Innovation Policy Handbook

CENTER FOR INTERNATIONAL SCIENCE AND TECHNOLOGY POLICY

Nicholas S. Vonortas Director Center for International Science and Technology Policy The George Washington University

Anwar Aridi The World Bank

Chapters Contributed By: Geetu Ambwani Patrick Besha Benjamin Boroughs Jordan Hosmer-Henner Eric Rouge Raﬁf al-Sayed Danny Waggoner Jeffrey Williams Timothy Williams

June 2, 2012 Contents

Preface 7

I Background 11

1 Technology, Innovation, and Economic Growth 12 1.1 Introduction ...... 12 1.2 Historical Economic Growth ...... 13 1.3 Economic Directions and Puzzles Regarding Technological Advance ...... 13 1.4 Returns to Research and Development ...... 17 1.5 Technology Diffusion ...... 21 1.6 Technology and Growth ...... 22 1.7 Evolutionary Theorizing ...... 26 1.8 Regional Considerations ...... 28 1.9 Summary Implications ...... 29 1.A Leveraging Investment in R&D Through Broad-Based Policy: Finland (1960-2000) ...... 32 References ...... 34

2 Science, Technology and Innovation Policy in the Era of Globalization 41 2.1 Introduction ...... 41 2.2 Should the Government Intervene? ...... 42 2.2.1 Market failure ...... 42 2.2.2 Beyond the market: System failure ...... 43 2.2.3 Life cycle of products ...... 44 2.2.4 Diffusion of knowledge ...... 45 2.3 Science, Technology and Innovation (STI) Policy ...... 47 2.3.1 STI Policies ...... 47 2.4 STI Policy and Globalization ...... 50 2.4.1 Multinational Corporations (MNC) ...... 52 References ...... 53

II Framework 55

3 Systems of Innovation 56

1 3.1 Introduction ...... 56 3.2 A Brief Overview of the Innovation Systems Concept ...... 57 3.3 Innovation Systems: The Local Dimension ...... 59 3.4 Innovation Systems: The Sectoral Dimension ...... 59 3.5 The Innovation Systems Approach for Developing Countries ...... 60 3.A Jordan: National Innovation System ...... 65 References ...... 67

4 The Entrepreneurial University: A Regional Perspective 70 4.1 Introduction: The Role of Universities in the Innovation System ...... 70 4.2 The Link between Industry and University ...... 72 4.3 The Role of Government ...... 74 4.4 American Universities and Entrepreneurship ...... 76 4.5 Case Studies ...... 76 4.5.1 Stanford University ...... 77 4.5.2 Singapore ...... 78 4.5.3 Volta Redonda, Brazil ...... 79 4.6 Discussion ...... 79 4.7 Conclusion ...... 81 4.A Moving towards the Entrepreneurial University Model in the Levant Region . . . 82 References ...... 83

5 Intellectual Property, Standards 88 5.1 Introduction ...... 88 5.2 Forms of Intellectual Property Protection ...... 88 5.3 Intellectual Property in the Innovation Ecosystem ...... 90 5.4 Intellectual Property and Development ...... 91 5.5 Determining the Need for and Impact of Intellectual Property ...... 93 5.6 Standards ...... 97 5.A Country Details: Lebanon and Jordan ...... 100 References ...... 101

6 National Competitive Advantage 107 6.1 Introduction ...... 107 6.2 Economic Growth and Development ...... 108 6.3 Deﬁning and Measuring Competitiveness ...... 110 6.3.1 Industry Competitiveness ...... 110 6.3.2 Global Competitiveness Index ...... 112 6.4 Conclusion ...... 114 6.A Jordan and the GCI ...... 116 6.B China’s Solar Industry ...... 116 References ...... 119

2 III Strategy 121

7 Alliances / Knowledge-Intensive Partnerships 122 7.1 Introduction ...... 122 7.2 Context of Strategic Alliances ...... 124 7.2.1 Deﬁnitions ...... 124 7.2.2 International Context ...... 125 7.3 A Practical Guide ...... 128 7.3.1 Partnership Opportunities and Dangers ...... 128 7.3.2 Partner Choice ...... 130 7.3.3 Partnership Negotiation ...... 131 7.4 Conclusion ...... 133 7.A Petrobrás Subsea Boosting Technology Development ...... 136 7.B Tata-Fiat Joint Venture ...... 137 7.C Vodacom-CWN Joint Venture ...... 137 7.D Indus Towers Joint Venture ...... 138 References ...... 139

8 Clusters / Science Parks / Knowledge Business Incubators 143 8.1 Introduction ...... 143 8.2 Clusters ...... 143 8.2.1 What is a Cluster and why are they desirable? ...... 144 8.2.2 Why do Industries Cluster? ...... 145 8.2.3 Agglomeration vs. Innovative Clustering ...... 147 8.2.4 Case Studies in Cluster Formation ...... 149 8.2.5 Can Governments Stimulate Cluster Growth? ...... 151 8.3 Science Parks and Incubators ...... 151 8.3.1 Science Parks ...... 152 8.3.2 Knowledge Business Incubators ...... 155 8.3.3 Assessments of Effectiveness ...... 158 8.4 Conclusion ...... 159 8.A Middle East and North Africa: Hi-Tech Entrepreneurship Efforts ...... 160 References ...... 160

9 Small Firms / Entrepreneurship 163 9.1 Introduction ...... 163 9.2 Overview of SMEs ...... 164 9.3 Types of SMEs ...... 166 9.4 Entrepreneurship in the twenty-ﬁrst century ...... 168 9.5 Challenges to growth in SMEs ...... 170 9.6 Approaches to policy ...... 171 9.7 Developing programs to support innovative SMEs ...... 173 9.A Comparison of SME initiatives in three European countries ...... 175 9.B Small Business Administration and SME incubation in the U.S...... 176 9.C SME credit ﬁnancing in Korea (Korea Technology Finance Corporation) . . . . . 176

3 9.D Fostering entrepreneurship in Chile (Start-Up Chile) ...... 177 9.E Lessons in business support services from Malaysia ...... 178 References ...... 179

10 High Risk Finance 183 10.1 Introduction ...... 183 10.2 Types of ﬁnancing ...... 184 10.2.1 Debt and Equity ...... 184 10.2.2 Equity Investors Provide Useful Expertise ...... 184 10.2.3 Investors Hindered by Information Asymmetries ...... 185 10.3 Stages of Investment ...... 186 10.4 Exiting ...... 188 10.4.1 Acquisitions vs. Initial Public Offerings ...... 188 10.4.2 Bankruptcy ...... 189 10.4.3 The Cost of Failure Matters ...... 190 10.4.4 Ease of Exit ...... 190 10.5 Challenges for Emerging Markets ...... 190 10.5.1 Intellectual Property Rights ...... 191 10.5.2 Taxation ...... 191 10.5.3 Consistent and Impartial Rule of Law ...... 192 10.6 Approaches for Supporting Financing ...... 193 10.6.1 Research and Development Subsidies, Microﬁnance, and Small Business Support ...... 195 10.7 Conclusion and Recommendations ...... 198 References ...... 199

4 List of Figures

1.1 Percent Change in GDP for Selected Countries (IMF 2011) ...... 14 1.2 World Average GDP Per Capita (Maddison 2008) ...... 15 1.3 The knowledge production function (micro level): A simpliﬁed path analysis (Griliches, 1990) ...... 18 1.4 Countries spending >2% GDP on R&D, and selected others (World Bank 2012, CIA Factbook, 2012) ...... 25 1.5 Public R&D Spending v. World Bank KEI Rank (World Bank 2012) ...... 26

2.1 Transition Between Two Technology Life Cycles (Tassey 1997) ...... 45 2.2 Historical Sugar Cane Yield in Brazil (Food and Agriculture Organization 2012 . 47 2.3 Science Is Becoming Internationalized (WIPO, based on data by Thomson in National Science Board 2010) ...... 52

3.1 Linear Model of Innovation (?) ...... 56 3.2 Evolution of Innovation Systems (Chaminade and Vang 2008) ...... 61 3.3 Innovation Systems and Development (Chaminade and Vang 2008) ...... 63 3.4 National Innovation System of Jordan (?) ...... 65

4.1 The Triple Helix Model ( )...... 71 4.2 Expansion of University Mission ...... 72 4.3 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 KAM Custom Scorecards: )...... 102

6.1 Global demand for solar PV modules (2008) ...... 118 6.2 Global production of solar PV modules (2008) ...... 118

8.1 The Diamond Model ...... 145 8.2 Science Park Characteristics (Battelle 2007) ...... 153

9.1 Share of enterprises by size class (number of employees), 2006 (EIP,2010) . . . 165 9.2 Share of employment by size class (number of employees), 2006 (EIP,2010) . . 165

5 6

9.3 Share of high-growth ﬁrms by sector, 2006 (EIP,2010) ...... 166 9.4 Arnold Staircase—Hierarchy of company types (Arnold and Thuriaux, 1997) . . 167 9.5 The SME Research Stairway (EURAB, 2004) ...... 168 9.6 KOTEC Loan Program Statistics (KOTEC 2011) ...... 177

10.1 Angel and Venture Funding ...... 187 10.2 Venture Capital Exits ...... 189 10.3 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 training course in science, technology and innovation (STI) policy. The audience of the training course was 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 around the world. The Handbook was intended to provide the background information to support the aforementioned training course in STI policy. It was not intended to set up the training course itself. We assumed no particular knowledge of the subject by the intended readers and only elementary understanding of economics. The Handbook sets up the context for STI policy, explains the institutions involved, deals with some of the most important issues in the STI policy sphere, and clearly suggests the most appropriate topics to consider in setting up the training course. We do not claim comprehensive coverage of all topics related to science, technology and innovation 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 research. Or, whereas we discuss intellectual property protection and standards, we do not delve into the important topic of technological paradigms and trajectories and the importance of IPR and standards in these. And, whereas we discuss strategic alliances and high-risk finance, we hardly put the two together to deal with innovative financing of high-risk networks. Rather than being comprehensive—an impossible task for a single volume—our aim was to distill and provide adequate information in one place that will prepare a diverse policy-oriented audience to 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 beyond the 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.

7 8

• 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 Six Major 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 on Foreign 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 STI policy as they relate speciﬁcally to economic growth and development. In building the Table of Contents, we have assumed an intensive training course of 4-5 days. The Handbook is comprised of 10 thematic chapters clustered under three overarching themes:

I Background: Introduces STI policy and provides the contextual background for modern approaches 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 how they are dealt with around the world. [Chapter 7-10]

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

Chapter 2: Science, Technology and Innovation Policy in the Era of Globalization. The Chapter starts by posing the question of whether and why should governments intervene when it comes to technological advancement and innovation. Then STI policy is formally introduced. Finally the Chapter places national STI policy into the broader context of globalization indicating aspects of policy that remain within the purview of national governments and others where the leverage of national governments has been eroded. 9

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 responsible for producing, adapting, and assimilating technological advancements; and (b) the broader socio-economic system that transforms these into innovations and places them into productive use. The Chapter indicates that the “systems” approach can be adapted to 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 the Triple Helix of a country: universities. It deals with universities through the prism of entrepreneurship and linkages with industry. The Chapter uses the Triple Helix concept to help focus on university-industry relations and then on the role of the government in trying to foster these by incentivizing higher education institutions to become more entrepreneurial. A number of speciﬁc examples are illustrated and ﬁnally lessons for the MENA region are drawn.

Chapter 5: Intellectual Property, Standards. This Chapter deals with two very important framework conditions of contemporary innovation systems: intellectual property protection and standards. Both these issues—left in the backburner for most of the modern history of industrialization—have been elevated to the forefront due to the arrival of the knowledge-based economy and globalization. Countries that want to be important players in the global economy simply cannot disregard them, even though for most policy decision makers they sound like boring, uninteresting subjects. The Chapter summarizes the state-of-the-art in our current understanding of these two topics and relates them to economic development.

Chapter 6: National Competitive Advantage. There is hardly anything more important for policy decision makers than being able as a ﬁrst step to determine the focus of their efforts 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? How is comparative (current) advantage determined? How is competitive (future) advantage determined and developed? This Chapter closes our discussion of the framework conditions for STI policy by dealing with those important questions.

Chapter 7: Strategic Alliances / Knowledge-Intensive Partnerships. One of the most important developments during the past few decades has been the proliferation of strategic 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 such collaborative agreements across all developed countries and the top tier of developing ones (BRIC+). There is more of an issue perhaps for countries lower on the development ladder. Still, a strong argument can be made that the available data have several deﬁciencies 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 company strategy and consequent policy implications. It provides a practical guide of the issues involved and illustrates through several cases around the globe. 10

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

Chapter 9: Small Firms / Entrepreneurship. This Chapter deals with one of the most critical 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 the Chapter tries to draw attention to such differences among the population. Differences in structure, organization, internal capabilities and sectoral focus also means differences in policy approaches. The Chapter primarily looks at this topic from the point of view of a developing country trying to underline the particularities of the phenomenon there. For instance, what is to do with “necessity entrepreneurship” (people setting up enterprises because they lack other employment) and how does it differ from opportunity entrepreneurship? What are common barriers to ﬂedgling companies?

Chapter 10: High Risk Finance. An absolutely crucial aspect of innovation is the transfer of an idea from initial concept to prototype and then to the market. A core component of this process is risk financing, that is, the ability to fund emerging business of higher than average 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 overview of the various types of finance for various stages of investment, addresses the important topic 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 Economic Growth

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 faith in technical advance is bolstered by achievements such as the atomic bomb, electronic computers, the landing of a man on the moon, heart transplants, and test-tube babies. We no 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 decades ago. It was one of a set of seminal publications in the late 1970s and early 1980s that changed the image of economists as laggards in the study of technological advance. This set would certainly include Caves (1982), Chandler (1977), Freeman, Clark, and Soete (1982), Mansﬁeld (1977), Nelson and Winter (1982), Rosenberg (1976, 1982), and Stoneman (1983), among others. While only a subset of these economists would classify their work into the “mainstream”, they have all stepped more or less on the shoulders of the same giants, including Smith (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 most important source of dynamism in capitalist economies and its relative neglect in most mainstream literature.” Freeman (1994, p. 463). Such views can better be explained by Nelson and Winter’s (1982) dichotomy between “appreciative” economic theorizing and “formal” economic theorizing. Appreciative theorizing stays very close to empirical analysis and case study work. Its strength lies in moving quickly to interpret what is going on and explain relationships among important variables. The principal weakness of this kind of theorizing is its basis in the analyst’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 used to provide stylized facts rather than wholesome stories. The strength of formal theorizing is

12 CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 13 the elimination of logical inconsistencies; its weakness is its slower pace that often leaves it detached from actual events. Formal economic theorizing is basically what one has in mind when one talks about “economic theory”: an abstract edifice to explore logical arguments. Its utility has been well proven, however technology has not always fit neatly into formal models. Appreciative economic theory has become a useful complement, allowing extensive progress in relating concepts and empirical findings to better understand the causes of technological advance and its impact on the economy. This Chapter presents basic economic arguments on technological advancement and its effects on economic growth. It starts with a few historical facts on economic growth and continues with concepts of technological advancement and innovation, a summary of how the current understanding of technology’s impact on economic growth evolved, and ends with policy-relevant messages emerging from this literature.

1.2 Historical Economic Growth

Most economists agree that for rich, highly developed nations, GDP growth should generally be expected around 2% a year (Ruttan, 2001). While this may seem small, if maintained, this still projects GDP doubling within 35 years. Even this can appear slow in comparison with rapidly developing nations, who may see growth rates in the double digits, as with India and China in recent years (see Figure 1.1) (IMF, 2011). Such rapid rates of growth are, in a broad historical sense, rather extraordinary. Growth in output has not necessarily been at a steady and even pace through all of human history. In particular, the past two or three centuries have seen a vast departure from the global growth rates that persisted prior. As shown by the long-run data in Maddison (2006) for the vast majority of history humankind has experienced minimal levels of growth. Conditions in early 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 early 19th century, a new trend of nearly exponential growth emerged. In 1850 the real GDP (in 2005 British pounds) of the United Kingdom was roughly 60 million pounds, and within a century, this had experienced an over ﬁve-fold increase, roughly 316 million pounds. It is this new period of historically rapid growth that continues to a greater or lesser extent throughout the 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 quality of life indicators that go with it, understanding the source of this remarkable expansion in output and the conditions conducive to it becomes an important task. For economists, this central question has nonetheless proven difﬁcult to fully answer.

1.3 Economic Directions and Puzzles Regarding Technological Advance

Economists became concerned with the effects of technological change early on, as the industrial revolution unfolded around them. Unfortunately, classical economists did not perceive CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 14

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 to conceive the true nature of natural resources as “man-made” rather than “natural”, missing the fact that changes in the relative scarcity of resources creates conditions for substituting one resource for another (including technological advance). And they did not adequately appreciate the fact that rapid technological advance is not simply the outcome of capitalist forces but also shapes and moulds the capitalist system itself. Classical economists had to overcome significant limitations, however. Their understanding of the forces underlying technological progress varied widely. They lacked reliable empirical information. And, the novelty of their field of inquiry made it difficult to agree on methodological issues. The introduction of consistent analytical structure in economic theory was the pursuit of the marginal utility school, starting in the second half of the 19th century. In addition to the factors influencing consumer behaviour, proponents of this school emphasized the objective aspects of production. But in the effort to produce a workable theoretical construction of the production function, the study of technological change was ostracized. “(A)s the importance of the production function increased, so the question of technical change receded into the background. Those who produced the most mathematical treatment of the production function, 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 — CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 15

Figure 1.2: World Average GDP Per Capita (Maddison 2008) economists were minimally interested in analyzing the process of technological advance in the ﬁrst 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 widespread and technology was recognized to be a central part of the engine of economic growth. Several reasons have accounted for the renewed interest of economists in technological advance since the mid-20th century (see also Rosegger, 1996): • Massive government investment in R&D during World War II demonstrated that purposeful searches for technological solutions to speciﬁc problems can behighly rewarding.

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

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

• Questions of international competitiveness, relating ﬁrst to the dominance of the United States and then to the emergence of Japan and Europe, increasingly focused on scientiﬁc and technological capabilities. CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 16

• A large group of newly established developing countries after the war were looking for ways 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 existence of which has been explained since the mid-1960s on the basis of intangible assets and related market failures (Caves 1996). The foremost intangible asset is frequently argued to be technological capability and, more generally, ability to innovate.

It was the appreciative theoretical work of Schumpeter (1942) that probably contributed most in providing the impetus for contemporary economic research into the causes and consequences of technological change. His stylised representation of the process of technological advance as “gales of creative destruction” captured the imagination and proved a turning point in economists’ conceptualisation of technological progress. Schumpeter’s contribution triggered a prolonged discourse over the relationship between market structure and evolution, economic institutions, and the incentives for and the intensity of technological invention and innovation. Sorting out the implications of these so-called neo-Schumpeterian hypotheses concerning market concentration, ﬁrm size, and the pace of technological advance attracted a lot of attention. It did not matter much that Schumpeter’s path breaking ideas were neither complete not always correct (Nelson, 1990). What really mattered was that economists now had a new handle on an issue too important to disregard. They started paying attention not only 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 progress into existing formal theory proved daunting. A number of unsettling observations were made quickly:

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

• This area required new thinking given that market failure in producing technological knowledge was suspected to be widespread, rendering traditional models less satisfactory.

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

• There was a problem with the actual process leading to technological innovation: only fairly simpliﬁed hypotheses of this process could be handled by standard economic theory, 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., endogenous growth theory (Grossman and Helpman, 1991; Romer, 1990) and the micro- level (industrial organization, game theory (Tirole, 1988; Stoneman, 1995) CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 17

• Have been creative in going around the third

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

The problem of formal theory with the process of technological advance has been known for some time. It has, for example, beset the traditional line of research trying to measure the contribution of past R&D investments to total factor productivity growth through an econometric production function (Griliches, 1979). Proxies of technology inputs and/or technology output are related to some measure of the ensuing economic outcome while the analyst is agnostic of the actual process of technological change. The exercise is sketched in Figure 1.3 which illustrates: (i) the transformation of R&D expenditures (R) into economically valuable, but imperfectly observable, technological knowledge stock (K); (ii) the approximation of the change in K over time (K ∂ K ) with the stock = ∂ t of patents (P) (or any other indicator of technology output; and (iii) the effect of K and other measurable 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 components are expressed by the error terms u, v. Thus, an attempt is made to estimate the direct relationship between P and Z. The intermediate stage of arriving at K and transforming it into R Z over time, as well as the complex interactions between X , K, and Z cannot be appropriately represented due to the lack of knowledge about the behaviour of the factors determining K’s intertemporal 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 aggregate across innovations and economic agents. To compensate, economists and business analysts have resorted to historical case studies. Detailed case studies of particular innovations are quite informative and show rather high internal rates of return to private R&D expenditures and 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 be generalized given the tendency to focus on the prominent and successful. A lesson learned is that no single approach can fully explain the relationship of technological advance and the economy. A complex, multi-dimensional phenomenon like innovation requires multi-dimensional analytical approaches based on formal theory, empirical analysis, acute observation and appreciative theorizing to establish regularities, and data from diverse sources including large databases, surveys, and case studies. It may even require new ways of conceptualising 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 approach and has been subject to well known limitations (see previous section). Several additional limitations must be emphasized, including:

• The private sector has been the main subject of study CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 18

Figure 1.3: The knowledge production function (micro level): A simpliﬁed path analysis (Griliches, 1990) CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 19

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

• The lack of consistent data has made this an “inexact science”, basing the analysis on data 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 contribute substantially to the growth of output in a variety of industries.

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

• The estimated elasticities and the rate of return to R&D investment vary considerably depending 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 elasticities of 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 significant outliers in both sets of measures at both levels.

• The majority of available econometric studies find that, for individual companies, the rates of return on R&D financed internally are significantly higher than those on R&D financed by the public sector. While the rates of return for private R&D range between 27% and 60%, those for publicly financed R&D are often insignificant and, in some cases, negative.1 Several strong caveats apply here. First, such estimations take into account only directly subsidized R&D and not the broad public investment in scientific and technological infrastructure (human and physical capital, institutions, regulations) that the private sector draws upon all the time to raise the efficiency of and returns from its R&D. Second, it has been argued that the use of US-based data for such comparisons is inappropriate due to the large share of defence-related R&D expenditures in that country 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 that changes in R&D affect the demand for inputs such as labour, materials, energy, and physical capital. The patterns of substitution and complementarities between inputs vary across industries (Bernstein and Nadiri, 1989; Nadiri and Prucha; 1990). In general, 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. CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 20

for labour and materials. Also the stock of R&D is subject to adjustment costs which affect the level of investment and rates of return to R&D. Investments in R&D are affected 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 affected by 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 of return. This implies that the innovator often has difficulty appropriating the full returns from 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. Various studies that Mansfield and colleagues have undertaken during the 1970s and 1980s indicated that detailed information on the nature of new products and processes are in the hands of imitators within a year from market introduction. The extent to which the social benefits from R&D are appropriable depends on how much competition the potential 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) did indicate the feasibility of using firm-level patent data to look at the direction of the flows of disembodied knowledge spillovers. Input-output matrices have been used for some time to capture embodied knowledge spillovers. These roughly correspond to the categories of knowledge spillovers and pecuniary spillovers above respectively. All available studies show significant flows of technological knowledge between organizations of different kinds, universities, firms, government laboratories), industries, and nations.

• There is increasing evidence that academic research has become a major underpinning of 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 possible without recent academic research and that the mean time lag between academic research and industrial innovation was seven years. Signiﬁcant differences between sectors existed. The mean social rate of return of academic research, with the most limiting assumptions, exceeded 20%.

• A strong positive relationship between basic research expenditures in the private sector and 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 produced by public research organizations and successfully applying it to their innovative activities. These estimates do not include more general societal returns from basic research which need to be appraised separately.

