The Context of Economic Development Schumpeter’s attention to innovation


The Context of Economic Development
Schumpeter’s attention to innovation and entrepreneurship proved ahead of its time; these
concerns now lie center stage in policy discussions about economic development. Entrepreneurs
are the agents of change in an economy and the source of increased productivity – those actors
who recognize opportunity and garner resources to create value. Innovation and entrepreneurship
are two sides of the same coin: Entrepreneurs identify opportunity and innovate, while
innovation is the commercial realization of value from a new idea or invention from an
entrepreneur. Innovation may result in new products introduced to the market, new production
processes or new organizational forms. While radical new breakthrough advances hold our
imagination, there are many more mundane industries and incremental forms of innovation that
are within reach and that rely on different types of knowledge. 

Successful firms often arise in
unusual locations, serving unanticipated customer needs in unexpected ways.
Despite the pervasive image of the lone genius, innovation is a social activity that
requires a mix of individuals with different skills to collaborate to create value. Rather than
distributed uniformly through time and across geographic space, innovation tends to cluster both
temporally and spatially. This creates cycles of boom and bust, causing disruption for people
who move to follow opportunity, as well as the many who remain. One of the reasons why
regions, and in particular, cities, have moved to the center of attention is that inventors heavily
rely on local information or knowledge in generating novel products or processes. When an
industrial activity dominates a landscape, the factors of production become calibrated to that
activity and generate increasing returns. These factors of production include specialized skilled
labor, which is often referred to as talent but extends to all workers involved in production.
Related and subsidiary activities, which support and create economies of scope and both
formal and informal institutions, which share expertise and define a future trajectory are all part
of the factors of production. Observing that much industrial know-how defies formal capture
through market transactions, Alfred Marshall (1890) is famously noted to have said, “the secrets
of the industry are in the air.” Despite the Internet and advances in teleconferencing and
communications, the process of innovation still requires debating ideas, unpredictable epiphanies
and chance encounters. Innovation is essentially unpredictable – rooted in the creative sparks that
make us human and the serendipity that makes life interesting.
This has implications for economic development in both creating the capacities that
promote innovation as well as easing the transitions for places and communities. Of course,
predicting what will be the next big thing or even next important industry is difficult, and most
likely too difficult. Location becomes important not only for recognizing opportunity but also for
providing an environment that is responsive to the entrepreneurs’ activity, which in turn lowers
the cost of innovating (Audretsch & Feldman, 1996). Innovation and entrepreneurship require
economic agents to venture into unchartered domains and test the limits of their capabilities to
realize potential rewards. Even the most accomplished venture capital investors and stock
analysts make bad investments from time to time. It is no easier for government than for private
investors to decide which companies will be successful or how markets will develop. We never
know which new opportunities will yield a high return and which projects or companies will fail.
The best way to hedge society’s bets is building the capacity of individuals to fully and
creatively participate in economic and social life, and to incentivize companies to more fully
realize their capability to add to the economy. By facilitating industrial upgrading and improving
infrastructure, government lowers transaction costs to expedite economic exchanges. By
investing in institutions, government lowers risk and supports the utilization of private sector
It is not uncommon for policy makers to talk about return on investment (ROI), yet this
belies the fact that government invests in those activities that the private sector does not find
lucrative enough to warrant their own investment in the short term, or for which the capital
requirements are so large and the number of actors so complex that collective action is required.
Porter (1998) does not articulate a role for government policy, but instead considers government
as a background condition with influence on all of the factors in what has become known as
Porter’s Diamond. Porter’s emphasis, however, does highlight what the private sector requires to
be profitable and internationally competitive. Porter advances the idea of geographic clustering
of industries in a model that includes the nature and extent of the inputs required by firms to
produce goods or services; the type and intensity of local rivalry; the quality of demand for local
services; and the extent and quality of local suppliers and related industries. These factors
certainly define firm and industry capabilities as one of the important components of a regional
economy. However, Porter does not directly consider capabilities that support and sustain
innovation and new firm formation. The focus on existing industries precludes an emphasis on
the nascent or emerging industries that offer the most in terms of upside economic potential. In
the Innovator’s Dilemma, Clayton Christensen (1997) points out that innovative firms that focus
solely on their currently profitable activities are commonly eclipsed by more forward-looking
innovators. Ideally, a firm’s potential is realized before the opportunity becomes obvious.
Clusters appear to occur spontaneously as a result of the intrinsic tendency for industrial
activity, and especially innovative activity, to cluster spatially. However, clusters build on
existing capacities (Audretsch and Feldman 1996). In many cases the design and cultivation of
competitive industry clusters, often seen as a policy panacea, has failed to produce meaningful
economic development (Martin and Sunley 2003; Duranton, 2011). This failure has also
contributed to dissatisfaction with government policy (Lerner 2009). One reason is that the
cluster model obscures the role of government and fails to consider how industrial
competitiveness translates into economic development outcomes for an economy. The concept of
competitiveness, while operational at the individual firm and industry level, does not translate
fruitfully into economic development activities, and often creates bidding wars between adjacent
jurisdictions that would benefit from cooperation. Despite all the attention to lowering tax rates
and increasing a pro-business climate, the evidence suggests that these factors have little effect
on economic growth, while actually decreasing the potential for economic development (Goetz
et al, 2011; Hungerford 2012). While empirical research has shown that industrial activity
certainly benefits from location (Greenstone et al. 2010), the resulting profits are typically not
distributed back to local residents and communities or reinvested in those same places that
provided the advantage to firms and industries. Indeed, there are few mechanisms other than
corporate social responsibility and philanthropy available for firms to reinvest in local areas due
to a preoccupation with low tax rates.

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