delanceyplace.com 11/24/09 - more innovation

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In today's excerpt - small firms have an advantage over larger firms in innovation and venture capital plays a disproportionately large role economic growth:

"Initially, economists generally overlooked the creative power of new firms: they suspected that the bulk of innovations would stem from large industrialized concerns. For instance, Joseph Schumpeter, (1883-1950) one of the pioneers of the serious study of entrepreneurship, posited that large firms had an inherent advantage in innovation relative to smaller enterprises. ...

"In today's world, Schumpeter's hypothesis of large-firm superiority does not accord with casual observation. In numerous industries, such as medical devices, communication technologies, semiconductors, and software, leadership is in the hands of relatively young firms whose growth was largely financed by venture capitalists and public equity markets. ...

"A study by Zoltan Acs and David Audretsch examined which firms developed some of the most important innovations of the twentieth century. They documented the central contribution of new and small firms: these firms contributed almost half the innovations they examined. ...

"What explains the apparent advantage of smaller firms? Much of it stems from the difficulty of large firms in fomenting innovation. For instance, one of Schumpeter's more perceptive contemporaries, John Jewkes presciently argued:

" 'It is erroneous to suppose that those techniques of large-scale operation and administration, which have produced such remarkable results in some branches of industrial manufacture can be applied with equal success to efforts to foster new ideas. The two kinds of organization are subject to quite different laws. In the one case, the aim is to achieve smooth, routine, and faultless repetition, ideas. So that large research organizations can perhaps more easily become self-stultifying than any other type of large organization, since in a measure they are trying to organize what is least organizable.'

"But this observation still begs a question: what explains the difficulties of larger firms in creating true innovations? In particular there are at least three reasons why entrepreneurial ventures are more innovative:

"The first has to do with incentives. Normally, firms provide incentives to their employees in many roles, from salespeople to waiters. Yet large firms are notorious for offering employees little more than a gold watch for major discoveries. ... Whatever the reason, there is a striking contrast between the very limited incentives at large corporate labs and the stock-option-heavy compensation packages at start-ups.

"Second, large firms may simply become ineffective at innovating. A whole series of authors have argued that incumbent firms frequently have blind spots, which stem from their single-minded focus on existing customers. As a result, new entrants can identify and exploit market opportunities that the established leaders don't see.

"Finally, new firms may choose riskier projects. Economic theorists suggest that new firms are likely to pursue high-risk strategies, while established firms rationally choose more traditional approaches. Hence, while small firms may fail more frequently, they are also likely to introduce more innovative products. ...

"On average, a dollar of venture capital appears to be three to four times more potent in stimulating patenting than a dollar of traditional corporate R&D."