• A meta-analysis of 1,128 observations of internal rate of return of agricultural R&D, primarily publically funded, reiterated the wide range of data and difﬁculty in isolating a CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 21

common methodology, however concluded several points, among them: i) rate of return has not diminished over time ii) rate of return may be higher in more developed countries iii) rate of return depends on the focus of the research, or the problem it is addressing iv) a lower rate of return for research plus extension, versus pure research v) there are systematic variations in reported IRR that correspond with speciﬁc methodological 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 throughout the economy (Bresnahan and Trajtenberg, 1995). GPTs are characterised by pervasive- ness, technological dynamism, and innovational complementarities. Information and communication technologies (ICTs), biotechnology, and new materials are often used examples. By diffusing through the economy GPTs result in disproportionate rates of innovation and productivity growth. While exact measurement of rates of return has eluded economists until now3, this may be attributed to our rather rudimentary understanding of the process of technological advance through the economy. Helpman (1998) argued for an initial “time to sow,” in which resources are diverted towards producing the adaptations necessary to allow for application of the new GPT. Output and productivity continue under the old GPT with reduced resources and can actually decline. At a 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 output growth. 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 economic significance. The contribution of R&D to the economic performance of a nation depends on the ability of firms to utilize and commercialise the results by introducing profitable products and processes. Technological diffusion is of the utmost importance (Karshenas and Stoneman, 1995). Economists have studied technology diffusion extensively through various approaches such as “epidemic” (logistic) models leading to the popular S-curves, technology vintage models, stimulus-response models, and process models. There is general agreement that both supply and demand factors affect the speed and direction of technology diffusion. Diffusion takes time and depends on (Rosegger, 1996):

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

• Factors attributable to the structural characteristics of adopters and non-adopters such as technological 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 everywhere except the productivity statistics.” This became known as the “productivity paradox.” CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 22

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

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

• Factors relating to the institutional environment of the ﬁrm and the industry such as the 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 this is a reﬂection of the changed perspective concerning the sources of growth with the advent of the “new growth” theory. In the basic neoclassical growth model developed by Solow (1956) there is no technological change and employment is assumed equal to the supply of labour. Restrictive assumptions of constant returns to scale, perfectly competitive markets, two factors of production only one of which (capital) can be accumulated, and optimising behaviour, result in a stationary path where capital per head does not grow over time. To accommodate the observation that economic 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 later heavily criticized for its crude treatment of technology, neoclassical growth theory continued its development course on more or less Solowian principles for some time. According to this approach, growth of economic output is triggered by changes in the employed factors of production, the capital stock, the labour force, and the available technology. A good compendium of neoclassical growth was presented by Barro and Sala-i-Martin (1999). In the mid-1980s, a major departure from the neoclassical approach was proposed that has resulted in an impressive collection of publications under the heading of new growth theory.4 The clear point of departure is that these studies allow for increasing returns to scale 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 the environment of such actions. Most proponents of this “new” endogenous growth theory focus on the effect of collective learning and knowledge on the efﬁciency of individual production processes. Externalities can enter in various ways: they can be the equivalent of a growth factor when they consist of endogenising Solow’s technological shift factor, or they can affect capital 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 the discovery of new intermediate inputs. Yet others incorporate innovation as a series of “creative destructions” in an effort to introduce Schumpeterian dynamics (Aghion and Howitt, 1992). Finally, growth in these models can also be realized through public goods and infrastructure that increase the productivity of private factors. New endogenous growth theory models are

4. See Verspagen (1992) for a review. CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 23 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 reduced forms (e.g., Barro, 1991). The new growth theory has also been criticized for not being all that “new” (Nelson 1994). The criticism is that new growth theorists have been three decades late in incorporating the significant insights into growth and the role of technology that appreciative economic theorists like Moses Abramovitz (1952) had been writing for a long time. The strong attraction to growth theory has traditionally been related to the effort to understand relative movements in international competitiveness and trends in convergence/divergence between countries. An important implication of the neoclassical growth theory is the convergence of economies with different initial endowments. According to the assumption of diminishing marginal returns, the productivity of capital is higher in countries with lower endowments in this factor. Hence, the growth rates in economies with lower capital endowments should exceed growth in the better endowed, richer economies and in the long run endowments, and thereby growth rates, should converge. Evidence, however, has been quite mixed,5 requiring to move from absolute convergence (initial capital endowments determine growth rates) to conditional convergence taking into account the dynamics of growth. A large part of the work on conditional convergence has been summarized in Baumol et al. (1994). It essentially amounts to the investigation of a convergence hypothesis according to which: “When the productivity level of one (or several) country(ies) is substantially superior to that of a number of other economies, largely as a result of differences in their productive techniques, then those laggard countries that are not too far behind the leaders will be in a position 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’s performance have a lot to learn from the leader. However, as the distance among the two groups narrows, the stock of knowledge unabsorbed by the followers will grow smaller and approach 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 far behind the leaders that it is impractical for them to profit substantially from the leader” knowledge will generally not be able to participate in the convergence process at all, and many such economies 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 necessitated the consideration of so many factors that formal economic theory still finds impossible to handle. Hence, most insightful analyses are frequently based on appreciative theorizing. One excellent 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 compare growth rates from the period from 1960 to 1985 to the initial endowment, measured by GDP per capita in 1960. In the case of 118 countries there is hardly any correlation between the two variables, the evidence even slightly indicates a positive relation, i.e. high endowments cause high growth rates and low endowments result in lower ones. For a selection of the 20 original OECD members the hypothesis holds, the relation is clearly negative and the sample fit is much better. CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 24 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 influence the ability of different countries to realize their potential (thus be members of the converging group). The first set of factors amounts to the so-called technological congruence. This is based on the observation that technology does not advance evenly in all directions. It advances in a biased fashion that reflects: (i) the past influence of science and technology on the evolution of practical knowledge; (ii) the complex adaptation of that evolution to the natural resource and factor availabilities and to market scales, consumer demands, and technical capabilities of those relatively advanced countries operating at or near the frontiers of technology. The laggards face varying degrees of difficulties in adapting and adopting the current practice of the leaders according to the extent that resource availabilities, factor supplies, technological capabilities, market scales and consumer demands conform well to those required by the technologies that have emerged in the leading countries. The degree of difficulty is not a constant but changes over time as the laggards’ development adapts to the factor supply and to the organizational and institutional challenges presented by more advanced countries. The second set of factors amounts to the so-called social capability. This covers the country’s levels of general education and technical competence, the commercial, industrial and financial institutions that bear on its ability to finance and operate modern, large-scale business, and the political and social characteristics that influence the risks, the incentives and the personal rewards of economic activity including those rewards in social esteem that go beyond money and wealth. Social capabilities are also not constant. They evolve in the directions to which the requirements of a leading technology point, or in the case of a leading country, in the directions defined by those of an emerging technology. Countries’ potentials for rapid productivity growth by catch-up, therefore, are not determined solely by the gaps in the levels of technology, capital intensity and efficient allocation that separate them from leading countries. They are also restricted by the natural resource endowments and more generally because their market scales, relative factor supplies and income-constrained patterns of demand make their technical capabilities and their product structures incongruent with those that characterize countries that operate at or near the technological frontiers. And they are limited by those institutional characteristics that restrict their capabilities to finance, organize, and operate the kind of enterprises that the frontier technologies require. CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 25

The Importance of Preparedness for the Knowledge Economy When looking at those countries that spend the most on R&D, 3% of GDP is currently targeted 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 of data, only five countries met this 3% threshold, and only 12 spent at least 2% of GDP.These countries are among the wealthiest, and have experienced much growth through increased productivity and innovation, but most of the R&D spending globally is concentrated in these few. One way to look at this is through the lens of convergence theories. Based on Abramoviz’s language of macroeconomic convergence, the “social capability” and “technological 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 nations can benefit equally from spending in R&D. Some are ahead and need to continue innovating to stay ahead, and some can benefit from the leaders’ technology, while some will 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 technology infrastructure, as an index of preparedness for the knowledge economy. (World Bank, 2008) CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 26

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 spending allocated to research and development and how highly the country ranks in the KEI. As the ability of the country to benefit from the products of R&D, the increasing returns can justify 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 are poor in natural resources. These countries have instead been able to develop and exploit their human capital as a resource. For large, less wealthy nations, the formula is different, particularly at the early stages of development, which is shown by China, Brazil and India, which are among the fastest growing nations in terms of GDP, yet rank somewhat lower in R&D spending. They concentrate resources in preparing the general economy through capital investment so that they are better able to benefit from the returns to both foreign spillovers and their native R&D spending. It should also be noted that size is a contributing factor. The capital investments needed to build infrastructure and provide education are much greater, and some perspective is needed in looking at percentage figures. China’s R&D spending in 2010 was still 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 a set 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 broad survey of the approach see Nelson (1995). CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 27 development of these theories has not yet matched that of mainstream economics, there is considerable unanimity among the school’s adherents about the intellectual framework and future directions. The challenge is comprehensive because the evolutionary approach is rooted in biology, thus explicitly considering dynamics and path dependence, whereas mainstream economic theory is much more mechanistic, more akin to (older) physics. At the heart of the evolutionary approach is that history matters: firms are constrained by past experience in their effort to optimise. Experience is embodied in routines — explicit and tacit rules of behaviour. Firms develop routines that incorporate both public knowledge about markets, technologies, and the business environment and firm-specific knowledge. In relatively stable competitive environments, this implies a selection process that rewards certain kinds of routines (behaviour) and penalizes others. Routines are gradually adapted on the basis of experience through learning. They tend to change more or less frequently depending on the business and technological environment. Evolution principles also underline the emergence and development of all institutions affecting the general business infrastructure such as laws, regulations, technical standards, etc. Schumpeter’s concept of “creative destruction” is embodied in evolutionary theories in the form of “mutations” through drastic innovation. Drastic innovation changes technologies as well as routines and institutions. The extent to which innovation succeeds or fails is dependent on a complicated interplay of initial conditions and path dependence in addition to standard efficiency criteria and technical superiority. This interplay explicitly recognizes historical and accidental events, and thus hardly fits the characteristics of an optimisation process. When they dominate, drastic innovations set a new process of evolution. Importantly, the concept of path dependence implies that a successful technology with widespread use may persist in dominating its market even after the reasons for its initial dominance have disappeared. In other words, a well-established technology may be very difficult to replace by demonstrably superior innovations. In contrast, selection in conventional economics is more mechanistic, largely dependent on straightforward efficiency criteria of the technology 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. This framework seems to be much closer to Schumpeter’s theorizing in which technical and institutional innovations played a central role in the economic process. The net effect of the evolutionary/structuralist framework on policy decision-making and how that differs from mainstream (sometimes called neoclassical) approach is currently a matter of heated debate among economists. One way of arguing has been put forward by Stanley Metcalfe in several publications whereby policies based on the mainstream approach are concerned with resources and incentives taking the technological possibilities and capabilities of firms as given whereas policies based on the evolutionary perspective focus much more on the process of technological advance, 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 approaches as complements, each with specific strengths and weaknesses that could be combined to draw valuable policy advice. Yet, others strongly disagree, arguing that the chasm between the two analytical approaches is just too big and often leads to strong differences in policy (Lipsey and Carlow, 1998). CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 28

1.8 Regional Considerations

Studies of economic growth as experienced in the Middle East and North Africa (MENA) have shown that circumstances such as reliance on oil, high population growth and unemployment, lack of mature capital markets and institutions, and heavy state involvement in the real economy have resulted in the primary driver behind growth in the region for the past several decades being accumulation of capital, both physical and human. This does not however preclude the potential of technological advance in driving economic growth. Information and communication technologies (ICTs) in particular can play a large role. In particular, a well developed ICT infrastructure may not have immediate effect on domestic GDP growth, but can help attract the foreign direct investment. This FDI is a form of the stable and accumulating capital 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 Africa Africa, and particularly Sub-Saharan Africa, has among the least developed infrastructure in the world. Transport is largely dependent on road networks, yet Africa has only 204 km of road per 1000 sq km, with 25 This shows an example of in the process of development, there is no strict requirement to 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 several generations. The investment needed to connect landlines across continents to connect every town and village is immense. Europe and America completed it at a time when it was the only viable option. Africa, in contrast is able to use new mobile technologies to extend access to communications with a much smaller capital infrastructure investment. More striking is the degree to which this technology, produced in high-income developed countries, has been taken up and integrated into the development pattern of the less developed countries of Africa. Africans who may have had little access to the international community are within a very short span of time, able to post text message updates to live feeds with global reach, reporting on events as they unfold. Markets have become more efﬁcient 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 Kenya costs half a month’s wage. Mobile phones have become a shared resource, used among families or having their costs split among many users, and while not every person may have 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 business, and can more than pay for themselves over time. In comparison to landline access that could take months and require stiff bribes, or the costs of travelling many miles to gather market information or search for employment, a phone and subscription becomes a relative bargain as a business expense. (Aker and Mbiti, 2012) Furthermore, access to the technology has inspired innovation of its own. M-Pesa is a payment system developed and popularized in Kenya that allows transfers of money via CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 29

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, and election monitoring organizations are using crowdsourced information to increase transparency. (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 back when airtime has expired, arose from the practice of quickly calling and hanging up to indicate the same. (Banks, 2008a) In this application, the spread of mobile telephony is a technology in its own right, but also a platform that increases the ability of the native population to collect, spread, and develop new ideas into innovations. These trends to date have ﬂourished in relative informal terms, and often without government direction. As countries progress in development, the resource requirements of innovation increase greatly, and there comes a greater need for the government and the institutional framework to properly support further growth through 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 the discipline of economics has much more to offer in the analysis of the incentives for and results from technological innovation than is typically assumed by critics. Major advances in both formal and appreciative economic theory have empowered economists with signiﬁcant tools to appraise the causes and effects of resources devoted to the production and dissemination of new technological knowledge. A mix of important developments and results from the reviewed economic theory with rich implications for policy and policy evaluation include the following:

• No single approach can claim monopoly in explaining the relationship of technological advance and the economy. A complex, multi-dimensional phenomenon like innovation requires multi-dimensional analytical approaches based on formal theory, empirical analysis, acute observation and appreciative theorizing to establish regularities, and data from 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 indicating high levels of inter-ﬁrm and inter-industry spillovers, market failures, and need for public sector intervention.

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

• R&D investment affects the structure of production. CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 30

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

• Available estimates of the rate of return to publicly funded research range from 20% to 60%. Such rates of return are dependent on the successful application of the knowledge produced by public research organizations in the production process. These estimates do not include more general societal returns from basic research which need to be appraised separately.

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

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

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

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

• General purpose technologies (GPTs) such as ICTs, biotechnology, and advanced materials serve as a source of widespread innovation throughout the economy. By diffusing through the economy GPTs result in disproportionate rates of innovation and productivity growth.

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

• A major development in the economic analysis of technological advance has been contributed 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 mainstream economics, there is considerable unanimity among the school’s adherents about the intellectual framework and future directions. Important factors in the evolutionary approach to technological advance include: CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 31

– History matters – Firms develop routines that incorporate both public knowledge about markets, technologies, and the business environment and firm-specific knowledge. Routines are gradually adapted on the basis of experience through learning. They tend to change more or less frequently depending on the business and technological environment. – A selection process (market, other) rewards certain kinds of routines (behaviour) and penalizes others – Evolution principles also underline the emergence and development of all institutions affecting the general business infrastructure such as laws, regulations, technical standards, etc. – Schumpeter’s concept of “creative destruction” is embodied in evolutionary theories in the form of “mutations” through drastic innovation. Drastic innovation changes technologies as well as routines and institutions – Path dependence. E.g., a successful technology with widespread use may persist in dominating its market even after the reasons for its initial dominance have disappeared. In other words, a well-established technology may be very difficult to replace.

The net effect of the evolutionary/structuralist framework on policy decision-making and the differences from the mainstream approach is currently a matter of heated debate among economists. An important argument has been that policies based on the mainstream approach are concerned with resources and incentives taking the technological possibilities and capabilities of firms as given whereas policies based on the evolutionary perspective focus much more on the process of technological advance, 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 approaches as complements, each with specific strengths and weaknesses that could be combined to draw valuable policy advice. Appendix 1.A Leveraging Investment in R&D Through Broad-Based Policy: Finland (1960-2000)

In trying to evaluate the impact of R&D spending on GDP growth, many of the countries with high R&D budgets have healthy rates of GDP growth, but the factors involved are often complex and it can be difficult to isolate increased spending in R&D from increases in other government expenditures. R&D spending is often higher in small, wealthy nations that many not have significant natural resources. The case of Finland, in the last decade of the 20th century however, provides a unique example of a relatively small country that made large gains in GDP over a short time period due to deliberate and intense efforts to increase technological output, with a focus on the electronics industry, and at the same time extensive data collection by Finnish authorities and the OECD provides an excellent record. (Walwyn, 2007) In 1991, with the fall of the Soviet Union, Finland saw one of its largest export markets rapidly wither, dropping 61% between 1985 and 1991. The paper, pulp, and other wood products industries had dominated the Finnish economy until then, comprising 45% of exports in 1980. The early 1990s saw considerable economic turmoil for Finland, as it sought a redirection towards Western markets. GDP dropped by 20% from 1991-1993, the banking sector 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 with the private sector made several key decisions that took advantage of many native strengths, leading to a dramatic turnaround. The fledgling electronics industry expanded rapidly, and Nokia, 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, electronics had become a dominant force, representing 31% of Finnish exports. (OECD, 2008) Between 1993 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’s decision to increase spending on R&D during the recession proved to be wise, but such a belief in the power of R&D did not arise overnight, nor was the government the sole force for 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 industrial investments. While this does not diminish the necessity of sound research policy, it emphasizes that 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 establishing a central Ministry of Trade and Industry to oversee funding for goal-oriented research, along with a separate national fund for industrial research. Though through the 1960s and 1970s Finland was among the lowest spending governments on R&D in the OECD, and the 1960s was late to start a coordinated science policy, Finland’s membership in the rich nation group and proximity to other technologically advanced countries like Sweden contributed to much of 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 goals in research, with limited linkages between academia and industry.

32 Through the 1970s this focus changed, with contributions from the success of Japan, and the government shifted from creating and supporting research institutions to actively attempting to increase industrial competitiveness. A committee of leaders from industry, unions, government, and research institutions came together and recommended that the country use the opportunity of a new wave of electronics innovation as a means of moving from old industries to new, knowledge intensive high technologies. The National Technology Agency was founded in 1983, and was given responsibilities formerly held by the old Ministry of Trade and Industry. The Ministry had focused on central planning aimed at broad scientific goals, where the new Agency served to create connections between researchers, industry, and government. Pro- grams were started to specifically develop technology transfer and diffusion. This model of networked collaboration was extended throughout the 1980s to include international cooperation, where Finland was able to be actively engaged with other innovative nations and learn from them. (Lemola, 2003) The economy deregulated many sectors, encouraging competition, particularly in the telecommunication sector, which even into the 1990s remained largely under state supervision in most OECD countries. The company Nokia was able to take its invention of a new telecommunication 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 industry internationally 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 1990s are a simple reaffirmation on the part of the Finns in the success of their research and export driven model, where other countries might have turned inward. The concept of the “national innovation system” introduced by evolutionary economists in the late 1980s became an explicit concept in Finnish science and technology policy, with a clear recognition that driving technologically led growth requires attention to a much broader set of actors and relationships than simple industrial policy. By adopting this systemic view, and by developing both research and the infrastructure needed to turn knowledge production into innovation and growth, Finland was able to justify its added investment in R&D by the industrial R&D activity that followed. Given the foundation of basic research, human capital, institutional support, and infrastructure, industry was then in turn able to recognize an even greater rate of return on its R&D investment. A 2007 study that modelled these investments with growth and determined that government investment increased the returns to industrial R&D threefold, while the ultimate return on government spending in GDP was 66 to 1. (Walwyn, 2007) A 2003 OECD report summarized the key factors in Finland’s success, affirming that business was the ultimate engine for innovation and growth, but that it was made possible through several key policy decisions, including:

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

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

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

33 CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 34

many different players together.

• Effective education policies to develop the workforce.

• Liberal trade and investment policies allowing integration into world markets as well as a visible presence in important standard setting international organizations. CHAPTER 1. TECHNOLOGY, INNOVATION, AND ECONOMIC GROWTH 35

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Science, Technology and Innovation Policy in the Era of Globalization

2.1 Introduction

Fostering a culture of innovation, where scientific inspiration is transformed into new products, 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 improve productivity and spur rapid economic growth, leading to better standards of living and increased national competitiveness. Naturally, policymakers seek to leverage the resources of government, whether associated with budgets, policies, regulations, or the legal system, to support innovation. Broadly speaking, this effort is encapsulated in a set of policies collectively known as Science, Technology and Innovation (STI) policy. While there are fairly standard concepts of science and of technology, the definition of innovation has been subject to rather long debates. Economists have traditionally defined innovation 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 most authoritative definitions of innovation, and what is involved in it, have been provided by a series 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 improved product (good or service), or process, a new marketing method, or a new organizational 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 even institutional innovations such as open-source computing. Innovation, in short, is the ability to create and capture economic value from invention. Let us address a misconception before we proceed. Developing countries face a startling array of socio-economic problems and limited resource endowments. Such a climate raises questions about the relevance or need for innovation policy. One should not lose sight of the fact that learning and innovation were the fundamental drivers of growth and industrial

41 CHAPTER 2. STI POLICY IN THE ERA OF GLOBALIZATION 42 competitiveness for all countries considered advanced nowadays. They will remain so for the catching-up efforts of developing economies. If innovation does not just refer to the introduction of processes or products that are “new to the world” but also to the absorption and productive 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 policy that deals with it directly. The needs of any nation are highly contextual with regards to the state of development of its economy at any given point in time as well as a multitude of political, economic and social factors. For instance, policies appropriate for the rich agricultural farmland of Brazil will differ from those applicable to the vast ocean expanses of Kiribati. Innovation policy can be fine-tuned to solving or mitigating problems that are specific to a country’s particular development context. Micro-credit financing, for instance, may not be effective in the developed economies of Japan or Germany, but represents a major policy innovation in Bangladesh to support a broad range of the population that the formal banking sector will not service. Innovation, broadly defined, is crucial for a socially inclusive catching-up process 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 of globalization on national innovation efforts.

2.2 Should the Government Intervene?

A key question facing both developed and developing countries concerns whether the public sector should fund research and implement policies specifically aimed at improving the nation’s science and technology base. STI policy purports to develop a social and economic environment most conducive to producing advances in science and technology, and to foster the commercialization of such advances through innovation. At the national level, this often entails funding for basic science research and efforts to communicate existing scientific knowledge to applied research outfits to develop domestic applications. The task of turning research results into specific products and services is typically left to the private sector. Noting the linkages between national research funding and economic growth, countries are increasingly developing policies to guide funding for science, technology and innovation into areas that will 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 development was developed in the 1950s and 1960s. Richard Nelson (1959), for example, argued that the social returns to research investment exceeded the private returns realized by the individual firm undertaking the investment. In other words, scientific and technical knowledge were said to possess a public good dimension: the benefits from advances in science and technology spill over to other firms and consumers. As a result, the private sector could be expected to underinvest in scientific research, necessitating the addition of public investment to achieve a socially optimal level of research. CHAPTER 2. STI POLICY IN THE ERA OF GLOBALIZATION 43

Not all research has the same level of public good qualities. Basic research is experimental and theoretical work that advances the state of scientific knowledge. It can be considered as an important input that enhances the productivity of applied research and technology development. Applied research draws upon basic research to create new applications and achieve specific objectives. Businesses typically focus on applied research because the results are much easier to commercialize and bring to market than results from basic research. If businesses do not wish to spend money on basic research — who will foot the bill? This responsibility typically falls to government. In addition to imperfect appropriability of research results (reduced ability to keep knowledge proprietary and benefit from it while excluding others), another market failure was said to 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 innovative company sells stock, thus, spreading the risk among multiple owners. Market failure can also be the result of factor indivisibilities—certain investments can only be undertaken at large scales—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 policy 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 evolutionary and institutional economics, the theory of complexity, and the study of innovation systems. These approaches have focused on system failures due to technical complexity and more general systemic complexity involved in scientific and technological advancement and in innovation. 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 technology may result in a lock-in of the initial technological trajectory, even though an alternative path of technological developments might be more efficient. A second line of argument emphasizes the institutional constraints on the utilization and diffusion of knowledge. In this view it is insufficient for the government to support the generation of new knowledge and technology. Greater weight should be given to more effective institutional arrangements for the transfer of technology. As a result of the systemic nature of innovation, there are many feedback loops between the various stages of innovation process. Institutional relationships and the flows of knowledge between actors in the system are of critical importance. The innovative performance of a country/region is argued to depend upon the development of a balanced system of knowledge production and distribution. Gov- ernment intervention is thus justified to avoid the coordination and institutional failures that may occur. The role of the government is also related to the necessary investments in human capital and in mechanisms to intensify the flows and absorption of knowledge. A major challenge today is the complexity of modern technology. Most important technologies, including information and communication technologies (ICT), are essentially systems of components that must work efficiently together. The components themselves are often based on scientific knowledge from several disciplines. Industry has found the development of such technological systems increasingly challenging. Several barriers to attaining long-term competitive advantage have emerged: CHAPTER 2. STI POLICY IN THE ERA OF GLOBALIZATION 44

• An increased segmentation of R&D across industries making up the various supply chains results in private sector R&D that is more speciﬁc and less coordinated. This implies a failure to capture both economies of scale and scope, with a major consequence being underinvestment 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 of R&D.

• More pronounced private sector underinvestment in a range of critical technical infrastructure and standards.

