borrower may not work well enough unless the terms of finance provide the right incentives. That might mean paying a proportion of profits. And this is what we want to underline and urge, (that) is the very important shift and reform you should want if you want to encourage innovation by providing insurance. What the innovator pays should be a proportion of its profits and not fixed interests, because fixed interests just put them in an unnecessarily risky position. And dealing with moral hazard is important to get plenty of information about the borrower and its plans, as well as to construct the contract so that if things only go moderately well, he doesn’t have to pay too much. I suggest with innovations we might think of application for funds, the way we in universities think of research grant applications such as peer review. This is something that banks were only partly doing well and lead out times to banking crisis, the big crisis we have gone through. Well there isn’t time now to get into that. The cost of doing good assessment may be substantial, and limit possibilities of innovation, but it’s essential.
Thank you very much.
James Mirrlees is the 1996 Nobel Laureate in Economics. He is the Distinguished Professor-at-Large at the Chinese University of Hong Kong.
Speech delivered at the opening plenary of the 3rd Dameisha Forum. Opinions expressed here belong to the author and do not necessarily represent the position of SZIDI.