Moreover, the issue of investment timing has gained attention in an era of shrinking technology life cycles. Technologies appear, mature, and become obsolete in a series of evolutionary phases, which greatly affect R&D decisions. Thus, an important economic factor is the timing of R&D investments relative to the evolution of a technology. The timing issue has two dimensions: investment decisions directed at attaining market share within a technology’s life cycle 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 larger systems, successive improvements in both design and process technologies increase total market value and standardize production processes. Dominant designs emerge, and a subset of firms 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’s structure takes on a commodity character (e.g., personal computer). Competition shifts to efficiency in production processes, and price and service become increasingly important determinants 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 demands advance planning for access to the next generation technology. This transition between two generic 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 greater the investment risk for individual companies and entire industries. Transitions to new technology 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 prospective research 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 new technology faces a projected potential performance pattern such as curve 2. Initially, the performance 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 prevailing technology life cycle. CHAPTER 2. STI POLICY IN THE ERA OF GLOBALIZATION 45

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

B). The probability of lower technical or economic performance, possibly for some time, adds to the risk associated with the dynamics of the marketplace.2 These arguments on the technology life cycle raise two key policy concerns related to the role of government in facilitating efficiency within life cycles and facilitating the critical transitions between cycles. First, within a life cycle, the amount and speed of technological advance achieved by a domestic industry over a technology’s economic life is critical, because such gains in performance determine economic returns. Second, transitioning between technology life cycles is an even more difficult issue. A number of high-tech companies manage transitions among successive product life cycles effectively. However, the transition to a radically new generic technology—disruptive technology—is infrequently achieved by firms champi- oning the defender technology. Most of these companies lose out to new companies. This process of “creative destruction” should only be a problem for policy makers if the new industry players reside outside the domestic economy, implying a loss of value added (jobs and profits). In addition, changes in competitive dynamics are altering the reward/risk ratio for R&D investments within and between technology life cycles. As life cycles compress, R&D at the 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 and technology concerns the beneﬁts of increasing international trade and global integration. Tra- ditional economic theory explains that the persistent poverty of many less developed nations is the result of a lack of natural resources or capital goods. In contrast, Paul Romer and others suggest 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 seldom give up without a fight, meaning that curve 1 may become steeper under intense competition. This further compounds the innovator’s risk and has accounted for several new technology failures in the past. CHAPTER 2. STI POLICY IN THE ERA OF GLOBALIZATION 46 countries (Romer 2007). In some ways, developing countries are at an advantage in the quest for new knowledge, because they can pick from the rich store of existing knowledge already created by the developed, industrialized nations. Access to this knowledge is facilitated by international trade and integration, whereby companies introduce new products and processes, scholars exchange ideas, and governments coordinate policies for mutual benefit. Countries can encourage such knowledge flows through the use of STI policies that seek to protect patent rights, permit foreign direct investment, and establish property rights. For these reasons, STI policies seek to create a climate conducive to the growth of domestic business—a goal which is addressed through the development of fundamental S&T capabilities and R&D activities at national ministries, basic research institutes, universities, and to some extent, private businesses. A firm can be innovative by creating a new product, but it can also be innovative by implementing 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. The process of diffusion is particularly relevant and important to developing countries. While they may seek to invent new-to-the-world products, a more significant source of technology comes via the successful diffusion of existing foreign technologies into the domestic economy. Such technology diffusion is a hallmark of globalization and the networked nature of knowledge economies.

Case Study of Brazil’s Agricultural Strength Brazil’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 commodities such as sugar, cattle, soybeans, beans, chicken, pigs, oranges, rice, corn, and coffee. But even with such valuable natural resources, the country struggled economically for most of the twentieth century.Finally in1973, Brazil began a fascinating and uniquely successful experiment in knowledge and technology creation—the world-class system of cutting-edge research known as the “Brazilian Agricultural Research Corporation”, or EMBRAPA. EMBRAPA is a national research system supported by the country’s science, technology and 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 its goal of the sustainable development of Brazil’s agricultural sector. Consider the beneﬁts of Brazil’s investment in agricultural technology: From 1970-2010, using advanced agricultural technology, Brazil nearly doubled its hectogram per hectare sugar cane yield. The work of EMBRAPA optimizes the country’s use of agricultural resources and contributes to economic growth. CHAPTER 2. STI POLICY IN THE ERA OF GLOBALIZATION 47

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&T investments lead to knowledge production and eventually innovation. Innovation is instead the result of a complex interplay of factors working harmoniously together in the sense of an “innovation system”, deﬁned as “elements and relations, which interact in the production, diffusion and use of new, and economically useful, knowledge. . . ” (Lundvall, 1992). Such a system includes key organizations and institutions, as well as the many linkages between actors including the triad of public sector, private sector, and universities. Institutions generally refer to the spectrum of established norms and practices, laws and regulations that govern relations between individuals, groups and organizations involved in science, technology and innovation. Examples include the intellectual property regime (and patent system), industrial policy, labor regulations, and various other institutions. Linkages refer to the myriad interactions between and within the organizations and institutions. Links between research institutes, or between public universities and private companies enable the broad utilization and enhancement of advances in science and technology. To the extent that STI policy addresses the “system”, then, it can be effective by seeking to strengthen the organizations and the institutions which allow knowledge to be produced as well as the methods by which knowledge can 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- CHAPTER 2. STI POLICY IN THE ERA OF GLOBALIZATION 48 ment most conducive to the latter. A 2008 World Bank report on the role of government in supporting 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 is extensive. 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 large chunk of applied research, and a much smaller share of development research (excepting national defense). The participation of the public sector in national R&D expenditure varies between a ﬁfth in East Asian countries such as Korea and Japan and a half in several countries of the European Union, with the United States in the middle (more than one-third). The public sector comes at higher levels in developing countries, ranging from very high in less developed to relatively lower higher up on the development ladder. The advantage of such subsidies is their selective nature: one can decide what to fund and what not to fund. The disadvantage is possible distortion of the market by decision makers removed from the market. CHAPTER 2. STI POLICY IN THE ERA OF GLOBALIZATION 49

Tax incentive programs The most well-known implementation is the R&D tax credit, now widely used around the globe. 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 beneﬁciaries decide their R&D focus. Funding authorities now do not have a choice regarding the type of research to fund.

Intellectual property management The patent system is one of the most important ways inventors can secure ownership rights for their inventions. In addition to their individual country of origin, inventors will seek to patent their most valuable inventions in the largest prospective markets which traditionally have included the U.S., Europe and Japan and more recently are expanding to include large rapidly developing nations. Increasingly the practice also includes universities which have been emboldened in the US since the passage of the Bayh-Dole Act in 1980. This Act allowed universities to patent inventions created through public funding. It also lent support to joint commercial projects between universities and businesses. In more recent years the Act has been 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 attracted a lot of attention in the past three decades or so. Setting up university-industry linkages and technology transfer offices aids this process. Innovation incubators and science parks. We will return to this STI policy tool later in this volume (Chapter 8). Suffice it here to say that the advantages 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 in a similar or related field(s). The basic idea is that in such a scenario knowledge can flow much more easily across people and organizations, spurring innovation and development. A virtuous cycle may develop whereby successful businesses generate economic returns, and draw other businesses to the area. Science parks grow around universities, aiming to facilitate university industry 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 educated citizens who handle them. Ensuring that schools produce citizens with the skills needed to function in a modern economy is important, and even more so as a country seeks to foster an advanced, knowledge-based economy. CHAPTER 2. STI POLICY IN THE ERA OF GLOBALIZATION 50

Entrepreneurial training in university outreach programs Instilling some basic concepts of business, a tolerance for risk and appetite for reward, and an understanding of economics in young people can help a country develop. Because an important factor in economic growth is the creation of new businesses, educational programs that inform young people and turn them to prospective business owners provide an invaluable service. Even in countries with limited capacity for large-scale public investment in science and technology, 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 education and training policies, provides support for entrepreneurs, and encourages network linkages between government, academia and business. Government can also play a role in strengthening demand-side policies by implementing regulations, setting standards, modifying pricing, educating consumers and setting tax and public procurement priorities (OECD 2011). Recognizing the role of knowledge and information as a driver of productivity and economic 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 and use of knowledge (OECD 1996). Many nations, including those in the Arab world, are interested in developing a knowledge-based economy to support competitive and innovative industries.

2.4 STI Policy and Globalization

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

Globalization OECD (1996a) summarizes the main resulting features of globalization as follows: • Simultaneous competition in each market between numerous new competitors from all countries. Each ﬁrm now has to compete in its own market with other ﬁrms and new players from all over the world. This new competition necessitates in numerous areas extremely rapid structural adjustment.

• Internationalization of production: multinational origin of components, products, services and capital. The various elements that enter into the manufacture of a product (capital, labor, technology, raw materials, intermediate goods, distribution) may come from many sources; countries and ﬁrms are now so interdependent, and CHAPTER 2. STI POLICY IN THE ERA OF GLOBALIZATION 51

the links between the so complex, that it is sometimes quite difﬁcult to determine exactly where the various elements come from. • Growing interdependence of the various levels of globalization (trade, direct investment 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 the most important, vector of globalization.

• Foreign direct investment has become a crucial factor in the worldwide process of industrial structuring and the development of genuinely global industries. Direct investment ﬂow generates exports from the countries making the investment; these exports are accompanied by transfers of technology and know-how, and capital movements (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, and distribution. 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 already a significant enterprise which is largely driven by the private sector. In 2007, global combined investment in R&D reached an estimated $1.1 trillion (National Science Foundation). The vast majority of this investment was directed and committed by industry.3 Since industry is quickly internationalizing, R&D is expected to follow suit. The main channels for STI internationalization include: i) an increase in the number of R&D laboratories located abroad; ii) the rising number of cooperation agreements or alliances either between firms or between firms and government or university R&D bodies; and iii) an increase in contract R&D to foreign organizations. Globalization presents both opportunities and challenges for national economies in the Middle East. On one hand, the opening of borders allows high-wage countries to shift production of some goods to companies in the region and sell their goods to a much wider group of customers. 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 UK industry spending 70% and 45% of their respective national totals. East Asian countries like Japan and Korea have even higher shares by the private sector, reaching 80%. CHAPTER 2. STI POLICY IN THE ERA OF GLOBALIZATION 52

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. Globalization also offers much wider access to new knowledge: knowledge flows from advanced nations to developing nations have multiplied as a result, to the great benefit of the latter. Greater access to 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 and some 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 and minimize 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. CHAPTER 2. STI POLICY IN THE ERA OF GLOBALIZATION 53

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

Foreign Investment in R&D There is an increasing number of offshore R&D centers in emerging economies like China and India which have also concurrently seen a rapid growth in domestic R&D expenditures and patent applications at home and abroad. Intel’s US$300 million semiconductor assembly plant in Costa Rica is one of the best known cases of positive spillover effects. Intel’s two plants directly employ 2,900, but the industry in Costa Rica now employs 12,000. The local support businesses for Intel alone reﬂects a base of 460 suppliers. The initial investment decision was the catalyst for a realignment of Costa Rica’s competitive platform and has led to subsequently secured FDI in other targeted sectors.

It is important to note here that the nature of the innovation process itself is changing in today’s internationalized economy. Peculiar terms only a little while ago, such as open innovation, are becoming standard business practices. Value chains are being reorganized at an international level. Since innovation is the outcome of interactions between different actors in a system, policy decision makers must concentrate on knowledge distribution (flows) and connectivity in the system. The possibilities for “smart” STI policy by small developing countries like Jordan and Lebanon 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 the name 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. CHAPTER 2. STI POLICY IN THE ERA OF GLOBALIZATION 54

References

Arab Knowledge Report. 2009. Towards productive intercommunication for knowledge. Tech- nical report. UNDP. . Arrow, Kenneth J. 1963. Uncertainty and the welfare economics of medical care. American Economic Review 53, no. 5 (Dec.): 941–973. Lundvall, B-Å., KJ. Joseph, C. Chaminade, and J. Vang. 2009. Handbook of Innovation Systems and Developing Countries. pp. 360-379. Press: Edward Elgar. Lundvall, Bengt-Åke. 1992. National Systems of Innovation: Towards a Theory of Innovation and Interactive 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-term growth. 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 on Trade and Development. Vonortas, Nicholas S., and A. Tolnay. 2001. Towards the knowledge-based economy: US and its APEC partners. In Technology policy for the knowledge-based economy, kluwer, ed. Maryann Feldman and Albert Link. Academic Publishers. WIPO. 2011. The changing face of innovation. Technical report. World Intellectual Property Organization. Part II

Framework

55 Chapter 3

Systems of Innovation

3.1 Introduction

The conventional view of technological advancement as a linear process rested on a series of sequential steps starting out with basic research, progressing to applied research and the development of ﬁnal products and services that reached the market and supported economic growth . 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 frameworks 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 scholars like Freeman , Lundvall and others. This concept emerged as the conventional linear model of innovation was seen to have limited explanatory power. The innovation-systems framework sees innovation in a more systemic, interactive and evolutionary way, whereby networks of organizations, together with the institutions and policies that affect their innovative behavior and performance, bring new products and processes into economic and social use (Lundvall 1992) (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. The innovation system concept has now gained widespread acceptance and is increasingly made use by policy decision makers at all levels of government and international advising organizations such as the World Bank, United Nations Agencies, and the Organization for Economic Cooperation and Development (OECD).

56 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 public and private sectors whose activities and interactions initiate, import, modify and diffuse new technologies.” Lundvall’s (1992) A rather deﬁnition focuses on “elements and relations, which interact 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 in innovation, including private enterprises, universities, and public research institutes. Techni- cal advancement and innovation are viewed as the outcome of complex sets of relationships among such agents (and their people) targeting the production, dissemination and application of knowledge. The innovative performance of a country is said to depend to a large extent on how these actors relate to each other as elements of a collective system of knowledge creation and use.

A Tale Of Two Nations: Interactions Matter Why, given two countries with almost the same level of risk, does one attract clusters of foreign investment, while the other fails? Mauritius and Senegal, both former French colonies, initially engaged in the same type of policy reforms and established export processing 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 considerable foreign investment, to become one of the few African countries with relatively high per capita income. It successfully transformed itself to from a mono-crop culture (sugar) to one diversiﬁed into manufactured exports and tourism. The success of the manufacturing sector is attributed to the successful establishment of EPZs in 1970. However, EPZ’s in Senegal did not show similar success. Studies (Yehoue 2005) suggest that at the core of the Mauritius’ success story was the interplay of the government leadership (through incentives and institutions) and the dynamism of its domestic entrepreneurs, which make available positive externalities for foreigners by clustering their investments. This interplay seems to have not been present in many other African countries.

The national innovation systems approach stresses that the ﬂows of technology and information among people, enterprises and institutions are key to the innovative process. Innovation and technology development are the result of a complex set of relationships among actors in the system, which includes enterprises, universities and government research institutes. For policy-makers, an understanding of the national innovation system can help identify leverage points for enhancing innovative performance and overall competitiveness. It can assist in pinpointing mismatches within the system, both among institutions and in relation to government policies, which can thwart technology development and innovation. Policies which seek to improve networking among the actors and institutions in the system and which aim at enhancing the innovative capacity of ﬁrms, particularly 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 CHAPTER 3. SYSTEMS OF INNOVATION 58 as the relationships that link them (Edquist 2001). Together, these elements make up the ecosystem in which interactive learning leading to innovation takes place. The three essential elements are:

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

• Institutions: These comprise the full spectrum of established norms and practices, laws and regulations that govern the relation and interactions between individuals, groups and organizations that undertake innovation activities. Examples of such inﬂuencing institutions are the prevailing intellectual property regime, corporate governance structure, industrial policy, labor regulations, as well as societal norms regarding corruption etc.

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

The innovation systems approach represents a paradigm shift in viewing systems of knowledge production. Whereas the traditional approach emphasized innovation resulting from knowledge production by focusing on research in science and technology, the new approach to innovation takes into account the system as a whole and recognizes that innovation is a complex interactive process that takes place within a network of organizations that are involved in the creation, diffusion, adaptation, coordination, diffusion and application of scientific and technical knowledge. There is a complicated two-way relationship of mutual embeddedness between institutions and organizations, and this relationship influences innovation processes and 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 key insight is that institutions are a critical component of the system: they shape (and are shaped by) 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 production but instead involves continuous feedback looks between the different stages of the innovation process.

• Different levels of economy can be analyzed depending on whether one is studying innovation at an international, national, regional, local or sectoral level. CHAPTER 3. SYSTEMS OF INNOVATION 59

3.3 Innovation Systems: The Local Dimension

Increasingly there is growing recognition of localized networks, i.e. the extent to which learning processes between organizations are interactive within regions rather than whole countries. It is now well understood that in nearly every industrialized nation, a few metropolitan regions 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 celebrated examples of such regional agglomerations (clusters) of high technology industry. Economic clusters can be viewed as networks of production of strongly interdependent firms linked to each other in a value-adding production chain. Clusters are, in principle, a specific type of innovation 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 interplay of these factors changes over time as clusters evolve. It is important to note that cluster formation is mostly a market-induced and market-led process without much direct governmental interference. However, the government does play a critical role as a facilitator of networking and institution building (OECD 1999). Clusters will be analyzed at greater length in Chapter 8 of this volume. A closely related concept is that of the regional system of innovation (RIS). A RIS generally has two features: the first is firms that interact with each other, especially those that display clustering tendencies, and the second is the supporting regional infrastructure which comprises public and private research laboratories, universities and colleges, technology transfer agencies, etc. A RIS can, in principle, contain several clusters as long as there are firms and knowledge organizations that interact systematically within the boundaries of that region.

3.4 Innovation Systems: The Sectoral Dimension

A look at history of specific cases of development and catching up brought forth a new dimension to the innovation forefront. Very often economic development and catching up by individual countries has been associated with the emergence and growth of a certain industrial sector. Cases in point are the catch up of Japan during the 1970s led by sectors such as automobile 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 sectoral perspective 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 the literature 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 dynamics of innovation and production in sectors. This perspective primarily focuses on firms, capabilities and learning processes as major drivers of innovation and growth. But in addition to the knowledge 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 CHAPTER 3. SYSTEMS OF INNOVATION 60 among actors; and finally the processes of competition, cooperation and co-evolution. It is important to note that the boundaries of sectoral systems are not easy to set. Boundaries may transcend local, regional, an national communities.

The Great Telecommunications Transition: Divergent Paths to Catching-up All 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 sectoral system of innovation with a government research institute at the core for technology development which was licensed to public and private sector domestic enterprises which converted this technology to manufacture equipment that in turn were sold to monopoly state-owned service providers. However the recent wave of privatization and deregulation of the industry and the arrival of mobile technologies has led to a radical altering in the industry has completely altered the working of the established systems. In transitioning to wireless telecommunication systems, we see two broad divergent paths emerge—at one end, we have the Chinese and Korean systems that have largely succeeded 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 have become increasingly net importers of telecom equipment. Some of the enterprises from the former group have now become important world players and have become the MNCs in their own right (Samsung, Huawei, XTE). In contrast, there are no major domestic manufacturers 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 coordination through R&D support, R&D consortia and public research organizations, the governments in India & Brazil followed a less directed and coordinated intervention approach. This difference in government action was the seed for the divergence between the two groups of countries. An interesting thing to note is that once indigenous capability has been developed, then paradigm shifts can serve as a window of opportunity as seen by the commercialization of the CDMA technology in Korea and development of the 3G wireless standard (TD-SCDMA) in China. For India & Brazil whose local production and R&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 (Malerba and Mani 2009) (Malerba and Nelson 2011) (Lee and Mu 2011).

3.5 The Innovation Systems Approach for Developing Countries

Innovation systems first originated in and have seen rapid acceptance in the policy circles of the developed world. One of the key reasons for adopting the innovation systems analytical approach 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 CHAPTER 3. SYSTEMS OF INNOVATION 61 sectors, as well as on the cultural and institutional behaviors and norms associated with the region or nation in question. The context specificity of the various case studies in the rich innovation systems literature lead us to conclude that there is no single model to generalize the dynamics of successful innovation systems. The innovation systems approach of looking at the system as a whole and examining various interactions and feedback cycles therein allows for the co-evolutionary development of institutions and technologies—an aspect which seems especially promising when it comes to developing countries. In developing economies, innovation systems are best understood as emergent i.e. only some of the building blocks are in place and where the interactions and relationships between components are still being formed. This is in contrast to mature innovation systems where interactions between the building blocks take place through market and non- market mechanisms such as informational links, interactions and other kinds of formal and informal networks. (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 in advanced countries. They are also quite heterogeneous among themselves. Hi-tech sectors exist alongside more informal sectors characterized by low productivity. Broad geographic variations in knowledge bases abound. As an analytical tool, however, the innovation systems approach can help identify systemic failures that impede the development of a country’s innovation ecosystem. Viewing the whole innovation process in a systemic way can help guide policy initiatives that are intended to address all the components needed by an economic system to facilitate CHAPTER 3. SYSTEMS OF INNOVATION 62 learning and innovation. The table below shows a list of systemic challenges in developing countries 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 of an emergent “weakly linked” ecosystem that was able to make the shift to a more dynamic strongly networked innovation system. Their effort carries several valuable lessons for policymakers in developing countries. In the case study, we view FIOCRUZ as a microcosm of the structure of the Brazilian health biotechnology innovation system. It illustrates the imbalances that can occur between the supply of high-level scientiﬁc knowledge and limited demands for research, development and design in manufacturing. It also shows how institutions (particularly policies) inﬂuence the behavior of individual organizations. At the same time, it shows how organizations can address systemic failures, and how their accumulation of technological capabilities can have a positive impact on public policies. CHAPTER 3. SYSTEMS OF INNOVATION 63

Figure 3.3: Innovation Systems and Development (Chaminade and Vang 2008) CHAPTER 3. SYSTEMS OF INNOVATION 64

Learning from the Brazilian Experience Brazil had considerable success in its research efforts in health biotechnology as measured in academic output. Yet this success was not translated into relevant economic goods and output. 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 and academic organizations. This close collaboration led Brazil to some spectacular successes like 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 industry production. Brazilian firms continued to rely on imported licenses and generic medicine production. There were very weak links between the basic research sector and the technology development sector. FIOCRUZ is a federal institute founded in 1900 with the goals of controlling bubonic plague, yellow fever and smallpox. This institution, affiliated to Brazil’s Ministry of Health (Brasilia), became the central knowledge-producing hub of the health biotechnology field in Brazil. More than 16% of the papers originating from Brazil in international peer-reviewed literature from 1991 to 2002 came from scientists of this institute. The institute also created a manufacturing plant, Bio-Manguinhos (Rio de Janeiro, Brazil), to centralize FIOCRUZ vaccine production. Until the mid-1990s, Bio-Manguinhos relied on basic process technologies and mostly concentrated on low value-added products. There were 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 a large-scale importer of vaccines. In the mid-1990s, the National Immunization Programme threatened the Bio- Manguinhos with closure. The National Immunization Programme and Bio-Manguinhos entered 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 to more complex technology-changing activities—starting with production, then engineering and entering development activities. At the initial stage, it absorbed the imported technologies, and started producing the vaccine. It used the new expertise to revamp its other 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 in the acquired technology. It used the extra revenue generated to invest in technological development, seeking partnerships with other FIOCRUZ institutes and other domestic and international organizations to develop new products and processes. As a result of these developments, Bio-Manguinhos has become increasingly prominent in the policy networks in the health biotechnology innovation system. FIOCRUZ is starting to bridge the gap between government agencies, linking actors in the system to coordinate government 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 national assessment of capabilities was undertaken (Bdour, 2009). Successive national plans have traditionally included strategies and policies for the promotion of scientiﬁc and technological activities. The Higher Council for Science and Technology (HCST) has led efforts over time to catalog S&T statistics and encourage the development of a national S&T base. The HCST has helped to establish a variety of basic research centers such as the National Nanotechnology program of Jordan (NANCEJ), the Biotechnology Research Program, the Energy Research Pro- gram, the Jordan Badia Research and Development Program (BRDP), the National Center for Human Resources Development (NCHRD), the National Center for Diabetes, Endocrine and Inherited Diseases (NCDID), and others.

Figure 3.4: National Innovation System of Jordan (?)

The Jordanian innovation ecosystem is, not surprisingly, idiosyncratic with unique features due to historical, cultural, and socio-economic factors. Nevertheless, like any other, it is also subject to two major concerns. One is with strengthening the national scientiﬁc and technological base. The other is with the utilization of this base, that is, ensuring that the linkages between the S&T institutions and the productive economy are strong.

65 Typical for developing countries, one of the key contributors to a country’s knowledge base is public spending on R&D. Government expenditure accounted for the largest share of a low national 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 much to be desired. This reportedly reflects very weak links between the university and industrial spheres. 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 government (Seidel, Domrose and Kocker. 2009) found that, although progress had been made with respect 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 and governmental institutes have announced separate initiatives of their own. Lack of coordination at the national level.

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

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

• Programs aiming to support entrepreneurial efforts are rated highly. Jordan has started to stimulate technology transfer between researchers and industry by launching programmes 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 direct incentives has led to a lot of brain drain.

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

• Design and implement a harmonized national innovation strategy.

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

66 CHAPTER 3. SYSTEMS OF INNOVATION 67

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

Overall, it should be a national task for the government to convince all actors within the NIS to orient their activities around catalyzing innovation. Jordan needs to create the appropriate economic, political, social and scientiﬁc institutions, and build technological infrastructure and interactions between institutions. Learning from the experiences of other nations regarding the creation of a wider range of technological capabilities and linkages was said to offer low hanging fruits for Jordanian authorities. CHAPTER 3. SYSTEMS OF INNOVATION 68

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Mytelka, L. K. 2000. Local systems of innovation in a globalized world economy. Industry and Innovation 77 (1): 15–32. Nelson, R. R. 1993. National Innovation Systems: Comparative Study. Oxford: Oxford University Press. OECD. 1996. National innovation systems. Technical report. Paris, Organization for Economic Cooperation 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 Marketing Review 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 national innovation system in Jordan. Technical report. VDI/VDE, Innovation + Technik GmbH (on behalf of the German Ministry for Economic Cooperation, and Development). Viotti, E.B. 2002. National learning systems: a new approach on technological change in late industrializing 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 Monetary Fund. Chapter 4

The Entrepreneurial University: A Regional Perspective

4.1 Introduction: The Role of Universities in the Innovation System

The conventional role of universities as centers for learning and creation of new knowledge has evolved dramatically in the past three decades. Universities are increasingly being regarded as an integral part of the National Innovation System (NIS) and their role is being re-evaluated accordingly, with major paradigm shifts in the definition and conceptualization of a successful university. Universities need to operate increasingly in close interaction with industry and government. This triple helix of university-industry-government relations is based upon independent, 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 social organization that is highly conducive to innovation (Etzkowitz et al, 2000). The triple helix of university–industry-government linkages can be regarded as a metaphor for the joint efforts of the three parties with respect to regional economic development. From this perspective, the universities are not only regarded as promoters of knowledge and innovation, but also supporters of its exploitation and commercialization through entrepreneurial activities. Such universities, known generally as Entrepreneurial Universities, have formally incorporated regional economic development into their mission statements, and have implemented strong mechanisms to promote innovation, entrepreneurship and technology transfer (Premus et al, 2003). In developed countries, a lot of emphasis is placed on the economic utilization of publicly funded research. This is particularly true for high technology and knowledge based sectors where scientific inputs are of key importance in the innovation process. In innovation systems networks of companies and organizations influence the innovation process in a particular area through 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 their R&D and innovation capabilities as well as innovation performance. But what is precisely the role of universities in the innovation system? According to the

70 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 effective as “antenna” for adopting external knowledge and mediator for local knowledge circulation, 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). Quality education and fostering an entrepreneurial culture are key for that end (Gibb, 2010). Innovation is taking place increasingly in concurrent activities of many actors; the knowledge base is becoming more ‘distributed’ (Smith, 2002), thus external knowledge becomes more important for generating new knowledge and innovations. Universities hold a key function 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 knowledge through 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 regional innovation systems in the emerging knowledge economy relates to the fact that graduates and highly skilled labor are one of the most powerful mechanisms for knowledge transfer to 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 from teaching to research and then to commercializing of the inventions and moving towards being entrepreneurial. CHAPTER 4. THE ENTREPRENEURIAL UNIVERSITY: A REGIONAL PERSPECTIVE 72

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 few decades as universities have become important knowledge sources for industry (Fargerberg et al, 2005) This is reflected in a variety of relationships such as R&D contracts, R&D collaborations, innovation partnerships, joint use of facilities and informal knowledge exchange. The objective has become to move from simple knowledge transfer towards knowledge sharing and interaction. Still, in this partnership with industry universities face difficulties in terms of commercializing academic inventions. Universities are increasingly challenged to produce, if not incubate, spin-off companies, especially in high tech industries and clusters such as ICT or biotechnology. The one main challenge for universities in this evolving relationship is how to interact with industry but preserve the freedom and diversity of academic research. All stakeholders should keep in mind that the role of universities is to contribute critical views, new ideas and complementary 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 acknowledge (Lord Sainsbury of Turville, 2007). Universities that are active at the heart of successful technology clusters do not just spin out companies. They develop highly skilled personnel who move between industry and academia; they incubate businesses and provide expertise; they produce knowledge that is used by technology businesses; they provide public space 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 academics and industrial researchers can interact and/or work together on research issues of common interest. 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 for start-ups, as well as opening collegiate networking between academia and business, between start-up companies and sources of expert knowledge (Etzkowitz, 2000). Table 2 presents the different stakeholders in university–industry relations. In general, universities have less experience and lower capability to commercialize knowledge. The concept of the entrepreneurial university exactly addresses this weakness (Vickers et al, 2001). Different individuals have a different mix of capacities for demonstrating and acquiring entrepreneurial behaviors, skills and attributes. These behaviors can be practiced, CHAPTER 4. THE ENTREPRENEURIAL UNIVERSITY: A REGIONAL PERSPECTIVE 73

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 of a technology licensing office that focuses on greater deployment of the university-generated technology to the marketplace. This focused support aims at creating new ventures, and launching programs to provide assistance 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 should also be nurtured throughout the curricula and through early involvement of students in small entrepreneurial projects and start-ups. There must be a major emphasis on developing entrepreneurial capacities for all students and staff. This also necessitates the adoption of innovative learning techniques that inspire entrepreneurial action (Etzkowitz et al, 2008). The relationship between the new style entrepreneurial university and SMEs they partner with must be win-win. Both partners must have strong positions, each one in its respective role so that their collaboration generates significant added value. Thus, researchers from the university develop their best technical solutions and the partner SMEs implement product development, production and marketing in order to reinforce their competitive advantage on the markets or to create new ones. Entrepreneurial universities have, by their nature, open boundaries that encourage effective flows of knowledge and transfer of technology between organizations. Also, multidisci- plinary approaches to education that mimic real-world experience and focus on solving complex world challenges is a major characteristic of entrepreneurial universities (Guerero and Urbano, 2010).

An entrepreneurial university, on its own, actively seeks to innovate how it goes about its business. It seeks to work out a substantial shift in organizational character so as to arrive at a more promising posture for the future. Entrepreneurial universities seek to 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: CHAPTER 4. THE ENTREPRENEURIAL UNIVERSITY: A REGIONAL PERSPECTIVE 74

• A consolidated steering core

• An expanded developmental periphery that makes connections with industry and includes outreach ofﬁces to industry, such as Transfer Technology Ofﬁces, liaison to industry, 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 exchange that assume that the university has identified which technology to commercialize. They ignore the importance of informal networks and relationships. ‘Pull’ models, which engage business at every stage in the research process and allow business to select which technologies to commercialize, are more effective (Fazackerley et al, 2009). Nevertheless, they require long-lasting networked 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 communicated through networks than through formal mechanisms. Further evidence suggests that informal knowledge exchange is quite effective (Abramovsky et al, 2008). Nonetheless, patents, which are a formal way of transferring knowledge, granted to major Western universities have doubled 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 funded to contribute to intellectual, economic and social progress. A practice that increases their income but prevents industry from accessing their knowledge is counterproductive. The model that should be aimed for is open innovation between universities and businesses. Open innovation describes a model whereby businesses appreciate that external sources bring knowledge and expertise and seek to integrate them into their innovation processes. It is essential to keep in mind that the purpose of industrial collaboration is not for universities to 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 for the evolution and sustenance of truly entrepreneurial culture in academia. However, the role of the government is still an issue of discussion and deliberations. The major question to be put forward 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 governmental policy, 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 government should not play a direct role in any aspect. However, a careful examination of many success stories (or failures) evince that the picture is more complex than simply to deregulate and step aside. Most studies recommend providing incentives and rewards directly to faculty CHAPTER 4. THE ENTREPRENEURIAL UNIVERSITY: A REGIONAL PERSPECTIVE 75 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 entrepreneurial universities or give incentive to move forward toward commercialization, these policies were only received positively by their target groups when they took into account the regulations, context, and structural determinants between countries and university systems. (Mowery and Sampat 2005). The complex role of government can be illustrated by a concrete example of the public policy 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 more than any other act or decision by a government. Originally, the U.S. government retained rights to use all inventions made by research funded through federal agencies ((Schacht, (2011); Mowery and Sampat 2001;). Further- more, twenty six different policies regarding the use of federally funded research existed which presented an enormous amount of obstacles. Pascoe and Vonortas (2012) discussed comprehensively the impact of Bayh-Dole act on universities entrepreneurship, as it moved the 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 the incentives this act has provided for technology transfer are a critical institutional factor in innovation. As a consequence of Bayh-Dole, American universities have substantially increased investment in technology transfer programs, faculty have become aware of the commercial potential of their research results, and industry has realized the benefits of collaborating with universities. The wide popularity of the Bayh-Dole act notwithstanding, many researches criticized this act as not really significant, for they considered that the true institutional factor that helped entrepreneurial universities to succeed was really the establishment of the technology transfer offices (Pascoe and Vonortas 2012). Others point out that it was universities which were already active in technology transfer that pushed for the Bayh-Dole Act. Thus, the Act came as a result rather than as a determinant of technology transfer. It merely allowed universities to benefit from their inventions. Many worried that the Bayh-Dole act contributed to the creation of a highly individualized and very competitive 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 countries in the absence of a comprehensive policy that takes into account structural factors and differences between universities and university systems. (Mowery and Sampat, 2005).). Gov- ernmental policies, in their zeal to promote entrepreneurship might undermine the university’s primary education, research and discovery roles. This is why a well formulated policy should balance the thrust for entrepreneurship with the conventional role of universities (Smith et al, 2010). However, for Levine (2009) the belief that the commercialization of inventions at universities will lead to entrepreneurshuo is a kind of a false promise. A policy for the promotion of entrepreneurial universities should be explicit about what should be done not to aggravate the conflict between advancing knowledge and generating revenues. Furthermore, Litan and Mitchell (2010) suggest that a policy to promote and create an CHAPTER 4. THE ENTREPRENEURIAL UNIVERSITY: A REGIONAL PERSPECTIVE 76 open, competitive licensing system for university technology can play a positive role in the successful addressing of the potential conflict between universities’ commercialization activities and their role in disseminating knowledge. Despite the criticisms, the Act played a significant role in fostering innovation and economic growth.

4.4 American Universities and Entrepreneurship

It is widely agreed that American Universities, in general, enjoy the most entrepreneurial ethos relative to their foreign counterparts. Moreover, they have proven themselves to be more prescient and responsive to changes in the social and economic world environment than any other group of universities around the world (Rosenberg, 2003). They are seen worldwide to be successful in a very distinctive aspect in the intensity of entrepreneurial activities and source of commercial innovation. US universities produce collectively about 3000 US patents per year (AUTM, 2006). By 2006, academia was responsible for more than 70% of the top 100 innovations (Mitchell, 2010). In order to understand the reasons behind such ability to respond flexibly to the different changes and requirements of the socioeconomic context, along with supporting entrepreneurship that marks a crucial element of both regional and national economies it is important to notice the salient features of the US universities in comparison with universities in other countries such as China and Europe. These features include (Rosenberg, 2003; Thorp and Goldstein; Byers et al, 2000): generous governmental funding for both basic and applied research, high levels of autonomy, and freedom from any external authorities; the traditional role of the university’s leaders as first and foremost fundraisers and network builders; the firmly rooted traditions of relations with the industry and high regard for the commercialization of new inventions especially in ICT and biotechnology; accumulated wealth and big endowments that allow recruiting the most talented and distinguished faculty members (which applies to both private and state universities); and, finally, rapid changes in the curriculum and introduction of new courses in what was 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 considered more successful in the United States than in other parts of the world. The major contribution of US universities has been the exchange of people: academics working with companies while also holding a university position, or cycling in and out of business and academia, taking advantage of the American society’s better appreciation of the link between the abstract and the practical.

4.5 Case Studies

In the following, three case studies of widely different universities will be discussed. These universities have had different experiences in moving towards the entrepreneurial university model allowing to draw lessons. CHAPTER 4. THE ENTREPRENEURIAL UNIVERSITY: A REGIONAL PERSPECTIVE 77

4.5.1 Stanford University Stanford and MIT are two schools renowned for taping the knowledge creation and invention 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 characteristics (Schramm, 2006). Stanford is considered a paradigm model of a university with intensity of Entrepreneurial activities and university generating innovations that lead to new technology-based ﬁrms. Stanford is a model of a research university that supports entrepreneurship and marks vital impacts on regional and national economies (Lenoir et al, 2004). The Notable inventions through the last decades have proven the great contributions of the university to major technology breakthroughs such as Recombinant DNA (with returns of $255M in1974); Func- tional Antibodies ($318.9M in 1984); Improved Hypertext Searching ($337M in 1996) (OTL Overview url) . A careful examination of the factors that make Stanford a conspicuous example of entrepreneurship can be very useful for other universities in different parts of the world aspiring to evolve into a successful entrepreneurial model. Principal among these factors was Stanford’s early realization of the importance of attracting the best talent.

Stanford University: The Recipe of Distinction The recipe for distinction that, was developed by Stanford administration in the 1950s was straightforward: focus on attracting and retaining the scientific and engineering talent most capable of winning federally funded research grants and contracts- steeples of excellence-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 better research. As early as 1970, Stanford established the office of technology licensing to promote the transfer of Stanford technology for society’s use and benefit while generating income to support research and education. Starting from such a position Stanford was among the main beneficiaries from the Bayh-Dole. Stanford’s policy of spin-offs as a major tool for marketing inventions was particularly intensive and productive. It adhered to the belief that establishing new venture companies was 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 the Silicon Valley responsible for 37 percent of all high-tech employment in the region (Byers et 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 means to create profitable exchange relations between industry and research labs, particularly in areas of electronics and computers. The relationship with industrial partners has been symmetric and co-evolutionary (Lenoir et al, 2004). Another important feature was that Stanford paid special attention, and was very successful in its licensing of inventions and establishing faculty consulting relations as means for 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, such as in entrepreneurial education and technology transfer. The Stanford arrangement there- CHAPTER 4. THE ENTREPRENEURIAL UNIVERSITY: A REGIONAL PERSPECTIVE 78

fore reﬂects a “modular” organization in which administrative interdependence and hi- erarchical structures are minimized, while cross-unit awareness and bottom-up processes are 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 an innovation-driven economy emphasizing the building of intellectual capital and its commercialization to create value and jobs. They considered transforming their conventional national university to an entrepreneurial university as a top priority in their strategic plan in order to compensate for three factors, also typical of numerous countries across the world: 1) a rigid bureaucratic control by the state; 2) a lower base of research and inventive outputs coming out from the university; 3) lower demand and ability of private enterprises to commercialize university knowledge. All these factors suggest that the pre-conditions for Triple-Helix dynamic interactions are much weaker in countries with such factors than in the advanced economies. Thus, there is more urgency for universities to assume an entrepreneurial role to compensate for the less- favorable preconditions that they start from.

The National University of Singapore NUS The government of Singapore’s policy towards its national university stems from the strategic National Innovation Policy adopted by the government to move from a stage where the primary focus was on developing innovative capability to support applied R&D as adopted in the 1980s and 1990s to a stage where the primary focus is on developing intellectual capital creation and commercialization and the entrepreneurial capability to support knowledge-based economic growth. The NUS has taken on an additional economic role not mentioned in the literature on entrepreneurial universities, that of the attraction of foreign talent. Given the small local population, Singapore needs to be able to tap top foreign talent to help staff the top echelons of specialized knowledge workers. In addition to emphasizing the technology commercialization role of the university, the NUS experience added more signiﬁcant emphasis on injecting a greater dimension of entrepreneurship to the contents of university education itself. This amounts to a re-orientation of the university’s core function of education. Its particularities notwithstanding, the NUS went through the well-established practices of establishing technology licensing ofﬁces and introducing structural changes such as the creation of a new division in the university known as the NUS Enterprise. This division introduced a number of major initiatives to reform the university policies with respect to governance of technology commercialization and to inject a stronger entrepreneurial element in university education. It also introduced two new units: 1) a Venture Support unit to provide focused assistance to new venture activities; and (2) an Overseas College CHAPTER 4. THE ENTREPRENEURIAL UNIVERSITY: A REGIONAL PERSPECTIVE 79

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 is fraught with difficulties. The following case study of the Regional University of Volta Redonda PUVR in Rio Do Janiero by Amaral et al. (2011) helps highlight the challenges and resulting failures to reach objectives. Since the 1990s the Brazilian Public Research Universities (BPRUs) have emphasized the need for efficiency, effectiveness and innovation in order to advance industry competitiveness. For that purpose, technology-based incubators, science and technology parks and technology transfer offices were created in the BPRUs in order to promote and encourage university- industry linkages and collaboration in order to transform the universities to entrepreneurial ones.

The Regional University of Volta Redonda The study of PURV’s activities indicated that the university did not manage to play an active role in the interaction process. There was no successful bridging to industry for transferring knowledge. An apparent major obstacle was the differences in behavior between academic faculty and industry researchers. Another was the rudimentary mechanisms designed to promote university-industry linkages, thwarting the desire to cooperate. Inadequate and outdated operating structures and excessive bureaucracy at PUVR was considered a major barrier to innovation management and industry cooperation. From the side of industry too there was no great willingness to interact and cooperate with the university. None of various typical mechanisms of accessing the university resources was strong, including the development of common ventures or projects, hiring of 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 becoming an entrepreneurial university Amaral et al. (2011).

4.6 Discussion

Reviewing these three case studies, we can extract common elements as well as distinctive characteristics in their approaches to entrepreneurship. Among the three, Stanford, of course, has the most important experience. What really distinguished 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 problem facing Volta Redonda was its apparent inability to bridge the gap with the surrounding industries. Singapore’s NUS is different; it is taking advantage of the strong governmental commitment to its National Innovation System to gain strong support in its cooperation with CHAPTER 4. THE ENTREPRENEURIAL UNIVERSITY: A REGIONAL PERSPECTIVE 80 the new knowledge-based industries. The challenge for the Brazilian university would be to focus on emerging knowledge-intensive industries, rather than the already established, mainly conventional manufacturing industries in its surroundings. As compared to many universities across the world, one might argue that Stanford is a special case that cannot be emulated. This is only partially true. While the enormous resources of Stanford would be difficult to match, the innovative approaches to their commercialization of inventions, seeking the talent as well as its agile and flexible structures can be a source of inspiration for many universities worldwide. As for the case of Singapore, it is worth noting that while the specific governance model and initiatives/programs adopted may be unique to the specific national context, the reform experience of the NUS may nonetheless be instructive for other universities seeking to develop their own entrepreneurial model. This is particularly true when these universities want to replicate the NUS experience in making its technical graduates more business savvy and entrepreneurially-minded. More importantly, the comprehensive approach of the government 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 and policy 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 transformation into an entrepreneurial institution is an easy path. Restructuring and introducing the entrepreneurial culture are good and useful, but the real challenges are for university leaders to define the required entrepreneurial attributes and flexible processes for interacting with local industry, with an adequate understanding of the needs and demands of the region where the 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 establish itself as a successful entrepreneurial university. Otherwise, it will retreat to mostly teaching functions with no significant research activities and diminishing ability to raise extramural funds. 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 stages possible, i.e. starting with curricula of undergraduates, and not merely depending on licensing offices and similar structures.

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

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

• Introducing as much autonomy and ﬂexibility as possible into the structure of the university 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 universities are already well endowed with: talent and creative minds. Universities should be more attuned to recruiting top talent than ever before. CHAPTER 4. THE ENTREPRENEURIAL UNIVERSITY: A REGIONAL PERSPECTIVE 81

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 of universities to an entrepreneurial context, where universities become an integral part of the innovation 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 on the challenges and issues that need to be addressed by universities in the Levant to achieve a successful transformation into an entrepreneurial university. In a nutshell, there are various concerns related to the process of transformation toward an entrepreneurial university in the region that can be divided into three levels: human factors, infrastructure and partnering policies, and institutional culture. Each of these factors deserves detailed scrutiny. If the university along with local and central government and industry can share resources and work together to promote entrepreneurial activities which would foster region-wide economic development, then this transformation process will be worth the intellectual, ﬁnancial and human resource investment that is going to be spent. A future where a university can turn into a constant source of talented manpower and knowledge whereas other economic development organizations and public institutions can put forth an adequate infrastructure, funding, and business environment to promote economic development will charge the innovation systems of the region. This is something that policy decision makers in the region will be looking into for some time to come. CHAPTER 4. THE ENTREPRENEURIAL UNIVERSITY: A REGIONAL PERSPECTIVE 82

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 evolve into entrepreneurial universities in order for university to make significant impacts on regional and national economies, or whether a new breed of specialized universities should be established to replace (or co-exist) with the older conventional universities. Should the state push and encourage extant universities to evolve and transform into new entrepreneurial universities? Are governments of the region willing to support robust policies to give incentives to universities, but not to interfere in budget allocation and in the research agenda? And do they understand the importance of investing in funding and supporting research, without imposing their agendas? Or should they just give up on these universities and establish new ones with a mission and vision focused on entrepreneurship? Examination of the previous three case studies and a serious understanding of the distinctive characteristics of universities in the Levant region 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 learning experience that must be acquired and a need for at least one successful model that can be emulated. There is a clear need to establish a new institution with a fresh sense of mission and unbounded by any previous legacy. Unlike the situation in Singapore, Lebanon and Jordan are not ‘considered newly industrialized countries’ but they have very strong motivations to join the knowledge based economy age with their highly educated population and highly driven developmental policies. In this region, major state universities (e.g., the University of Damascus, the Jordanian University, the Lebanese University and many others) are mammoth institutions encumbered with bureaucracy and an extremely conventional approach to their academic roles. While it will be challenging to nudge them towards an entrepreneurial culture, it will be unwise to leave them doing their business as usual. They can start by introducing courses and projects that nurture the entrepreneurial culture and practices to selective units and departments in these universities, as well as establish science parks that deal directly with these units, provided they are guaranteed the autonomy and flexibility to be able to perform in this different context. A number of smaller universities in the region with relatively good academic records (most of them private) can become viable candidates for a transformation into fully-fledged entrepreneurial universities (e.g. the Lebanese American University in Beirut and the Yarmuk University in Jordan). Their transformation can be phased and gradual, but the opportunity is worth taking, not only because of the benefits that will accrue to these universities, but also because the transformation process can become a learning experience from which lessons can be learned and used later with other institutions. Specialized universities are likely to find such change easier than comprehensive ones. The specialized universities already have a focus and are often characterized by an engineering or business-type rationality that eases the contradictions of the old and the new. As the case in Singapore, emphasis should be directed at introducing the entrepreneurial culture to students from the earliest possible stages. We must be prepared to face the situation where some CHAPTER 4. THE ENTREPRENEURIAL UNIVERSITY: A REGIONAL PERSPECTIVE 83 big universities will choose to resist any change in their culture and mission, and entrench themselves in their old ways (not taking into account that they will become less and less relevant with the advent of time). At one point, if the new wave of entrepreneurial universities will result in a major paradigm shift in the scene of higher education in the Levant, then these universities 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 may be asking too much from the region’s universities to emulate Stanford, it is worth taking into account that only through recruiting and retaining the best brains did Stanford reach its current position. There is also concern for lack of support mechanisms, which include research funds, venture 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 governments in more advanced countries commit large funds to support research and quality education. Investment in these institutions is the only guarantee for the region’s countries to survive in the new economic paradigm of the world. CHAPTER 4. THE ENTREPRENEURIAL UNIVERSITY: A REGIONAL PERSPECTIVE 84

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Intellectual Property, Standards

5.1 Introduction

This chapter examines intellectual property and standards, two elements of the innovation landscape that in the past have often been overlooked by policy practitioners in developing countries. First to be highlighted will be intellectual property (IP), a set of rules and institutions designed to foster innovation and ideas. As developing countries are often technology followers, the primary role of IP is often to encourage foreign investment and trade with the hopes of economic and knowledge spillovers into the domestic economy. The chapter will then discuss standards and their role in domestic innovation and in international trade. Standards have the potential to boost innovation in developing countries, but also have the potential to stiﬂe domestic industrial creativity. The chapter concludes with short proﬁles of the current state 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 of direct or indirect economic gain. Intellectual property regimes are nation-level mechanisms designed 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 and economic growth, and thus the implementation of IP regimes to protect those ideas will have a strong bias towards fostering economic growth. There are four methods of formal IPR protection: patents, copyright, trademarks, and trade secrets. Patents and copyright will form the bulk of the IP discussion in this chapter as they are 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 must pay a ﬁne or other penalty to the owner of the idea. Patents must be applied for and must prove (a) patentable subject matter, (b) utility, (c) novelty, and (d) non-obviousness. Patents last 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 original work of authorship such as books, software, music, and movies. Copyright gives holders the 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 original 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 legal for someone to write a different love song. The idea of love cannot be copyrighted; only its expressed 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 protected and cannot be used by competing goods or services. Trade secrets protect various types of firm-specific technical and business knowledge. In principle, anything can be kept secret. Proof of violation requires evidence that information was obtained by improper means (e.g., industrial espionage). Trade secrets that are discovered accidentally (e.g., reverse engineering) are not protected. Informal IPR protection includes the use of secrecy, complex routines, and speed in technological advancement. Secrecy refers to the ability to keep abstract or applied technical ideas secret. It is probably the most effective informal method for retaining proprietary intellectual property. Whether knowledge can be kept secret is a matter of the technology involved. If reverse engineering is relatively easy, then formal protection is necessary. Secrecy helps avoid the revelation of information to prospective competitors through published patents, thus, avoiding “inventing around” patents. Complex routines refers to the situation where competitive advantage consists of accumulated experience (routines). In such cases, firms may consider themselves reasonably protected 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 technologies. 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 market importance 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 the object of protection. Inventors will rely upon them as long as the explicit and implicit costs of doing so appear justified by the potential benefits. Frequently they decide not to use formal protection in order to avoid revealing too much information. Informal protection thus seems to be used extensively. Two well known studies of US firms (Levin et al 1987; Cohen et al 2000) found that, for most manufacturing sectors, informal methods of IP protection were seen as being more important than formal IP protection for maintaining an innovative advantage. While the results have since been replicated elsewhere, the fact of the matter is that companies pursue intellectual property protection today more than ever before. When asked, they reply they do so for strategic reasons. CHAPTER 5. INTELLECTUAL PROPERTY, STANDARDS 90

5.3 Intellectual Property in the Innovation Ecosystem

Nations have separate sets of regulations to protect IP and physical property because they are fundamentally different types of goods. Today’s global economy is built largely off of the exchange 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 the application of learning and technical ideas, and it is the knowledge behind these goods that is protected by IP regimes. But how exactly are IP and physical property different? For one, knowledge is a cumulative good; what we know today is built off of what we learned yesterday. Another way to phrase the previous statement would be to say that knowledge follows a path dependency (Malerba et al 1999). A country may decide that it will be world leader in nanotechnology, but if there is no history of nanotechnology expertise in that country, then it will be difficult to innovate in that arena. In contrast, a country with a tradition of agricultural excellence likely is able to swiftly and efficiently adopt and adapt new agricultural techniques. A second characteristic of knowledge is that it is irreversibly transferrable; once someone learns something, that knowledge cannot be taken away. From an industrial standpoint, this means that personnel do not forget what they know when they move to a different company or country, and once a competitor understands a firm’s internal processes, that understanding cannot suddenly disappear. Third, knowledge is subject to increasing returns to scale, meaning that outputs stemming from knowledge increase at a proportionally greater rate than an increase in inputs for its production. It is this characteristic of increasing returns that allows knowledge-based economies to be so dynamic.2 Fourth, knowledge has high initial costs and much lower marginal costs of production (in some 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 illegally copy 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 of knowledge to appropriate rents stemming from the development and commercialization of that 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 the invention, 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 that it is easy to spread (spill over). Employees can jump to new firms and carry knowledge over with them and competitors can reverse engineer a finished good. Secondary parties then could exploit the knowledge company A paid to create. As one of the characteristics of knowledge is high up-front costs for its production and low marginal costs for its reproduction, competing producers of products largely based on this specific piece of knowledge appropriated without proper payment to the owner are now at a huge cost advantage which can allow them to profitably undercut company A in the market.4

2. It is this feature of knowledge that underlies the explanations of economic advance of new growth theory discussed 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 CHAPTER 5. INTELLECTUAL PROPERTY, STANDARDS 91

For example, if a firm creates a new pharmaceutical, it may pay an up-front cost of upwards 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 more than marginal cost, greatly undercutting the first firm and taking control of the market for that drug. In this situation, the first firm will not have the incentive to create the drug at all, as it is highly likely that it will never recoup enough money to cover the initial expense. On the contrary, 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 IP regime 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 enforce those laws due to lack of resources, training, or enforcement authority, then it would be as if the laws did not exist; there would be no encouragement for innovation. As will be shown in the discussion on Lebanon and Jordan later in the chapter, lack of enforcement and weak penalties 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 ask a more nuanced question: what is the role of IP in the innovation frameworks of countries at varying 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 efficiency and dynamic efficiency. Simply put, allocative efficiency means that, assuming no future inventions, the efficiency of the economic system is maximized by spreading knowledge around: everybody knows everything. Dynamic efficiency changes the basic assumption: if there is knowledge to be created and things to be invented in the future, then some sort of monopoly power expectation must be created to incentivize the necessary expenditure from individuals or organizations. In the extreme, allocative efficiency corresponds to the absence of IP protection. In contrast, dynamic efficiency requires such protection. The problem is that in actuality we need both: prospective inventors must have some guarantee of legal appropriability, whereas the economic system will progress with people other than the inventor eventually getting hold of the specific knowledge. Extant IPR regimes have sought the middle ground by providing monopoly rights for new patentable ideas but for a price and for a limited time period after which 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 the number of claims on a single patent. We refrain from these topics herein. CHAPTER 5. INTELLECTUAL PROPERTY, STANDARDS 92 extent of intellectual property protection. In particular, could it be that countries at different stages of economic development would benefit from different degrees of protection? The answer may well be affirmative given that countries at the top of the development ladder base their competitiveness on the creation and application of state-of-the-art technologies based on advanced scientific research, whereas those on the other end often find it more profitable to concentrate limited resources to the identification, adaptation and adoption of extant technologies and broad dissemination of information (Lall 2003). In other words, advanced nations are expected to push for stricter IPR regimes focusing primarily on dynamic efficiency whereas lesser developed nations are expected to push for laxer IPR regimes as they are primarily concerned with allocative efficiency. The question above proves, in fact, to be one with no easy answer. Intellectual property has different impacts on innovation for countries at varying levels of development largely because 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 going to want to be assured of protection for their investments, and most are more eager to sell in countries where a reasonable IPR regime is in place (Branstetter et al 2005). The presence of a functioning IPR system is a strong market signal to prospective firms. Are, then, countries that lack a reasonably functioning IPR regime effectively cut off from technology imports? Not at all, as firms will export technology in a format appropriate to a customer nation’s level of technological capacity. Specifically, there are two factors that determine a country’s technology capacity (or absorptive capacity). The first characteristic is appropriability, which conditions technology transfer on the ability of domestic R&D concerns to incorporate foreign technology and learning into their own production processes. The second is usability, which argues that the level of technology imported depends on the level of development of the target country (Gibson and Smilor 1991; Javocik 2005; Park and Lippolt 2008). For example, a less developed nation may import semi-conductor technology in the form of finished computers (usability), but there might not be any domestic firms that could import the latest semi-conductor know-how and use it to develop a new computer themselves (appropriability). Firms, then, generally will export finished, high tech goods to areas with weak IP protection and are more comfortable exporting know-how to a country with stronger IP protection.7 Know-how exports may be in the form of a factory or processing facility, or a collaborative venture with local firms, or direct licensing agreements.

When putting together policy for IP and standards, developing nations should use both multilateral and bilateral agreements. The latter are more ﬂexible and might be able to provide 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. CHAPTER 5. INTELLECTUAL PROPERTY, STANDARDS 93 developed nations will see much more efficient outcomes by focusing on importing technology rather than creating the infrastructure to create it locally (WIPO 2011). Moreover, IP regimes that are too stringent for a developing nation may lead to technology-associated economic rents being directed to foreign firms (Ganslandt et al 2005; World Bank 2010), thus decreasing the efficiency of a national system. On the other hand, developed nations will see much more efficient 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 invest in innovative activities by providing a more secure appropriability of rents.

5.5 Determining the Need for and Impact of Intellectual Property

As with any other policy option, it is important to understand the needs of the population directly impacted by that policy. While it may be a simple matter for a developing country government to copy an IP policy framework from somewhere like the US or an EU member state, 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 those entities 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 in general encourages innovation, and if innovation is associated with economic growth, then IP can 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 single measure of impact. For example, Branstetter et al (2005) point out that stronger IPRs will attract more technology investment from foreign firms, but that measurement alone does not tell us if the new investment is putting domestic firms out of business, leading to a trade imbalance, or over- burdening existing infrastructure. Outside of the explicit innovation environment, consumers in general might be affected if stronger IP rules attract more foreign technology imports with the 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 IP standards has led to a diminished domestic innovative capacity in the area of pharmaceuticals (Malpani 2009). Thus, evaluating an IP policy involves understanding the innovation ecology of 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 dynamic efficiencies discussed earlier will not apply uniformly across their economies. Some areas of technological skill in a developing nation will be far from the cutting edge, while others might be much closer. The rapidly advancing BRIC nations—Brazil, Russia, India, and China—represent this middle ground on a grand scale. All of them, in various fields of technology, are innovative leaders and followers (Tseng 2009). From an IP policy standpoint, this is a difficult position to occupy and all four of these nations have tried varying forms of IP legislation in an effort to encourage simultaneously domestic innovation and foreign technology investment. The act of balancing domestic innovation needs and foreign IP requirements, CHAPTER 5. INTELLECTUAL PROPERTY, STANDARDS 94 while stimulating growth at home, have at times attracted sanctions or threats of sanctions from more developed nations (Bird and Cahoy 2007). Countries further away from the cutting edge of a technology may find it beneficial, or at least tempting, to relax IP rules and enforcement. While this increases access to knowledge from foreign sources and lowers the barrier to innovation for domestic producers, care must be taken that laws are enforced appropriately. Purposeful lax enforcement of strong rules or creation of weak rules that deliberately allow domestic firms to “legally” steal foreign technology can drive away foreign investment and technology and harm the domestic innovation landscape. For example, in the early 1980s, South Korean IP laws tacitly allowed for what essentially amounted to theft of foreign IP.In one instance, trademarks were considered valid only if the brand was familiar to most Koreans, a loophole that meant many foreign-made goods de facto lacked IP protection. The response of foreign technology suppliers was a round of steep trade sanctions (Ryan 1998).

Korean Pharmaceutical Industry and Development In the 1960s and 1970s, Korea, like many industrialized, developing nations, was building its technology base by copying mature foreign technology. With relatively cheap labor costs, Korean firms were able to produce these mature technologies for domestic and international consumption at competitive prices. As the nation developed economically, however, those labor costs rose. At the same time, other nations, such as China, had workforces with even lower wages, and were thus able to out-compete Korean firms on a pricing basis on the international market. In the 1980s, Korean firms began to manufacture more sophisticated, value-added technological goods, with increased technological know-how coming from three sources: copying cutting edge foreign technology, increased spending on R&D, and a base of domestic technology experience developed from copying mature foreign technology. Intellectual property became a concern for Korea in the 1980s. Prior to that period, the foreign technologies that Korean firms were able to copy were mature, with innovation coming mainly in the marketing and manufacturing processes and costs highly driven by worker wages. With such mature technologies, IP played a much smaller role in maintaining a competitive advantage, and thus foreign firms were less likely to block Korean firms from using that technology. However, once Korean firms began to create and copy more value-added products like pharmaceuticals, they came into more frequent conflict with foreign firms who owned the more advanced IP. The pharmaceutical industry in Korea grew very rapidly in the 1980s, and this was almost entirely due to the copying of foreign products. At first, Korea officially honored process patents, but not product patents, which allowed for domestic firms to jump into high-tech manufacturing once a product’s manufacture was deciphered. And as mentioned in the text of this chapter, Korea’s trademark law only allowed trademarks for products that were well-known to the Korean people, thus tacitly allowing the copying of any foreign good. Foreign governments cried foul, and the Korean government created tougher laws. However, enforcement was notoriously lax, and the copying continued. By the end of the 1980s, nearly 90% of the Korean pharmaceutical market was supplied by domestic CHAPTER 5. INTELLECTUAL PROPERTY, STANDARDS 95

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 IP enforcement. Today, Korea has a thriving pharmaceutical industry, thanks in large part to the lax enforcement of IP during the formative years of the industry in the 1980s. Certainly, this path of development is not conducive to winning the trust of international partners. It also important to not let lax IP enforcement undercut one’s own internal development by de-incentivizing investment in domestic high-tech industries. The Korean experience thus provides lessons on both the balancing of IP enforcement and technology development, as well 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 domestic innovation and supports the legal importation of foreign technology is difficult. It is critical for policymakers in these situations to understand the needs and capabilities of prospective domestic innovators and be able to revisit and rebalance the national IPR regime. The tools to do so are variable. Surveys are a useful tool because they assist in obtaining detailed information such as frequency of patents and copyrights, ease of obtaining IP protection, income generated from IP-protected goods, whether IP owners consider the process a good investment of 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, but making contact with as many business owners as possible, both innovators and those who use their innovations, is critical. A good example are the OECD Economic Surveys, which describe the innovation environment for individual countries. Interestingly, Lebanon and Jordan, the two countries detailed later, have rates of patenting that are low enough that each could actually 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 of patent data. Patents have the advantage of being a distinct, quantifiable phenomenon. Patent data 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 on which 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 the government’s efforts to have universities participate more in the innovation process. But such an increase in patenting may be missing a possible long-term effect in decreased innovation as universities redirect their focus towards short term research. Briefly, another form of intellectual property protection that is growing in importance and use will be discussed: geographical indicators (GI) (OECD 2011). A GI is applied to a specific product or good that is ethnically or geographically distinct and attributable to specific region or territory. For example, champagne is a type of sparkling wine from the Champagne region of France. Recently, it was ruled that any sparkling wine of the same vintage as champagne but not from the Champagne region in France cannot use the word “champagne” in its product name (Bramley and Kirsten 2007). As the example above shows, a GI functions in much the same way as a trademark, except that it is applied to a type of product associated with CHAPTER 5. INTELLECTUAL PROPERTY, STANDARDS 96

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 process of having that good registered with the WTO or recognized through multilateral or bilateral trade is more administrative than developmental. Of course, as the example of Basmati rice shows, the negotiation process may still run up against powerful commercial and government interests (IPR Commission 2002). Even countries or regions that do find recognition for a geographically-based good, that does not guarantee any sort of income. As with a trademarked item, the reason behind filing for a GI at least partly is that it has some sort of marketable value (USPTO 2011). All countries should take advantage of any available opportunities in this matter, but as a course of development, a focus on the fundamental drivers of innovative push 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 in a complex innovation environment. Not only does an IPR regime need to be calibrated to encourage domestic innovation and remove barriers to the spreading of new technology, but, for developing nations especially, it must provide foreign technology providers with confidence that their knowledge investments will be safe. This is a difficult path to navigate, and requires policymakers to pay careful attention to the creation and implementation of laws and institutions. Table 1, below, is indicative of the lack of uniformity of technology and developing countries. In that table, a selection of Upper Middle Income countries is provided, along with the major technology fields for patent applications. With the exception of Jordan, no country in this list has a major focus in any one technology. Such an arrangement highlights the need for IP policies that are able to incentivize domestic innovation and foreign technology transfer in multiple fields simultaneously. CHAPTER 5. INTELLECTUAL PROPERTY, STANDARDS 97

5.6 Standards

Standards constitute another driver of innovation, and they are becoming more important as markets internationalize. Goods and services are no longer sold to just the neighboring city but to a wide variety of markets and cultures with different requirements on materials and processes and different preconceptions of what is good or bad. “Standards are not only a technical question. They determine the technology that will implement the Information Society, and consequently the way in which industry, users, consumers and administrations will benefit from it” (EC 1996) Standards encompass an increasingly wide range of manufacturing, process, and ethical requirements placed on commercial goods. Standards can be imposed by governments, international bodies, trade associations, or can be the outcome of regular market transactions. Less developed countries rarely have the opportunity to set their own technology standards. Typically, only those countries on the technological frontier will be able to set the standards 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 or circumstantial setting of standards (Gort and Klepper 1982). Technology followers by definition 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 provide the opportunity for developing countries close to the frontier of a specific technological field to set or influence standards. Market size is one of those circumstances. A great example is China’s attempt to set its own signal security standard for all wireless devices sold in China, including imports. Makers of wireless devices from other nations balked at this proposal, as it would have created a second set of security standards for makers to meet, upending international markets and virtually forcing foreign firms to provide Chinese manufacturers with proprietary information (Gibson 2007). While the proposal for the new standard was ultimately withdrawn due to international resistance, the chain of events indicated a couple of things: (a) China was advanced enough technologically to set their own wireless security standard; (b) China had a large enough internal 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 the domestic innovation environment stemming from acceptance of extant technology standards. There are three common ways for standards to be set: the marketplace, negotiation, and a standards leader (Varian et al 2004). First are standard wars conducted in the marketplace. A classic example of this is the VHS and Betamax technology battle (Hall 2005) replayed today in Blue Ray versus DVD. The benefit of allowing markets to set standards is that it follows the path of least resistance in terms of existing innovation. Technology flows where the skills and the 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 markets operate, and these are all areas in which governments set the tone. For countries that have national champions, allowing the markets to set standards can be tricky, as there is no guarantee that the home country’s firm will survive the standard war. Nor is there a guarantee that consumers will direct the market to the best possible outcome; small events at different stages CHAPTER 5. INTELLECTUAL PROPERTY, STANDARDS 98 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; Gallego 2010). The second channel for setting standards is negotiation. Governments can play a direct role here. Recall the example of wireless signal security and China, and how it was resolved with international negotiations (primarily the US government). Negotiation typically involves compromise, which means that all players may have to sacrifice some element of gain for the betterment of the whole. Consumers can be the big losers in these situations as negotiations might not settle on the most cost effective or well-functioning standard. It is also difficult to determine exactly when a standard would be set naturally (Jakobs 2000) leading to the possibility that the necessity of entering into negotiations artificially sets the limit to further standard development. Having a standard leader is the third form of standard setting. Such a leader can come out 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 by the standard having been in place for a long period of time, or requiring a vast infrastructure that is infeasible to duplicate for a new standard (Gallego 2010). Perhaps no greater example exists of this than the Internet.

Brazil’s Personal Computer Endeavor In 1985, Brazil passed the National Information Technology Policy in an attempt to turn its burgeoning, domestic IT industry into a pillar of productivity and growth. The law blocked imports of some foreign computer and IT-related goods and for those imports that were permitted, foreign firms were required to interact with Brazilian-owned firms for in-country sales. This protectionist move had two goals: boost domestic technology growth by keeping out foreign competition; and provide an avenue for domestic economic development. At the time of the passage of the Informatics Law, as it was called, Brazil did have a small computer manufacturing sector. Most of the domestically produced computers followed 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 Law shifted all of the standard-setting to domestic producers. Recall from this chapter that the three methods for setting a standard are the marketplace, 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 market was not large enough to be self-sustaining, the protectionist move was unilateral and involved no negotiation with other countries or multilateral bodies, and Brazil possessed no domestic producer that was already a standard leader. Brazil did see a growth in the domestic technology capability of some producers as the vacuum of foreign goods was filled. However, consumers suffered as the Brazilian products 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 were enjoying booming IT growth through much more liberal trade policies. Consequently, CHAPTER 5. INTELLECTUAL PROPERTY, STANDARDS 99

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 credited with boosting the IT growth of Brazil. (Botelho and Smith 1985; Perini 2006; Magalhaes et 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 a entrepreneurs entering the international market. Standards also can inhibit local innovation by 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 the impact of standards on international trade. Importantly, the studies examined found a mix of positive and negative impacts of both national and international standards on the conduct of 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 the most important modern efforts at international standardization, that of IP under the TRIPS agreement. All in all, policymakers must consider the impact of standards on domestic innovation. In the same manner to IP legislation discussed earlier in this Chapter, any decision on standards must be made in light of factors such as the level of domestic innovation, domestic technology appropriability and usability (absorptive capacity), specific areas of technological strengths and weaknesses, and areas of potential trade growth. CHAPTER 5. INTELLECTUAL PROPERTY, STANDARDS 100

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 capital city of Beirut. Literacy rates are impressive, at nearly 90%, and the 2010 GNI of close to $9,000 puts the country in the World Bank ranking of Upper Middle Income. Like Lebanon, Jordan is 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, and China. The population of Jordan stands at just over 6.5 million, with an overall literacy rate of about 90%. IP protection and standards have received little attention in the past from government officials in these two nations. They are currently experiencing increasing interest due to the determination of public authorities that technological advancement and innovation is going to be an important element of growth in both nations’ economies. In Lebanon, the government confronts a relatively young, well-educated population with few 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 opportunity for new research talent to be trained in the full set of skills needed for private sector innovation (Arvanitis and M’henni 2010; Bizri et al 2010). This lack of connection, combined with a low government investment in research (Arvanitis and M’henni 2010), creates a strong barrier against innovative activity. Jordan, in comparison, has a stronger current potential for innovation. It is home to multiple universities, and has a large population of engineers. Like Lebanon, Jordanian leadership is 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 focus on theoretical and not applied research at universities, very small and scattered government expenditures on R&D, almost zero private sector R&D, and a limited creative class (Rischard et al 2010). IP appears to be of limited impact on the domestic innovation environment for both Lebanon 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 supply of innovation or demand is not clear from the data. However, given that small, informal firms with 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-friendly policies. 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 sector was 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 in that same time period. 431 patent applications were submitted from international entities that same year, with 64 being granted (Ministry of Industry and Trade 2011). Domestic demand for 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 perceived need for innovation among most business owners (Rischard et al 2010). Even for business owners 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 CHAPTER 5. INTELLECTUAL PROPERTY, STANDARDS 101 that IP is an important issue. The Jordanian Higher Council for Science and Technology now actively educates potential innovators about the benefits of IP and has built IP targets into its national S&T plan (ESTIME no date provided; Higher Council for Science and Technology 2004). 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 in contrast 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 calls for more aggressive enforcement are coming from foreign trading partners. Despite Lebanon’s current, well-defined IP laws (Ministry of Economy and Trade 2011b), there is a perception among 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 environment are said to be the high level of corruption, red tape, and general inefficiencies that make it difficult to enforce properly IP institutions (Bizri et al 2010). Lebanon is also not yet a member 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 signatory to several of that body’s treaties, especially those centering on copyright (WIPO 2011a). In Jordan, 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 free trade agreement with the US in 2001, but problems still remain (International Intellectual Property Alliance 2009; Office of the US Trade Representative 2011). Jordan is a member of both the WIPO and the WTO, which should theoretically encourage FDI which can then foster growth in the local innovation environment. It is likely that in the foreseeable future both Lebanon and Jordan will remain consumers of standards. Neither of these countries has a large internal economy to command international authority or is near the technological frontier. At just over 4 million people, Lebanon is not a large economy, nor, apparently, does the nation control enough of a single good to allow it to dictate market structure outside of its border. Natural resources and farm products make up the bulk of exported goods. Though some machinery is exported, it isn’t clear that Lebanon is at the forefront of any technology field (Ministry of Economy and Trade 2011). Jordan is in very much the same situation as Lebanon. However, as one of the more innovative Arab countries, there is opportunity for Jordan to become a leader of that regional set of nations as they develop into a coherent cultural, market, and innovative body. Chart 1, shown below, provides an overview of innovation environments for Lebanon and Jordan. The United Arab Emirates (UAE) is also included for comparison as it is considered one 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, and researchers per million inhabitants for all three selected countries are not available, at least in this format. Assuming this is the most current data, these countries have incomplete knowledge of their internal innovation environments. Therefore, any IP regulations or decisions on technology standards run the risk of being inefficient as they will be based on incomplete information. CHAPTER 5. INTELLECTUAL PROPERTY, STANDARDS 102

Figure 5.2: Comparison of Lebanon, Jordan, and UAE Innovation Environments(Bank KAM Custom Scorecards: ) CHAPTER 5. INTELLECTUAL PROPERTY, STANDARDS 103

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National Competitive Advantage

6.1 Introduction

Countries seek national competitiveness as a way to promote economic growth and spur development. Excelling in a specific sector or sectors allows a nation to increase national productivity through specialization. National competitiveness encourages the production of goods and services that can be traded internationally to benefit a rising and sustainable standard of living in a country. Economists have tried to understand the conditions that allow countries to pursue this virtuous path (Abramovitz, 1986, 1994; Baumol et al., 1994; Freeman and Soete, 1997; Rostow, 1990; Ruttan, 2001; Tassey, 2007). Targeting specific sectors to provide capital investment represents 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 to increase crop variety and yields) or move up the value chain (e.g., in addition to extracting ore and minerals from the ground, a mining company may choose to begin smelting or refining activities). In the past few decades economists have also been very much concerned with the processes that allow countries to restructure and upgrade their economies in order to retain and enhance 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 and current performance and international competitiveness of individual sectors and (2) assess the prospects of individual sectors for future growth and decline. Assessing national competitiveness is as much an art as it is a science, and the best approaches are interdisciplinary, featuring analysis rooted in a variety of fields including economics, politics and sociology. The best outcome of policy intended to promote national competitiveness is likely to be an increase in national productivity, as certain sectors expand. Such expansion is not necessarily at the expense of other countries, as international trade is not necessarily a zero-sum game. That is, as one country expands, other nations do not necessarily contract, as one might expect between two competing corporations. Each country seeks economic 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

107 CHAPTER 6. NATIONAL COMPETITIVE ADVANTAGE 108 high value-added products and services in its national output. For example, countries that specialize in the production of raw textiles, a relatively low value-added industry, may seek to broaden the number of sectors in which they can compete internationally and enjoy higher economic returns.1

6.2 Economic Growth and Development

Before delving into the specific factors and processes by which nations become competitive, it is useful to review some basic concepts related to economic growth and development. Countries generate economic growth through four fundamental processes. The ability of a country to harness these four processes effectively leads to increased national productivity and competitive advantage. • Investment: The productivity of the average worker is constrained by the quality of his tools. Increasing the level of capital input—improving the quality or quantity of the tools used—can lead to economic growth. Consider the differences in productivity between a farmer with a hoe and the farmer with a tractor. The latter will be able to plow an entire field 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 can yield increases in income. A nation may seek to enter a market in which it can have a comparative cost advantage as a producer of goods. International trade is based on comparative, and not absolute advantage (i.e., a country need not be the lowest-cost producer of products in order to trade). Furthermore, each economy also considers which industries will provide the highest added value to GDP. A country may seek to specialize in a particular industry which affords a balance of comparative advantage and satisfactory value added. Lowering the transaction costs associated with trade, such as rents charged to farmers to operate market stalls, costs of commercial transportation, or import/export duties can contribute to increases in commerce. • Scale: Population growth can contribute to economic growth, because it allows for increased specialization of labor. For example, a small town may grow large enough to support a variety of vocations including farmers, carpenters, mechanics, politicians, teachers and even artists. However, it appears that population growth can also lead to a tightening of resources to slow economic growth, so some effects of scale work both ways.

• Knowledge/Technology/Innovation: A signiﬁcant input to economic growth is the application 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 contributes to development through enhanced standards of living, improved education among youth and the workforce and increased ability to manufacture high-value-added goods and services. 1. The economist Paul Krugman (1994) cautions that a belief that a country’s economic problems are solely the result of national competitiveness (or lack thereof) in the world markets is misleading. CHAPTER 6. NATIONAL COMPETITIVE ADVANTAGE 109

This last input—technological change—is an important determinant of national productivity growth and, ultimately, of the standard of living in a country. The economic effects of technological change can be studied by analyzing the relationship between research & development (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 applications and 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 improve upon past inventions and innovations.

The government principally funds basic research and some applied research, while the private sector primarily funds applied research and experimental development. The impacts of technological change on economic growth have been explored by a wide variety of experts, reaching a broad consensus that technical knowledge has been a crucial driver 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 concluded that the most robust estimations utilize econometric analysis focusing on the effects of changes in R&D on production costs, output and productivity. A commonly used function is a typical Cobb-Douglas production function:

λ α β γ Q t = At e Kt 1 Lt Rt 1e − − where Q is real output, A is total factor productivity (TFP), K is the stock of physical capital, L is 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 investment can be quantified using such techniques. Policymakers may consider both the private returns—to the organization undertaking the research—as well as the broader returns to society. Consider that technical knowledge can be used by many people at the same time (nonrival in consumption). Also, consider that most technical knowledge cannot be completely withheld from others (partially nonexcludable). The result is that some knowledge created by an individual, 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 firm can 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 innovative businesses, academic institutions and research partners are co-located (see Chapter 8).

2. Chapter 1 of this volume focuses on this issue CHAPTER 6. NATIONAL COMPETITIVE ADVANTAGE 110

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 a deﬁnition 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 market conditions, produce goods and services that meet the test of international markets while simultaneously expanding the real incomes of its citizens. Competitiveness at the national level is based on superior productivity performance and the economy’s ability to shift output 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 competitiveness of national economies is built on the competitiveness of firms that operate within national borders. To a large extent, then, it is an expression of the dynamism of domestic firms (reflecting management practice) and their capacity to invest and to innovate both as a consequence of their own research and development (R&D) and of successful appropriation of technologies developed elsewhere. Importantly, however, it was argued that international competitiveness 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 capital investment, its technical infrastructure and other factors determining the “externalities” on which firms can build. This is to say the productivity of firms populating a particular sector largely defines the sector’s performance. A number of fundamental points in the brief definitional discussion above 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) should be productivity and market share. When seeking to identify competitive industries, one should examine these two indicators ﬁrst.

• It is necessary to understand the more general socio-economic fundamentals affecting company actions. A second line of indicators becomes necessary which deal with the factors 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 ability of firms to react to changing economic/technological conditions, to restructure and to upgrade. A third line of performance indicators is thus suggested which take a more dynamic approach by considering industry evolution and changing company capabilities. Such indicators may include those related to: (i) the dynamics of competition in an industry, 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) CHAPTER 6. NATIONAL COMPETITIVE ADVANTAGE 111

the innovative capability of ﬁrms in an industry, such as the rate of introduction of new products and production processes, upgrade of the product mix, upgrade of the quality of the factors of production, technology output (patents, licenses, etc.), technology imports and exports, R&D expenditures/intensity; and (iii) the participation of domestic producers in regional, national, and international production and innovation networks.

Nurturing competitive industry: Chile’s wine industry Because of its ideal climate and cultural history, for centuries the world’s finest wine was produced in certain regions of continental Europe. However, new winemaking regions in the southern hemisphere are slowly displacing the old. Chile’s wine industry has emerged as an important and globally competitive player. Globalization allowed Chilean wines, produced using inexpensive labor and abundant natural resources, to compete at a lower cost compared to European varieties. Beginning in the late 1970’s, the country liberalized its economy and allowed greater foreign direct investment. The participation by globally competitive companies such as Spanish giant Miguel Torres introduced new technology and displaced outdated methods of production (Chilevid, 2006). The clear advantages of stainless steel tanks, temperature- controlled facilities and advanced production lines quickly became apparent. Technology and knowledge transfer occurred through spillovers from one company to another in the regional winemaking clusters that sprung up around fertile valleys. Domestic production capacity and national exports soared in the early 1990’s after domestic firms fully implemented 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 market 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). Such companies then leveraged their distribution networks to sell wine around the world. The government also provided funding to increase national research capacity, with an aim to develop technology and knowledge that could support the agriculture and winemaking 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 and applied sciences research. In recent years, these efforts have increased crop yields and improved 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 is often complemented by funding from private industry associations such as Asociación de Productores de Vinos Finos de Exportación A.G. (Chilevid). The Chilean wine industry demonstrates several potential lessons for nurturing competitive domestic firms. First, the introduction of foreign companies and foreign direct investment proved to be a vital source of new technology necessary to upgrade existing production capabilities. Second, the increased linkages with glboal firms improved distribution networks, leading to an increase in export volume. Third, the winemaking clusters in thirteen of Chile’s most fertile valleys facilitated knowledge spillovers and the diffusion of technology. Finally, the role of government in supporting public R&D funding for agricultural research, and support for public-private partnerships between universities and private companies greatly aided the development of new technology, production processes CHAPTER 6. NATIONAL COMPETITIVE ADVANTAGE 112

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

6.3.2 Global Competitiveness Index3 Developed by the World Economic Forum, the Global Competitiveness Index (GCI) measures the 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, business and governments interact to generate wealth. Measures include: property rights, ethics and corruption, undue inﬂuence, government inefﬁciency, security, corporate ethics, ac- countability.

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

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

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

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

6. Goods market efﬁciency: Market efﬁciency, degree of competition, impediments to business activity through government intervention, and demand conditions. Measures include: intensity of local competition, extent of market dominance, effectiveness of anti- monopoly policy, extent and effect of taxation, total tax rate, number of procedures and time required to start a business, agricultural policy costs, trade barriers, trade tariffs, prevalence of foreign ownership, business impact of rules for FDI, burden of custom procedures, imports as a percent of GDP,degree of customer orientation, buyer sophistication. 3. This section is based on World Economic Forum (2011). CHAPTER 6. NATIONAL COMPETITIVE ADVANTAGE 113

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

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 different countries on the basis of the country’ stage of development. Although all twelve pillars matter to some extent for all countries, the relative importance of each one depends on a country’s particular stage of development. The first four pillars make up the basic competitiveness requirements and are key ( i.e., more heavily weighted) for factor-driven economies, the next six pillars are efficiency-enhancers and key for efficiency-driven economies, and the last two comprise of innovation and sophistication factors and are key for innovation-driven economies. The country categorization draws on the economic theory of stages of development, which can be traced back more than half of a century (e.g., Rostow, 1960), was crystallized a couple of decades ago in a major publication by Michael Porter (1990), and was adapted to the needs of the GCI more recently (Sala-i-Martin et al. 2007). Countries are categorized into three groups. Countries in the first stage of development feature a factor-driven economy whose main competitive advantage factor endowments—primarily unskilled labor and natural resources. Companies in these countries sell basic products or commodities, tend to have relatively low productivity, pay low wages, and compete on price.4 Maintaining competitiveness at this stage of development requires well-functioning institutions (Pillar 1), good infrastructure (Pillar 2), a stable macroeconomic environment (Pillar 3), and a healthy workforce with at least basic education (Pillar 4). More competitive countries feature higher rates of development, increased productivity and higher wages. Such countries are said to be in the efficiency-driven stage of development where they begin to develop more efficient production processes and increase product quality in order to remain competitive. Competitiveness is now considered to be increasingly driven by higher education and training (Pillar 5), efficient goods markets (Pillar 6), well-functioning labor 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 their businesses to sell new and unique products. Wages have now risen and citizens expect higher standards of living. At this stage, companies must compete by producing new and different goods using the most sophisticated production processes (Pillar 11) and by introducing new ones (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 the manipulation of past wealth. The CGI formulation drops the wealth-driven stage of development, presumably categorizing those countries into less competitive innovation-driven. CHAPTER 6. NATIONAL COMPETITIVE ADVANTAGE 114

In terms of Porter’s formulation (Figure 2), the factor-driven economy has only partial strength in the “factor conditions” corner, the efficiency-driven economy has partial strength in “factor conditions”, “demand conditions”, “firm strategy, structure and rivalry”, and the innovation-driven economy has full strength in all four corners. Linkages and the effects of networking are increasingly the focus of academic inquiry into competitiveness and innovation. The literature suggests networking may support technology transfer, access to new markets, risk sharing, pooling of complementary skills, some intellectual property protections, and knowledge spillovers (Pittaway 2004). Furthermore, it is suggested that such networking may be crucial to success in high-technology firms, and those that do not participate may suffer reduced access to knowledge and technology. Many of the benefits associated with networking are developed through the accumulation and diffusion of tacit knowledge. In contrast to implicit knowledge, which can be gained through reading a manual or purchasing a patent, tacit knowledge is dependent upon geographical proximity and participation in informal networks. Furthermore, these informal knowledge networks may be crucial for regional competitiveness (Saxenian 1994).7 For example, effective management styles and institutional practices are forms of tacit knowledge. The list would also include the spontaneous and informal interactions that might take place between a medical researcher and an aerospace engineer that leads to a new innovation in materials science.8 Tacit knowledge is a key source of knowledge diffusion in both clusters (discussed further in Chapter 8) and multi-national corporations. A crucial feature of national competitiveness in the 21st century is the presence of multinational corporations (MNC). About two-thirds of global trade is believed to occur in intra-firm trade between far flung subsidiaries of MNC’s (Dicken 2007). One could suggest that the rise of ostensibly stateless multinationals should diminish the importance of the various nation- dependent determinants outlined above. In fact, conditions in the host country are fundamental to the competitiveness of MNC’s and contribute certain advantages to host countries, including vast distribution networks and intra-market relationships, knowledge and technology transfer, and substantial innovation.

6.4 Conclusion

Developing national competitiveness is an interdisciplinary task that requires the expertise and insights of many stakeholders. The preceding chapter reviewed some key strategies and policies, yet it is important remember that policymakers do not act in a vacuum, and current political needs can sometimes trump far-sighted strategies for national development. While the full range of policies that government policymakers can choose to support may be bound by 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 transfer is predicated by both increasing dynamism and path dependence. This approach, which borrows heavily from evolutionary biology, appears to explain many key aspects of technological change such as why certain products of inferior technology but with widespread use dominate the market long after more advanced competitors have emerged. Furthermore, in this conception the appearance of “mutations”, or radical innovations, holds the possibility of upsetting the entire system (Metcalfe 1998). CHAPTER 6. NATIONAL COMPETITIVE ADVANTAGE 115

Developing countries seeking to enhance their competitive position would be well advised to consider the various measures outlined in the Global Competitiveness Index, particularly the first four pillars of competitiveness. Knowing where a future market opportunity may lie can be the key to success and can help focus innovation efforts. To this end, government provides a great service when it publicly announces its national priorities and most pressing challenges. Such challenges may include the need to produce renewable energy, find an inexpensive source of clean water, or create and adopt the newest information technologies so the country can join the ranks of the most advanced nations. Such goal-setting allows individuals and companies to focus their efforts on a 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 customer at a minimum, and potentially a much broader base of customers. Setting national goals can inspire and spur to action entrepreneurs, scientists and engineers, yielding long-term benefits vastly larger than the initial investment. CHAPTER 6. NATIONAL COMPETITIVE ADVANTAGE 116

Appendix 6.A Jordan and the GCI

In recent years, Jordan’s position in the Global Competitiveness Index has fallen 21 places from 50th in 2009-10 to 71st in 2011-12. The country has managed slight declines in every factor 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 tax rates and corruption. Jordan could improve its competitiveness by focusing on several key factors that are currently underperforming: • Innovation policies: Increasing the quality of scientific research institutions, private and public spending on R&D, enhancing university-industry collaboration, and encouraging the production of patents.

• Labor market efficiency: Increasing participation of women in labor force, increasing staff training programs, developing more transparent and legally-sanctioned hiring/firing practices. • Investment: Decreasing trade tariffs to encourage free trade, improving investor protections by closely regulating financial markets and the banking sector. Beginning in 2007, the Jordan National Competitiveness Observator has published annual reports benchmarking the country’s progress, using over half a dozen different indices and models.

Appendix 6.B China’s Solar Industry

The role of government in industry is a hotly debated issue. While too much government intervention can negatively affect the free market (as seen in some “closed” economies), some intervention 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 industries have 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 chain by 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 country pursues an industry development strategy based on strong government intervention and a bevy of supportive industrial policies. In 2012, about ten years after the country began a sustained political and economic effort to develop its solar industry, China was the world’s dominant producer of solar products. Through state investments in raw materials, technology and production facilities, and aided by fiscal incentives and export assistance, Chinese companies have surged to claim a dominant market share in nearly all segments of solar panel production. China’s industrial CHAPTER 6. NATIONAL COMPETITIVE ADVANTAGE 117 policies satisfy national development needs and support domestic companies competing in the global market. A key to the country’s initial success appears to be the timely pairing of an export-focused business model with massive government subsidies in a number of European nations designed to bolster the use of solar power. The generous subsidies afforded by the German and Spanish governments for solar photovoltaic feed-in tariffs in recent years created significant demand for 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 technology clusters. Initial evidence suggests that solar firms located in Jiangsu province clusters were granted certain advantages, including tax waivers, loan guarantees, low-cost land to build factories and R&D funding. High-technology companies in other sectors were also attracted to the clusers, creating an environment conducive to productivity. As illustrated below, approximately 97% of China’s solar photovoltaic (PV) products are exported to the European market, with Germany (46.9%) and Spain (22.65%) accounting for a majority of the global demand in 2007 (see Figure 3). China produces many more solar PV 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 supply with demand. (Besha 2011) CHAPTER 6. NATIONAL COMPETITIVE ADVANTAGE 118

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

Figure 6.2: Global production of solar PV modules (2008) CHAPTER 6. NATIONAL COMPETITIVE ADVANTAGE 119

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Strategy

121 Chapter 7

Alliances / Knowledge-Intensive Partnerships1

7.1 Introduction

The confluence of important developments in the international economic environment during the past two-three decades has turned inter-firm cooperation into an important mechanism of business interaction and market and technology access.2 Particularly in high- and medium- tech industries, the private sector has increasingly used various kinds of cooperative agreements 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 relationships than arm’s-length market exchanges but fall short of complete mergers. They involve mutual dependence and shared decision-making between two or more independent parties. When research and development is a focus of the partnership, universities and other research institutes may also participate. The proliferation of inter-firm alliances has raised expectations of accelerated long-term growth opportunities for developing countries through faster access to markets and technologies and greater learning possibilities. Available evidence, however, shows that, although developing country firms have increased their participation significantly, recorded partnerships are still overwhelmingly concentrated in developed economies. It also shows that a rather small group of newly industrializing countries and economies in transition with significant capabilities and domestic markets have benefited disproportionately more than others. Overall, the opportunities for widespread partnering for developing country economic convergence has fallen short of expectations. Although indicative, such evidence should be interpreted carefully. Not only is the underlying data subject to significant bias, the nature of recorded partnerships has been changing dramatically. Rather than equity-based, the vast majority of partnerships 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 for Development” 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).

122 CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 123 pressing need for strategic flexibility in high-tech sectors. Strong arguments can be made that non-equity agreements can play in favor of developing country firms as they require less commitment and get closer to informal kinds of cooperation. Numerous cases of transnational companies operating in developing countries and emerging economies have shown how cross-border partnering and networking can significantly raise those countries’ technological prowess and business competitiveness. Analysts may, in fact, have overreached in trying to extrapolate from the experience of developed countries in forming expectations for developing countries. They may have paid too much attention to formal forms of partnering—like those mentioned above, involving explicit contracting among parties—and much less attention to various forms of informal partnering among organizations and individuals. Anecdotal evidence indicates that informal partnering probably accounts for a very large share of partnering activity in industry, involving extensively small and medium-sized enterprises (SMEs) in proximate geographical areas. Formal and informal partnering should be seen as a continuum, where formal enterprise cooperation, clustering and networking are perceived as alternative, and often complementary, modes of operation. Formal partnership requirements—including strategy formulation and significant partner contribution in tangible and/or intangible resources—may be placing the 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 pursue. It now seems quite probable that more informal partnering through networks and clusters is a way for many firms in developing countries to increase their sophistication and become stronger and more competitive, thus gradually preparing for more formal partnerships. For firms that do graduate to formal partnerships, this Chapter expounds a roadmap to harnessing their potential for promoting technological prowess and economic competitiveness. Key lessons for success include a clear understanding of the firm’s objectives in the partnership, the negotiation of a suitable agreement with sound dispute resolution and exit clauses, the treatment of the agreement as a “living” document, and the awareness of the importance of knowledge and relative capability distribution among partners. For these firms, policy decision-makers and international organizations have important roles to play in terms of spreading the message of partnership opportunities, on one hand, and in terms of creating a supportive infrastructure, on the other.

Common Types of Alliances Three 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 the alliance partner. Example: In 1999, Renault and Nissan entered a strategic alliance through a cross- shareholding agreement, whereby each company purchased a minority equity stake in the other. Renault currently holds a 43.4% stake in Nissan while Nissan holds 15% of Renault shares. This arrangement ensures that each company will act in the ﬁnancial and strategic interests of the other while maintaining its own identity and culture. Activities include joint production of engines, batteries, and other key CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 124

components.

Joint Venture Arrangement in which partners agree to contribute resources and equity to develop a new business entity with a specific purpose in mind. Example: In order to save money on procurement operations, in 2011 Deutsche Telekom (DT) and France Telecom (FT) created a new 50/50 joint venture firm known as BUYIN. The new company, which is based in Brussels, manages the procurement of terminal devices, mobile communications networks, and fixed network equipment for the two telecom giants. The alliance is expected to save the companies about €1.3 billion over the first three years of operation. Furthermore, DT and FT have expressed interest in expanding the joint venture to other areas such as IT infrastructure in the future.

Contractual (non-equity) Arrangement that lacks shared ownership or dedicated administrative structures. Cooperation is undertaken through non-equity based means such as licensing deals, technology exchange agreements, sourcing relationships, co-marketing, etc. Example: Malaysia’s AirAsia and Australia-based Jetstar teamed up in 2010 with a plan to reduce the two budget airlines’ operating costs. Through a non-equity alliance, the airlines agreed to explore opportunities to jointly procure aircraft, cooperate in passenger handling in Australia and Asia, pool aircraft components and spare parts, and jointly acquire engineering and maintenance supplies and services. The airlines expect the alliance to reduce costs, pool expertise and result in cheaper fares.

7.2 Context of Strategic Alliances

7.2.1 Deﬁnitions Alliances refer to agreements whereby two or more partners share the commitment to reach a common goal by pooling their resources together and by coordinating their activities. Partner- ships denote some degree of strategic and operational coordination and may involve equity investment. They can occur vertically across the value chain, from the provision of raw materials and other factors of production, through research, design, production and assembly of parts, components and systems, to product/service distribution and servicing. Or, they can occur horizontally, involving competitors at the same level of the value chain. Partners may be based in one or more countries. A narrower set of partnerships can be characterised as innovation-based, focusing primarily on the generation, exchange, adaptation and exploitation of technical advances. Called strategic technology alliances (STAs) herein, these arrangements are of primary concern to both developed and developing countries as a result of expected direct contribution to national 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 CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 125 routinely partner informally on short-term business endeavors, and (b) informal partnerships may account for the vast majority of collaboration. Informal partnerships are unfortunately almost impossible to track down systematically. They fall more in the realm of clusters and networks 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 very important mechanism of business interaction and market and technology access around the world. A proliferating literature in economics, business and policy has tried to identify and interpret the important features of cooperation among firms, universities, and other public and 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 be key:

Globalization Transnational companies have pushed into new product and geographical markets relentlessly.

Technological change The pace of technological advance has accelerated signiﬁcantly, partly as a result of increasing competition through globalization. In addition to being an outcome 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 technological advance have robbed ﬁrms of their ability to be self-sufﬁcient in everything they want to do. The current management mantra is to do internally what a company does best and outsource the rest through partnerships.

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

Such developments have changed the nature of international business interactions that has supported the development of a score of developing countries since the mid-twentieth century. Traditional mechanisms of technology transfer including licensing, the acquisition of capital goods, and the transfer of complete technology packages through foreign investment are being supplemented by many semi-formal and formal new mechanisms for gaining access to technologies and markets. These new mechanisms entail the formation of dense webs of inter-organizational networks that provide the private sector with the necessary ﬂexibility to achieve 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). CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 126 been an increasing interdependence on a global scale that few firms interested in long-term survival and growth can escape. The available literature on formal business partnerships and networking has tended to focus 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 than four fifths of the activity over the years. More recently the rapidly developing economies of China, India, and Brazil have registered significant international cooperative activity, especially large multinational corporations based in these countries. The same firms also dominate international 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 collaborative activity (such as in a joint venture). Sectors registering large numbers of partnerships around the globe include pharmaceuticals, chemicals, electronic equipment, computers, telecommunications, and financial and business services. Service sectors took an increasing share of the 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 more significant 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 communication industries a major driving force towards international partnerships seems to be the effort to develop new global product and system standards. In pharmaceuticals, cost economizing and speed to market seem to be very important. In the automotive sector, securing resources to develop state-of-the-art technologies for environmental friendly vehicles, achieving economies of scale in production, and accessing markets appear to be major drivers. Finally, in the airline industry cost savings through investment in common systems of reservations, ticketing, and client 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 the 1960s had jumped to about 150 at the end of the 1970s. Sharp increases were recorded during the 1980s, reaching about 500 deals by the end of the decade. A short respite in the first couple of years in the 1990s was followed by yet another increase in new STAs. Annual announcements of STAs fell back to about 500 in the second half of the past decade. However, our databases which have traditionally depended on public announcements of collaborative agreements are becoming less and less dependable as alliances have become mainstream strategy in industry and they are not vigorously reported. Major databases have thus been discontinued and others have become very problematic.5 A major development has been the contrasting evolution of equity-based STAs (e.g., traditional joint ventures) and non-equity STAs in the past two decades. From almost 100% in the mid-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 and Bruton (1999), and Vonortas (1998). A series of publications by UNCTAD review the literature on partnering and 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 increasingly unreliable. CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 127 in the 1980s, less than 20% in the1990s, and less than 10% more recently. The gap has been filled by non-equity, contractual forms of STAs such as research consortia and joint development agreements that have provided the main mechanism of inter-firm collaboration in more recent years. For instance, all countries with significant public R&D programs fund research consortia these days, with the most prominent example being the Framework Programmes for Research 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 in transition, one starts from a rather small base but the trend is upward: developing countries have increased their participation in technology-intensive partnerships during the past couple of 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 country category. The distribution of recorded STAs is very skewed across countries, reflecting their industrial 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 leveraged alliances to develop their technological capabilities and dramatically expand their GDPs over the past several decades. In each of these countries, the overarching government strategy has been a three-fold process: (1) link domestic ﬁrms to the global economy in order to build indigenous skills and technological capabilities; (2) leverage relationships with other nations and international ﬁrms in order to form meaningful connections with strategic 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 objectives 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 and technologies) • Science and technology institute (for acquisition, reverse engineering and diffusion) • Export-marketing agency (to provide firms with relevant information on markets) • 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 learn from and compete with developed country multinational corporations. CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 128

• Restrictions on foreign capital (to ensure that FDI, licensing agreements and technology exchange hastened the building of technological capabilities at the enterprise level) • Institutional framework by which the Government allocated performance- based promotional privileges, such as subsidized credit, to a small number of entities that became large conglomerates.

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

• Incentive system and institutional framework to attract multinational ﬁrms • Investment promotion agencies (which searched worldwide for ﬁrms and industries 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 markets and technologies and for governments interested in indigenous capacity building and economic growth. However, benefits do not flow automatically; nor do partners necessarily gain equally. There is a lot of learning associated with setting up and managing successful partnerships and room for policy decision making to facilitate them. This section distills lessons from past experience to draw a practical generic guide to negotiating and managing successful partnerships. 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 strategic 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, marketing, 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 either carried out in-house or bought from an external source? CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 129

• How is a partnership expected to assist in accessing the requisite resources and capabilities 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 ﬁrm will 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 technologies, 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 components of 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 be put 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 acquisitions would be “love affairs” instead of “marriages”. Alliances also entail costs. Regardless of strategic goals, inter-firm collaboration always implies a trade-off between greater access (markets, finance, resources, capabilities) and lesser control of strategic decision making, day-to-day management, technological and other kinds of 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 resulting in the involuntary loss of important assets, particularly intangible assets such as technological and other types of knowledge. Other potential drawbacks from partnering include: CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 130

• Increased transaction costs due to (a) increased management needs, (b) diversion of management attention, (c) employee coaching into the agreement, (d) decisions and responsibilities that are subject to negotiation. • Lack of compatibility of the collaborative activity with core firm interests; e.g., locking the 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. Reasons for participation can shift over time, implying shifts regarding the perceived benefits and costs of collaboration. The motivation to enter into a joint relationship must, then, be not only strong 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 generally considered 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 for running the partnership. The chance for disagreements, for instance, between partners on market strategy, technology designs, and decision-making processes rises. Everything else constant, like-minded partners with similar management perspectives, goals and will result in fewer conflicts and lower costs of managing collaboration.

A common alliance problem: the wrong partner The risks involved in strategic alliances increase substantially when the alliance is codiﬁed in a written contract, and especially when there is uncertainty about the future or a partner’s reliability. For example, when Dow Chemicals signed a $17.4 billion Joint Venture Formation Agreement with Kuwait’s state-run Petrochemical Industries Company (PIC) in 2008, everything seemed to be on track for the creation of a new leading global plastics manufacturing company known as K-Dow. Shortly after the 50-50 joint venture deal was inked, however, PIC’s parent company, Kuwait Petroleum Corporation, reneged on the agreement with concerns over the ensuing global recession. The breakup of the joint venture agreement had severe consequences for Dow, which had expected $7.5 billion in revenue from the sale of several chemical plants to PIC. Prior to the debacle, Dow had agreed to acquire a rival ﬁrm, Rohm and Haas, with the funds it had planned on receiving from the joint venture deal. Not only did the failure of the venture lead to a drawn out legal battle between Dow and PIC, but Dow is also facing a lawsuit from Rohm and Haas for failing to honor the acquisition deal. Sources: Sieb, C. (2008). “Kuwait decision to quit joint venture puts Dow Chemical’s Expansion in Jeopardy.” The Times, December 30, pp. 39; Westervelt, R. (2009). “Dow CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 131

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 are extremely important and tend to dominate the negotiation phase: • Control of the partnership, including its equity structure and veto power over various aspects 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 item in 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 strategy In 1999, Eli Lilly established the pharmaceutical industry’s first “Office of Alliance Man- agement” which was established specifically to implement and guide alliances once agreements are made. Eli Lilly’s management recognized that most unsuccessful alliances fail due to implementation issues, personality conflicts and other non-technical factors. The Office of Alliance Management addresses these issues and works closely with partners to ensure strategic, operational, and cultural alignment to optimize resources and meet alliance goals. This office is part of a larger framework of Eli Lilly’s alliance building strategy, which also includes offices geared towards identifying opportunities and negotiating agreements with partners.

6. The section draws considerably on Miller et al. (1995). CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 132

Source: Gary Stach, (2006) “Business alliances at Eli Lilly: a successful innovation strategy”, 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 alliances may occur when a multinational corporation (MNC) with a global strategy forms a partnership with a local partner pursuing more narrowly defined goals. Global strategies frequently require the MNC to incur costs in one country in return for profits in another. Local partners may thus be placed at a disadvantage. Given that relationships can shift over time, this may become a problem during the course of the partnership. Such problems can include the following:

• Export rights. Exporting sometimes represents a fundamental difference between industrial and developing country partners. A MNC may not want the partnership to freely export products to markets already be served from other manufacturing points in its system. The developing country partner will be of a different opinion as it will typically view exports as a natural avenue of expansion. • Tax issues. The optimization process undertaken by the MNC will cover its worldwide 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 may affect its preference of dividends over reinvestment in the partnership. Again, the local partner may have diverging views. • Partner size. Large size differences may introduce difﬁculties during rapid expansion periods of the partnership due to their different resource base. Size differences may also have operational implications that can cause problems (e.g., the larger ﬁrm not taking the partnership seriously enough).

Ownership and control problems Long-term, strategic partnerships may need operational management with considerable independence from either partner. Problems may arise from changes during the lifetime of the partnership. A possible change involves the management in one of the partners that may affect this ﬁrm’s attitude towards the speciﬁc partnership. In addition, one needs to consider possible disagreements over time regarding 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 based in different countries and the corporate culture that characterizes each company. Both types of cultures condition how people view their environment and how they interpret issues. Complaints concerning arrogance, business practice, corruption, and so forth have not been unknown to partnerships.

Problems related to changes over time The changing environment within which the partnership operates alters partner relationships and can cause stress. CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 133

• Experience in a partnership results in learning. Learning can modify how one views the contributions of the partner. Learning should happen from all sides and involves better market understanding and improved capabilities. Learning boosts self-confidence and raises expectations for partner contribution. The result sometimes is dissatisfaction. Moreover, dissatisfaction is frequently the result of differential 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 all sides agree.

Common alliance problem: differential rates of learning Looking to expand into the Japanese marketplace in the 1970s, General Foods Corporation entered a partnership with Japanese food giant Ajinomoto. Ajinomoto offered its marketing expertise and knowledge of local business practices in Japan, and General Foods agreed to disclose its advanced processing technology for products such as freeze-dried coffee. After several years of successfully partnering together, Ajinomoto’s management began to feel that the alliance was unnecessary because Ajinomoto had internalized the advanced processing technology and was no longer learning from its American partner. General Foods, however, was not as successful learning about the Japanese marketplace and still needed Ajinomoto’s expertise. When the collaboration deteriorated and eventually disbanded, General Foods was left disappointed. Source: Barlett et al. (2008) Transnational Management: Text, Cases and Readings in Cross-Border Management. 5th ed. New York: McGraw-Hill.

7.4 Conclusion

The proliferation of partnerships during the past three decades has raised expectations of accelerated growth through faster access to markets and technologies and greater learning possibilities. There is evidence that inter-firm partnerships can be an extremely useful tool to assist developing country firms in their efforts to catch up. Partnerships can accordingly assist countries speed up the process of establishing competitive indigenous industries. Partnerships can also play a major role in mobilizing the necessary resources and technological expertise to upgrade 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 imply that the expectations of widespread catch-up opportunities through partnerships have not yet materialized (Freeman and Hagedoorn, 1994). We have argued elsewhere against that such interpretation on two grounds. First, partnerships alone cannot be expected to bring developing 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, CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 134 with few exceptions, developing countries have made their presence felt only the past 10-15 years. 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 experience of developed countries, missing important flags. Going back to the basic dichotomy between formal and informal partnerships, the available empirical information has overwhelmingly been on the former. In contrast, we have a lot of anecdotal but little systematic information on the latter. Available anecdotal evidence strongly indicates that informal partnering probably accounts for the lion’s share of partnering activity in industry. It involves firms and all other kinds of organizations, but it involves especially small enterprises in proximate geographical areas. In fact, we have developed various terms to capture aspects of more informal modes of interaction. We talk about clusters. We talk about districts. We also talk about networks. Each term means something different, but they also share considerable ground: the willingness and ability to interact closely with the surrounding environment, with peers, with buyers and suppliers—by and large on an informal basis. An expanding literature has, in the past few years, tried to amass evidence of such interaction and of policies that promote it in developed and developing countries.7 Various programs have been implemented by development agencies around the world to promote clusters and networks (UNIDO, 2001). The next Chapter deals with them directly. Formal and informal partnering should be seen as a continuum, not unlike the way enterprise 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 country firms to grow competitive. The question rather becomes which kind of partnering may be more appropriate—or more prevalent—at different stages of development and in different sectors. Available data on formal partnerships show that the vast majority of them involve participants from developed countries (Section 2). An increasing, but still minority of cases involves participants from few countries in the upper echelon of NICs, few countries in transition with significant industrial capabilities, and few developing countries with large domestic markets and/or relatively low-priced resources (increasingly semi-skilled and skilled human resources). Little else remains. While part of this skewed distribution undoubtedly reflects data collection bias, it would be difficult to attribute everything to bias. Simply put, formal partnerships 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 financial resources, intangible assets, market familiarity, market access, etc. Frequently, the required 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 and unsophisticated) firms in the majority of developing countries. Hence, it could be argued, the relatively 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 probable that 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). CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 135 taged developing country firms to become stronger, more competitive, and to meet the minimum capability prerequisites in order to graduate to formal partnerships. Governments may be wise to try addressing most small firm problems related to size and competitive position through 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 agreement may 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 the event of irreconcilable differences, the exit mechanism to be employed in terminating the partnership.

• Monitor and review the partnership throughout its lifetime. CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 136

Appendix 7.A Petrobrás Subsea Boosting Technology Devel- opment

Over the last several decades, Brazil’s Petrobrás has evolved successfully into a global leader in deep sea drilling techniques by using strategic alliances to help it absorb external knowledge and generate unique solutions. Particularly, the alliance strategies that it employed during the 1980s 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 sea oil fields. This has been an important area of concern for Brazil since most of its recent large oil discoveries have been found under these conditions. Before Petrobrás utilized subsea production, it was limited to using a Floating Production System (FPS) which was subject to problems including limited depth capabilities and setbacks due to poor weather. Petrobrás’s development of Subsea Multiphase flow Pumping Systems (SBMS) showcases how it navigated these challenges to join the select club of firms that operate subsea production systems. It began with little to no knowledge of the technology, but was able to join an industry 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 this experience to monitor the progress in SBMS technology and understand new developments that occurred. The project ultimately failed, but Petrobrás succeeded in gaining a much deeper knowledge of the hurdles facing the technology and which competing avenues held promise. This knowledge helped Petrobrás take the next step and establish a technological cooperation agreement with German pump manufacturer Borneman, with the goal to develop a prototype system that was suited for utilization in Brazil’s offshore fields. It took a much more active role in this project and contributed extensively to a testing campaign that identified and ultimately solved the bottlenecks in the system. By 1997, Petrobrás was ready to put the innovation into production. At this time, Petrobrás ended its relationship with Borneman and entered a new joint industry project in which Westinghouse, Leistritz, and a host of other suppliers would take part in delivering the system to Petrobrás. The decision to shift away from Borneman was purely an economic choice. Petrobrás had already acquired the technological know-how it needed to implement the system and became more concerned with system costs than technology development. The experience of Petrobrás in its development of SBMS systems highlights how it used different modes of partnering at different stages of development in order to attain the maximum benefit at each stage. In the first stage, it was mainly concerned with learning about opportunities, and the joint industry project served as an entry point to monitor progress in the sector while minimizing costs to the firm. From here, Petrobrás was able to develop its own technology through a technology cooperation agreement and ultimately mastered this technology. Finally, it commercialized this technology through the use of industry collaboration in order to reduce its costs. Although the Petrobrás experience is special due to the great amounts of capital available to the company, it illustrates how partnering is a fluid endeavor with requirements that change and evolve as a firm progresses towards its objective. Source: Furtado, André Tosi and Adriana Gomes de Freitas, 2000 CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 137

Appendix 7.B Tata-Fiat Joint Venture

The challenges of developing a successful joint venture are exemplified by the partnership between the Italian automaker Fiat and its Indian partner, Tata Motors. In 2007, the companies created a joint venture firm to produce engines, transmissions, and complete automobiles at plants in India. With a strong relationship previous to the agreement, the JV firm seemed like a natural progression for two companies with similar values and objectives. Fiat already had a 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 company executives to believe the company could not ‘go it alone’ in the Indian market. They felt that Fiat needed a committed partner to identify appropriate products and prices for the Indian market, build an effective distribution network, and commit to a long-term arrangement. Tata Motors, on the other hand, was in a position to benefit from Fiat’s technical expertise and global business network. In 2005, the two companies began a dialogue on how they could mutually benefit from cooperation. Through high-level discussions, Fiat and Tata executives soon realized that the companies had much to gain from one another. The meetings soon led to a Memorandum of Understanding, which solidified their intent to “analyze the feasibility of cooperation, across markets, in the area of passenger cars that would encompass development, manufacturing, sourcing and distribution of products, aggregates and components.” A year later, the two companies signed an agreement for a dealer sharing network in India, with Tata Motors managing the marketing and distribution of two Fiat models, the Palio and Palio Adventure. Soon thereafter, the head of Tata Motors, Ratan Tata, was appointed to the board of directors of Fiat, signaling a new era of cooperation between the firms. This increasing level of integration set the stage for the fifty-fifty joint venture, which was agreed upon after a long negotiation process involving aspects such as asset values and exit clauses. The agreement seemed at first to be a golden opportunity for both firms. Four years later, the alliance between Fiat and Tata is still in operation, with over X vehicles produced by the joint venture since its inception. However, as of 2011 the partnership has yet to break even and has been on shaky ground in recent months. Fiat’s product line has struggled 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 challenges associated 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: executives from both firms must work together to improve Fiat’s image and appeal in the Indian marketplace 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 between South African telecommunications firm Vodacom Group, and the Democratic Republic of the Congo’s Congolese Wireless Network (CWN). In December 2001, the two companies formed CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 138 a strategic alliance with Vodacom’s purchase of a 51% stake in CWN, and the subsequent establishment of a new telecommunications firm in the DRC, known as Vodacom Congo. In the early 2000s, Vodacom had already established a strong customer base in South Africa and expanded internationally into the nearby African countries Lesotho, Mozambique, and Tanzania. However, its largest competitor was involved in 15 African countries and some parts of the Middle East. The DRC represented one of the fastest growing markets in Africa, and had high potential for further expansion. These factors made it a prime target for Vodacom’s expansion plans. There existed several challenges in the DRC marketplace such as political instability, economic uncertainty, existing rivals within the country, and the difficulty of securing a license to operate. With these issues in mind, Vodacom executives decided a partnership was the best route to take. From CWN’s perspective, Vodacom offered desperately needed technological expertise. The marriage between the two firms and the resulting joint venture was initially successful, with Vodacom Congo growing from CWN’s initial 20,000 customer base in 2001 to 2.6 million in 2007, becoming the DRCs largest telecom company. However, cultural differences plagued the alliance from the outset, and perceptions of inequality tarnished the relationship between South African and Congolese employees. There was an unequal distribution of income, opportunities, and decision-making power between employees. Furthermore, the South African staff was criticized for arrogance and disrespect. According to interviews with Congolese employees, South African managers routinely ignored dress codes, made no effort 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 with little mutual respect. Although top executives realized this problem and made attempts to improve the institutional structure of the firm, animosity remained between workers. Over the following years the company lost ground to competitors, falling to the number three operator by 2010. The final nail in the coffin may have been Vodacom’s proposed cash injection of $484 million into Vodacom Congo, which would have significantly diluted CWN’s shares in the company and caused objections from its staff. The confrontation set the stage for Vodacom’s decision to sell its shares in Vodacom Congo and exit the DRC market, a process which is still ongoing as of November 2011. In the end, this case represents a failure of understanding and respect among cultures, contributing to the downward slide of a potentially successful venture. The case illustrates that, even in ventures involving two developing countries, feelings of mistrust and disrespect can develop if significant attention is not given to preventing these issues. This effort cannot be made on a piecemeal basis, as the issues are interrelated and no single component can be dealt with in isolation. Reforming the management policies and structures 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 Indian tower management company Indus Towers. Indus Towers was established in November 2007 through a joint venture between Bharti Airtel, Vodafone Essar, and Idea Cellular, with the goal CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 139 of reducing passive infrastructure costs for each company. Over the past decade, the Indian telecom industry has been undergoing extraordinary growth, with some experts forecasting an 80% penetration rate by as early as 2017. Early competition in this industry was intense and marginal revenues were very low compared to other countries, which led to challenges with capital investment in new tower infrastructure. At the beginning of 2007, only 25% of wireless towers in India were shared between telecom operators. This system was inefficient for operators because firms were building towers in overlapping areas that could easily be serviced 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 core businesses of providing telecom services. Together, they decided to jointly establish an independent firm to construct and manage towers throughout the two firms’ common operating regions. Idea Cellular, the third largest telecom operator in India, was also offered a smaller share 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 challenges that needed to be resolved by the parties involved. Determining how to value the assets that each company contributed was an early area of friction, which was resolved through the establishment of a point system where towers were rated based on attributes such as location and size. The companies then contributed capital for new towers such that the point values were equal among each partner. Other early issues included network downtime, the lack of a standardized data sharing platform, and conflicts between strategic company objectives. In the face of these challenges, Indus Towers was able to find solutions in large part due to equal representation on the management board and a shared understanding of the challenge that needed to be solved. Over the past four years, Indus Towers has grown into an efficient vehicle to operate towers throughout 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 of over 110,000 towers and plans to add 5,000 more each year until 2015. Sources: Gulati, Ranjay et al., 2010; CHAPTER 7. ALLIANCES / KNOWLEDGE-INTENSIVE PARTNERSHIPS 140

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Clusters / Science Parks / Knowledge Business 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 in economic development. In the old economy, factories had to be near raw materials like coal or iron ore. In the new economy, business would be global, with workers across the globe engaging with one another via mobile devices and the Internet. Instead, the last 20 years have shown that location still matters. While some services (e.g. call centers) have been outsourced, they’ve been outsourced to particular places, like Bangalore in India, where many companies compete for business within a geographically restricted space. With this realization, economic development is now focused on creating local and regional agglomerations with a specialty, often aimed at the high-technology sector which is perceived to 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 Parks and Knowledge Business Incubators. Despite the fact that many parks and incubators remain limited in scope, policy makers sometimes view such subsidized initiatives as the first seeds or stages of an economic continuum leading ultimately to the emergence of a vibrant hi-tech cluster with many profitable private firms.

8.2 Clusters

In the second quarter of 2011, the Silicon Valley Region of the US State of California captured 39% of the roughly $7.5 Billion in US venture capital funding in that quarter. In a nation as vast as the United States, how did one relatively small geographic region, far from the ﬁnancial and political centers of the US East Coast come to play such an important role in technology 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 among technology and industrial policy makers across the world.

143 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 interaction and economic efﬁciency, so does concentrating businesses and specialists in one region increase their productivity and innovation. Michael Porter offers this succinct deﬁnition of clusters:

Geographical concentrations of interconnected companies, specialized suppliers, service providers, ﬁrms in related industries, associated institutions (for example universities, standards agencies, and trade associations) in particular ﬁelds that compete but also cooperate (Porter 1998)

More generally, clusters are agglomerations of people, firms, institutions, and other economic actors working in a similar field who interact in a relatively small region. While this chapter focuses on hi-tech clusters, such as in the fields of biotechnology and information and communication technology, low-tech clusters can also be extremely important economic drivers. Indeed economic dynamism and innovation are precisely the qualities that attract policy makers to aid cluster-formation. High paying jobs, high economic growth, market dominant companies with export potential, and the prestige of being an international technological leader, are just some of the reasons hi-tech clusters are so valued. A cluster can become a global center for the activity performed there, drawing investment from across a nation and the 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 Valley or biotechnology like Route 128 in Boston. Often hi-tech clusters draw on the talent of top universities in the previous examples, Stanford and UC Berkeley and MIT and Harvard respectively. Clusters are often described geographically, but it is not merely the proximity of related firms and institutions which makes them successful. It is the social interaction between economic actors which help to drive innovation. A university may contain a brilliant scientist, a firm may retain a skillful lawyer or engineer, and a banker may possess access to great sums of capital, but if they never meet and discuss the ways that each may help the other a new innovative company is unlikely to be formed. In successful clusters, such collaboration and entrepreneurialism 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 Next Silicon Valley”. It is not necessary to go after a leading edge high tech ﬁeld such as software, biotechnology, or advanced materials to be innovative. Applying new technologies to older industries and encouraging an environment of collaboration, competition, entrepreneurship while extremely difﬁcult, can boost the competitiveness of a region. One example is the Sinos Valley region of Brazil, which has grown from a regional center of shoe production into a major global exporter of shoes. Firms there have developed strong CHAPTER 8. CLUSTERS / SCIENCE PARKS / KNOWLEDGE BUSINESS INCUBATORS 145

ties between ﬁrms, suppliers, and international retailers; this has dramatically increased the 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 between firms, competition, and specialization spur development. A virtuous cycle develops where people seeking to be at the forefront of their field choose to live in the leading cluster and large talent pools in turn attracts more businesses. Workers then are even more likely to move to such an area because they are confident of finding employment and so on. Specialized financial institutions, tailored to a particular industry emerge, making business transactions easier. Increasing rates of return and positive externalities are key features of clusters (Breschi and Malerba 2005).

Michael Porter’s Diamond Model

Figure 8.1: The Diamond Model Porter 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 labor, access to capital, natural resources, and institutions. Demand conditions describe the structure of a region’s home market. If the region’s home market contains many sophisticated consumers of a technology, the region will be at an advantage because of the rapid market feedback they can receive. The web of supportive and related industries can also play a key role for the emergence of a cluster. Companies with active and engaged suppliers are more likely to innovate. Firm strategy, Structure, and Rivalry deﬁnes how ﬁrms in a regional cluster will relate to one another. Collaborative, open relationships can speed the transfer of knowledge among market participants, but rivalry can also spur innovation CHAPTER 8. CLUSTERS / SCIENCE PARKS / KNOWLEDGE BUSINESS INCUBATORS 146

through competition. The government can influence all aspects of market environment through its use of regulations, subsidies, taxes, education policy. Finally chance can heavily influence the developmental trajectory and cannot be fully controlled by either firms or the government (Porter 1998).

Clustering also occurs because of the characteristics of four different kinds of knowledge relative 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 understanding of the state of the field. Both with regard to technology and changing business conditions; 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 critical for strategic planning. Analytical or scientific knowledge makes up “Know-why” which can be thought of as explanation of the works of nature. Both “Know-what” and “Know-why” are codifiable, that is, they refer to knowledge amenable to being written down, codified, and transmitted. Thanks to modern communication technology, codified knowledge can be transmitted around the world in a matter of seconds. Imagine a racing automobile; there is a great deal of information which can be transmitted about its qualities, specification, and care. This information can be found in 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 One racing team from even the most intelligent and athletic group of people unfamiliar with auto racing. 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. Such knowledge, like the ability of a mechanic to instantly diagnose an unusual engine problem or a driver to know exactly how much to engage the clutch when approaching a hairpin turn cannot be appropriated through reading a book. Tacit knowledge is said to be “sticky” not moving fast or far from those who have it. Many industrial processes involve a great deal of tacit knowledge. Only by working side by side or closely collaborating can individuals fully master the ability to efficiently complete certain tasks. Finally, “Know-who” refers to who knows how to do what, that is, information linking individuals and organizations to particular pieces of knowledge. Put differently, networking is the intimate knowledge of which individuals are truly important as innovators and institutional gatekeepers. Reputations can be difficult to judge from afar. Media sources may report on scientists who are the most interesting to readers or “colorful” while ignoring those in the field who are truly driving progress. Similarly in government or corporate bureaucracies, someone who holds a certain high rank or title may not actually be the key to an organization’s management. 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 out that much of analytical knowledge is as well. A study of research cited in patents reveals that papers from nearby universities are more likely to be cited than papers from universities located farther away (Fagerberg, et al. 2005). CHAPTER 8. CLUSTERS / SCIENCE PARKS / KNOWLEDGE BUSINESS INCUBATORS 147

The Importance of Small and Medium Enterprises (SMEs) in Clustering and Innova- tion The common perception of a “high-tech” company remains a large wealthy corporation with gleaming research labs full of expensive equipment. And it’s true that such companies do invest a great deal of money in research and development, employ many scientists and engineers, and produce very complicated, state of the art products. But fundamentally, innovation is a profoundly disruptive process. For many corporations, game-changing technologies 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 market truly innovative products.

8.2.3 Agglomeration vs. Innovative Clustering Cities have long contained districts which cater to a speciﬁc type of industry. Sometimes this occurred because of deliberate policy—grouping all butchers and abattoirs in one block to separate the process of animal slaughter from the rest of the city. Often though, and especially as modern industry began to emerge, clusters formed organically as tradesmen grouped together to leverage economies of scale and to more effectively compete for business. A history of the original industrial revolution in Britain testiﬁes to the importance of such clustering,

Very shortly other ’external economies’ developed. Once a pool of skilled labour grew up in a mill town that added to the ’inertia’ of location. It made it more worth the while for expansion to occur in the same locality. A factory-trained labour force, of semi-skilled women and adolescents, was also an immense local advantage by the second generation. Another very important external economy was the convenience of specialized service industries—such as the bleaching ﬁrms, the machine-making shops, machine-servicing facilities 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. While not a cut and dry distinction, one key difference is the degree of backward and forward linkages between ﬁrms. Some regions, perhaps because of easy access to a vital natural resource tend to specialize in the production of a particular good. While such groupings may contribute to certain positive externalities such as a deep talent pool, they may not on their own lead to an innovative or competitive environment.

Local Living Conditions—Amenities as a strategy for talent attraction While the greatest force which pulls skilled workers to a cluster is the promise of continuous employment because of the large number of specialized local ﬁrms, secondary locational traits can help to lure employees towards an emerging cluster. Bangalore sits on a plateau, unlike other major Indian cities which are located near the ocean or in tropical lowlands. The pleasant climate is a real advantage. Boulder, Colorado, a ﬂedgling tech hotspot, is located on the front range of the Colorado Rockies. The scenic views and CHAPTER 8. CLUSTERS / SCIENCE PARKS / KNOWLEDGE BUSINESS INCUBATORS 148

opportunities for outdoor recreation represent a signiﬁcant recruiting tool, as employers seek to attract highly educated, and highly mobile workers. Universities, too, serve to enhance the appeal of an area. Cultural events such as concerts, lectures, and art exhibits that universities often sponsor provide opportunities for recreation and intellectual stim- ulation which may be otherwise lacking in industrial towns. Developing countries with signiﬁcant foreign diasporas seek to attract their citizens back home with similar incentives. 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 corporation is the degree of communication that can occur within a company. Bureaucratic politics aside, 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 leads to innovation separates an innovative cluster from a stagnant agglomeration. Backward linkages are the connections between businesses and their suppliers. Forward linkages are the ties between businesses and their customers. The more information that ﬂows up and downstream, the more innovative and responsive a company can be. Knowing that a battery supplier is close to a breakthrough in lightweight battery research and also having a 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 developed speciﬁcally for the jogging market. Without the information the company might continue to produce the same heavy music player mindlessly until it was forced to adopt the new battery by its competition.

Cities: People Magnets in Flat World Thomas Friedman popularized the concept of the "ﬂat world" in which information and communication technologies combined with widespread political and economic reforms over the last 20 years have changed nature of international trade and competition. While previously nation-states and then multi-national corporations were the main drivers of globalization, Friedman argues that individuals are now competing on a global scale. Furthermore new technology means that the best and brightest from all over the world can compete without needing to move to a “leading” country to be successful (Friedman 2005). 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 fully expressed unless they can live in close contact with other skilled people. Florida looks to cities as the engines of economic growth, and says that while the world may be ﬂattening for 2nd and 3rd tier cities and workers in manufacturing; 1st tier cities with a high degree of innovation are pulling even further ahead. He calls these cities “spiky” because of their high degree of economic and innovative activity in contrast with the surrounding countryside. Florida points out that people look for different amenities in cities at different times during their lives. Young people are looking for lots of economic activity and a large po- CHAPTER 8. CLUSTERS / SCIENCE PARKS / KNOWLEDGE BUSINESS INCUBATORS 149

tential mating pool. Middle-aged workers tend to want safe neighborhoods and excellent schools for their children. Top knowledge workers want to live in diverse cities that accept creative 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 cluster, Silicon Valley. Despite advances in other regions throughout the US and the rest of the world, this area south of San Francisco, California still attracts the best and brightest minds in engineering, software, and web development. Silicon Valley did not emerge as the tech powerhouse it is today overnight. In fact, the San Francisco Bay region has been an important center 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 development of the transistor or semiconductor, a key ingredient of which is silicon, was central to the region’s success. The Dean of Engineering at Stanford University, Frederick Terman, helped create the Stanford Industrial Park in 1951. Companies, including many founded by Stanford grads moved onto this real estate to be closer to the research being done at the University and to 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 firms were heavily supported by procurement from the US government, especially the military which used the hardware in aircraft, missiles, and other advanced weaponry. Activity was accelerated by the spin-off culture. Partially a result of the region’s existing business culture, it was also aided by the state of California’s ban on non-compete contracts. In many states employees are barred from starting work on new projects that could directly compete with their former employer. In California, without such restrictions, there are stronger incentives to take advantage of business opportunities provided by technological advancement. Technical expertise and an entrepreneurial culture weren’t the only factors contributing to the Valley’s rise. As early as the late 1960’s, Venture Capital firms and boutique law firms began to do business in the area. These specialized legal and banking services made it easier for first time businessmen to make the leap from employee to owner. As the number of people with start-up experience grew, there were more opportunities for mentoring relationships to develop. Experienced investors guided their protégés in business development. Strong social links were formed between entrepreneurs, stimulating the flow of information about technological developments and investment opportunities. Some of the drivers of Silicon Valley’s growth have remained constant; a cooperative, collaborative, and entrepreneurial business climate, a strong talent base of scientists and engineers, regional pride and rivalry, and close university-industry relations. Others have developed later and aided growth or have faded away, such factors were; government procurement contracting, venture capital infrastructure, specialized legal firms, high intra and inter-national immigration, cheap land values (Kenney 2000; Hospers, et al. 2009). CHAPTER 8. CLUSTERS / SCIENCE PARKS / KNOWLEDGE BUSINESS INCUBATORS 150

Bangalore, India Bangalore in the state of Karnataka, India was once known primarily as a resort for retired persons. Today it is the third most populous city in India and the center of the country’s telecommunication, defense, computer, and IT industries. With a fast growing and dynamic economy, Bangalore attracts skilled engineers from across India and transnational corporations hoping 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 to Silicon Valley. The first is presence of large companies working for the Indian government working to develop high tech products for telecommunications and defense. The second is the large 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 maintained a highly regulated domestic economy. As trade liberalization began in the late 1980s and early 1990s, exposure to imported goods produced by foreign manufactures increased the level of completion among firms to produce higher quality products. Businesses owners in the region 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, and Oracle, have invested in Bangalore, often in one of two hi-tech, industrial parks, Electronic City and Whitefield. Many foreign companies view Bangalore as a cost effective location for research and development. Indian hi-tech companies specializing in IT, engineering, and management consulting have seen rapid growth. Wipro and Infosys are the second and third largest ICT Indian ICT companies and are headquartered in Bangalore. From 1995-2005 the ICT sector has grown to over 70% of Bangalore’s total exports. In 1995 Bangalore’s ICT sector accounted 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, high skilled, low cost labor to attract foreign companies and in turn foster the development of innovative 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 ICT businesses. This success stems from a variety of factors, including deliberate government policy. Israel’s human capital provides its main competitive advantage. Israel’s commitment to education, especially in computer science and engineering as well as an influx of scientists and engineers from the former Soviet Union in the early 90s, have provided a strong pool of potential knowledge workers. These workers have strong networks with one another because of 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 made significant advancements in secure networking and encryption technologies. This in-country research placed Israel in a strong position when the internet began to mature and a need for such technology became apparent. As new firms began to grow, a need for stronger venture capital markets was identified. In response, the Israeli government set up a special venture capital program called Yozma in 1993, which promised to match private investment in Israeli technology companies. Since then it has seeded 10 VC Funds with $20 million each giving CHAPTER 8. CLUSTERS / SCIENCE PARKS / KNOWLEDGE BUSINESS INCUBATORS 151 them a 40% Government share and 60% private. Eventually in all but one case, these seeded funds, the government share was bought out by private investors. Today, total venture capital under management in Israel stands in excess of $10 Billion with around $1.5 billion invested annually (Wylie 2011; Engel and del Palacio 2011). The Israeli government started a number of incubators but after poor initial performance these were privatized and have since become more 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 develop strong links with Silicon Valley. Today, Silicon Wadi boasts the highest number of non-US companies listed on the NASDAQ exchange and many American firms operate subsidiaries within Israel (Bresnahan 2004).

8.2.5 Can Governments Stimulate Cluster Growth? Every city planner, regional politician, and national economic ofﬁcial hopes to emulate the success of Silicon Valley or one of the other dynamic regional clusters mentioned above. But each 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 development across both the developed and developing world. The good news is that some policies can improve the performance of local ﬁrms and spur innovation. The bad news is that there is no “out of the bottle” solution for creating high-tech innovative clusters. Most cluster-based development policies have been at best mildly helpful. At worst they use up resources that could better be used elsewhere and produce no discernible impact (Braunerhjelm and Feld- man 2006; Colombo and Delmastro 2002)

Knowledge or Skills? Spillovers from Universities Scientists and engineers at leading research universities spend their time advancing the frontiers of knowledge. But do technology businesses really co-locate with universities in order to access state of the art research? The degree to which knowledge really “spills over” 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 businesses look to universities as a source of talented workers with specialized skills. By staying close to these rich talent pools, tech businesses are assured access to a steady stream of faculty and graduates equipped with latest knowledge and expertise.

8.3 Science Parks and Incubators

This section examines two related strategies for promoting innovation and regional economic development. Science Parks or Research Parks are mixed-use real-estate developments built close to Universities which seek to encourage Industry-University knowledge transfer. Business Incubators are also often located near universities (sometimes within science parks) and offer CHAPTER 8. CLUSTERS / SCIENCE PARKS / KNOWLEDGE BUSINESS INCUBATORS 152 incentives such as low-rent property and networking opportunities to encourage spin-offs from university 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 science parks and encouraging private industry to open branch research offices on or near campus where they would have easy access to talented graduates. The goal was increased knowledge spillovers and product commercialization. Science parks were envisioned as a location where government, industry, and the university could collaborate and share ideas. This collaboration would hopefully result in entrepreneurship and human capital development, which could serve as kernel for developing a regional agglomeration of knowledge workers. Another impetus for creating science parks was desire to garner greater benefit from science research. In the United States, 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 research would lead to economic growth. As public science funding came under budget pressure in the 1970s and 80s and as the US faced economic competition from Europe and Asia, Science Parks began to be seen as method for increasing technology transfer. Since the emergence of the first science parks in the United States during the 1950s, the concept has proliferated with over 400 parks worldwide. In North America today there are 174 research parks which collectively employ over 300,000 workers and occupy over 47,000 acres (Battelle 2007).

Korean Clustering: Grappling with Tradition For the last half century of Korean economic development, young clever workers have sought corporate positions in the chaebols (large conglomerates). These leading companies were considered national champions and employment at a chaebol carried great social prestige. Entreprenuership was seen skeptically, an indication that someone had failed to make the cut at a larger firm. However, as the Korean government has recognized the economic 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. Despite having the advantage of being collocated with KAIST, Korea’s leading research university, and significant government and corporate support, the science park was not particularly successful in stimulating the formation of new hi-tech firms. The government has struggled to turn the science park into a self-sustaining cluster. Since the 2005 renaming of the science park, Daedeok has begun to see improved performance, between 2005 and 2009 sales increased from $2.5 to $12.3 Billion. Additionally it added 13 new companies to the KOSDAQ, an impressive number since previously the park had only produced 11 in total. 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 more easily and bankruptcy laws have been altered to make the consequences of failure less dire (Watson 2011). CHAPTER 8. CLUSTERS / SCIENCE PARKS / KNOWLEDGE BUSINESS INCUBATORS 153

Figure 8.2: Science Park Characteristics (Battelle 2007)

At their start, Science parks were essentially real-estate developments aimed at attracting high tech ﬁrms. Local municipalities or Universities used the prospect of cheap land and tax incentives to encourage high tech industry to move to the research park. One of the primary reasons for the creation of science parks in the developed world has been the relative resiliency of universities in the face of economic decline. In many regions which have experienced de-industrialization, universities remain one of the few functioning large institutions and so attempts at economic rejuvenation are centered around the university. A similar logic prevails in developing countries, which are attempting to build an innovative environment from scratch. In either case, ties to a university lend credibility to such developments and imply a longer-term commitment by policy makers.

Ciudad del Saber (City of Knowledge): Redevelopment As Panamanian officials prepared to take control of the former US-controlled region called the Canal Zone, they looked for ways to utilize the buildings and other infrastructure that were being abandoned by the Americans. Ciudad del Saber (CDS) was established by a private, non-profit organization in 1999, at the site of Fort Clayton, a former US military base. CDS houses a variety of affiliates within its properties including businesses, educational programs, and international organizations and NGOS. The park focuses on 5 major “work areas”: Information Technology, Biosciences, Environmental Management, Human Development, and Business Management and Entrepreneurship. CDS also houses an onsite business incubator. Some of the main draws for the park are its reliable access to electricity and telecommunications, a business friendly tax policy, and proximity to CHAPTER 8. CLUSTERS / SCIENCE PARKS / KNOWLEDGE BUSINESS INCUBATORS 154

Panama City and a nearby tropical ecosystem region called the Panama Canal Basin. CDS has become a UN hub (housing many UN agencies servicing Latin America), and currently houses 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 to move into the parks. As it became apparent that these loose ties were ineffective in promoting robust development, policy makers began to recommend a more activist approach to park administration. Stronger ties between faculty members and park tenants were encouraged. Business assistance services became more common. The focus began to shift from recruitment ties with large corporations to promoting the establishment of start-up companies. Efforts to increase the number of innovative small businesses led to the incorporation of business incubators into many science parks, a subject which will be discussed at further length later on.

Hsinchu Science and Industrial Park Taiwan: A Success Story Beginning in the 1960s and 70s, Taiwan began to be seen as a low cost manufacturing destination for basic electronics for foreign firms, and local SMEs began to make imitation products. In 1980 the Taiwanese government decided to invest in a science park near two well-regarded technical universities. Additionally, the organization exemplifying the national effort to research semi-conductors, ERSO (Electronics Research and Service Or- ganization) was moved into the park. The park hosted many small emerging computer and electronics companies that were augmented by the government’s policies for seeding venture capital funds. Rather than backing individual companies (picking winners and losers) the government sought to create a competitive local environment with incentives tilted towards the creation of IT companies. One key to the park’s success was luring back Taiwanese scientists and engineers who had been living and working in Silicon Valley. These individuals were offered substantial incentives, such as 49% government investment in any firm they started within the park and management positions within companies and park administration. These returnees brought with them knowledge about how to start and run hi-tech companies and also founded the first private VC funds in Taiwan. The science park augmented the knowledge base of local companies which were already aggressively expanding. The park served to funnel knowledge from the universities and abroad into the private sector. From 1988 to the pre-recession height of 2007, annual sales from the science park grew 2300% from 489.86 Billion NT to 1.14 Trillion NT (US$ 37 Billion) (Bresnahan 2004).

Proximity between industry and universities does not automatically result in collaboration. Science parks may succeed on some level, but there is little hard empirical evidence to suggest they stimulate new economic growth. They do provide a conducive environment for communication and coordination between industry, government, and academia. The most effective parks are deeply integrated into the communities where they are located. They must CHAPTER 8. CLUSTERS / SCIENCE PARKS / KNOWLEDGE BUSINESS INCUBATORS 155 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 transfer. 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-sustaining clusters, but many other factors are responsible for regional economic development. Realistic time horizons must also be kept in mind. Even successful science parks such as Research Triangle in North Carolina have taken over 50 years to become fully established. An attractive campus with several prestigious sounding businesses grouped closely together may make Science parks an attractive option for policy makers seeking an impressive looking end 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 incubators which 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 with universities, business incubators seek to encourage spin-offs and start-ups. Incubators try to create a welcoming environment for entrepreneurship by lowering startup costs and providing consulting services.

Technological MIDI: Brazil The southern Brazilian city of Florianopolis has sought to encourage the development of a hi-tech innovative economy but faces difficulty because of its distance from the commercial and financial hubs of São Paulo and Rio de Janeiro. The local technology business council ACATE, founded Technological MIDI in 1998 with the aim of incubating up to 10 companies. 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% of market 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 as well. It is registered to receive federal subsidies under Brazil’s so-called “IT Law”, which encourages domestic IT innovation. By 2007, companies which had graduated from the incubator had achieved sales of US$ 13.9 Million and employed 385 people. This success earned the incubator the best technology incubator award in 2008 from the Brazilian innovation and entrepreneurship association ANPROTEC.

Key features of incubators are temporary leases in business rental property offered at below market rates, professional business managers, and structured networking opportunities with venture capitalists. CHAPTER 8. CLUSTERS / SCIENCE PARKS / KNOWLEDGE BUSINESS INCUBATORS 156

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, testing 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 to address the unique needs of client ﬁrms

• Design or use of long-term ﬁnancial support strategies that draw on locally available investment sources, client fees, and downstream equity or royalty returns

• Reliance upon a supportive community infrastructure to facilitate access to the widest possible range of ﬁnancial, management, marketing, technical, legal and information resources needed for tenant training, networking, market analyses, regulatory compliance and product development (Johnsrud 2003).

Business incubators have become even more widespread than science parks, not the least because of the fewer resources needed to establish one. Incubators carry additional appeal because 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 companies are 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. This experience 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 businesses are inherently risky and unproven, they suffer from a lack of investment, resulting in a market failure. Governments seek to correct for this failure by subsidizing the establishment of such firms (OECD 2006). Incubators attempt to bridge this gap in three key ways, by providing infrastructure, 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 help new businesses by simplifying this tedious and time-consuming phase of establishment. By offering 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 a home) confers added legitimacy to new firms at time when this image is especially important for attracting investment. Business incubators typically house multiple firms. These firms are able to share the costs of the various services such as a receptionist, audio/visual equipment, CHAPTER 8. CLUSTERS / SCIENCE PARKS / KNOWLEDGE BUSINESS INCUBATORS 157 printers and faxes, and insurance. Interactions between tenants can stimulate further growth as synergies between complementary firms can develop.

Business Support The level of business support varies widely by incubator but can include help with composing business plans, mentoring or coaching from more experienced managers, training sessions, accounting services, IT support, legal assistance, as well as other options.

Equity Stakes Incubators that are started by the public sector tend to be focused on economic development and increasing local employment levels. As a consequence they tend to ask little financially in return from the entrepreneurs they host. However there are private incubators 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 of their value, but this incentivizes incubators to work harder since they will share in the final 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 be in the form of events where founders make pitches to investors or business lunches with local leaders to gain social capital.

Other Types of Incubators Accelerators Rather than allowing for slow growth like more traditional incubators, business accelerators aim to rapidly bring entrepreneurs from the initial idea phase forward to a solid business plan and a prototype or website. They often try to connect budding 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 but need help with other aspects of business development. Virtual incubators use the internet to connect entrepreneurs with management counseling and other services without having to move to a central shared location. CHAPTER 8. CLUSTERS / SCIENCE PARKS / KNOWLEDGE BUSINESS INCUBATORS 158

8.3.3 Assessments of Effectiveness The word “incubator” is key. Business incubators aim to “graduate” companies from the incubator and into the regular market once they become established. Successful operation of a knowledge business incubator require solid selection criteria and robust standards for firm exit. By being selective about which firms they choose to house, incubators can increase the chances of success. Similarly being clear about when firms must exit provides certainty and encourages firms to expand quickly to become profitable enough to survive outside the incubator.

Incubator Examples ICEHOUSE (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 new SMEs. Partners for ICEHOUSE included the University of Auckland Business School, BNZ, HP, NZTE, Gen-i, Ernst & Young, Paul Diver, Grafton Consulting Group, and Microsoft. The ICEHOUSE incubator is linked to New Zealand’s largest network of angel investors and has a monthly event where 25 entrepreneurs can attend a seminar explaining how to launch a start-up and have the opportunity to meet with incubator staff about joining ICEHOUSE. The incubator offers 3 basic levels of service, market validation, business plan development, and full incubation. ICEHOUSE primarily aims to incubate companies with an intellectual property component with a high growth potential in an emerging market. Since 2001 it has launched 75 companies and attracted $50 Million in angel investment. It was ranked as one of the top 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 a presentation called “Demo Day”, an event which has become extremely inﬂuential. Applicants are rigorously screened, but Y-Combinator seeks to invest a small amount of money across a large number of companies. Those accepted into the program are given approximately $18,000, business training, and access to Y-Combinator’s network of experienced entrepreneurs and investors. The budding companies cede a 6% equity share to Y-Combinator in exchange for their service. To date, this accelerator has launched 380 companies, including notable internet businesses such as Dropbox and Reddit (Y-Combinator url 2012).

It is critical for policy makers and the managers of a business incubator to be clear about the objective of the operation. There is a wide range of potential incubator sponsors including municipalities, universities, government agencies, non-profit agencies, who may all seek different end goals. This includes privately owned business incubators whose goal is to achieve CHAPTER 8. CLUSTERS / SCIENCE PARKS / KNOWLEDGE BUSINESS INCUBATORS 159 a profit. This can sometimes come at the expense of local economic development. If the goal of a knowledge business incubator is to spawn numerous high technology companies to stimulate growth, this must be explicit. Managers may choose to allow successful businesses to remain on site too long because of the steady revenue from rent and fees. Similarly, they may allow unrelated businesses to rent what is essentially subsidized office space. These practices consume resources that could be used by desired technology startups. Knowledge business incubators are a cost-effective way of stimulating the creation of high tech businesses and fostering a local culture of innovation. However they must be carefully managed and focused on their specific objectives. Innovation and quality should be more highly prized than simply filling 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 governments. While there is no well-deﬁned recipe for this type of economic development, certain ingredients may be helpful. These include strong links between research and development at universities and emerging industries, access to capital markets, and a local culture of competition and collaboration. Policies such as the creation of science parks and knowledge business incubators can help foster technology transfer and entrepreneurship but are unlikely to stimulate self sustained economic growth in the absence of other factors. They cannot alone make up for deﬁciencies in local systems of innovation. Without stable macroeconomic environments, strong labor and capital markets, respectable intellectual property protection, a reasonable research and development base, rule of law, and other basic requirements, an entrepreneurial high tech business culture is unlikely to take hold (Fagerberg, et al. 2005; Asheim, et al. 2006). CHAPTER 8. CLUSTERS / SCIENCE PARKS / KNOWLEDGE BUSINESS INCUBATORS 160

Appendix 8.A Middle East and North Africa: Hi-Tech Entrepreneurship Efforts

Governments throughout the Middle East and North Africa have increasingly turned their focus 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 gas proﬁts decline. Most countries have established science parks, which often serve as the base for business development, networking, and incubator programs. A recent development has been the creation of online networking sites aimed at connecting prospective entrepreneurs, mentors, investors, and organizations. Techwadi and Wamda are two examples of such networking 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 success stories and tutorials. Its Wamda fund invests in early stage companies at the $50-75K range 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 development agencies and potential entrepreneurs to facilitate knowledge ﬂow and best practices from the leading clusters back to emerging MENA ICT centers. CHAPTER 8. CLUSTERS / SCIENCE PARKS / KNOWLEDGE BUSINESS INCUBATORS 161

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Small Firms / Entrepreneurship

9.1 Introduction

Over the past several decades, small firms and entrepreneurial activities have emerged as vital aspects of innovation and economic growth worldwide. As more firms transition away from the vertically integrated business models of the twentieth century, the traditional sources of competitive 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 of the knowledge-based economy is engendering a new system in which small and medium-sized enterprises (SMEs) and entrepreneurship are the driving forces of social and technological change. These activities are closely linked with transformational breakthroughs, knowledge transfers, open innovation, and other developments that drive the “creative destruction” of less efficient ways of doing things. Policymakers, especially in the developing world, must address the growing importance of this phenomenon if their innovation policies are to reach their full potential. The speed at which new ideas diffuse in today’s global economy creates challenges that traditional large businesses are unequipped to address. In order to be competitive in the twenty-first century, firms must constantly work to identify trends and opportunities, react quickly to changing market conditions, and take risks involving the use of new unproven business techniques. As discussed in Chapter 2, technological innovation can be described in terms of technology lifecycles, whereby rapid improvements in new technologies diminish over time until an even newer technology finally overtakes them as the dominant design, signaling a new technology lifecycle. During these transition periods, large firms tend to remain committed to established 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 the average 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 means as well. Indeed, innovative activity involves much more than science and technology, and the wealth of information available in today’s world has placed a premium on the creative use of this information. The wider range of actors in the global economy, and increasing complexity

163 CHAPTER 9. SMALL FIRMS / ENTREPRENEURSHIP 164 of relationships needed to maintain competitiveness, are creating the need for innovation in firm organization as well as in how firms interact with external organizations. Additionally, the transition to a service-based economy has placed a greater emphasis on the non-technological business aspects of firms in many developing and developed nations. Altogether, these factors are redefining the role of small firms in the global value chain, and are creating opportunities for small firms to innovate while older and larger firms have more difficulty modifying their traditional methods of operation. In general, the role of government in relation to SMEs and entrepreneurship should be to establish the institutional, organizational, and regulatory conditions necessary for a healthy “enterprise culture.” Government actions alone will not create this atmosphere, but their actions can either facilitate or destroy it (UNIDO, 2004). This role has often been compared to that of a gardener working to create the conditions necessary for their crops to flourish. First of all, the weeds must be pulled from the landscape before the seeds can be planted. The weeds are analogous to impediments to enterprise: high taxes; complicated regulations; bureaucratic corruption; and barriers to competition. Next, the soil must be prepared by tilling the land and adding fertilizer. The quality of soil represents the quality of institutions and organizations necessary for entrepreneurial activity. Aspects such as intellectual property and entrepreneurial 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 with development and demonstration programs, are set by identifying market demands and commercial 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 understood to be “non-subsidiary, independent firms which employ fewer than a given number of employees” (OECD, 2005). The legal definition of an SME varies by country as well as by industry, but the maximum number of employees in an SME generally ranges between 200 and 500. Many countries make further distinctions between micro, small, and medium-sized enterprises. The EU, for instance, defines a small business as having no more than 49 employees and a micro business having no more than 9 employees (UNIDO, 2004). Across the globe, SMEs account for the vast majority of all firms and usually account for the bulk of jobs in a country’s economy. In particular, micro-firms consisting of less than 10 employees constitute at least three-quarters of all firms in most countries, and are responsible for 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. In OECD 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 share of total firms and total employment, respectively. In addition to birth rates and death rates, another important factor distinguishing SMEs is their rate of growth. OECD defines “high-growth enterprises” as firms that have annualized growth in employees greater than 20% over a three year period, and have at least 10 em- CHAPTER 9. SMALL FIRMS / ENTREPRENEURSHIP 165

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) CHAPTER 9. SMALL FIRMS / ENTREPRENEURSHIP 166

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 enterprises are seen by analysts as a source of entrepreneurial vitality, and are promoted as important drivers of economic growth and job creation. Figure 9.3 shows the number of high-growth enterprises—broken down by the service and manufacturing sectors—as a percentage of all firms in selected OECD countries. An especially important subset of high-growth enterprises is firms that are less than five years old. These young high-growth firms—often referred to as “gazelles”—represent less than 1 percent of all firms in most countries throughout the world, but are responsible for a much larger percent of new jobs created and economic growth. Encouraging the success of gazelle firms is a critical aspect of innovation policy in most developed countries. As will be discussed in the next section, however, an effective policy regime will address all types of SMEs and not just the gazelles. Lastly, two other useful metrics that provide insight into the health of the SME environment are birth and death rates. Birth rates refer to the number of newly created enterprises with at least one employee, as a share of all firms in an economic unit of analysis. Similarly, death rates represent the number of firms that cease to exist as a share of all firms. Birth rates and death rates 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, OECD data 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 issues where asymmetrical information comes into play, innovative activity varies widely across CHAPTER 9. SMALL FIRMS / ENTREPRENEURSHIP 167

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 by many different types of enterprise, ranging from high-tech electronics and advanced materials manufacturers to small independent service providers, such as barbers and cafe owners. A small percentage of these SMEs invest heavily in R&D and are highly innovative, while many others do not engage in formal research at all. That said, analysts have developed various systems to categorize SMEs by their technological and innovative capacity. One common categorization is the “Arnold Staircase” shown in Figure 9.4 below. The diagram is used to describe categories of enterprises with varying levels of R&D competence and their core characteristics. Another common classification is the “SME Research Staircase,” which separates SMEs depending on the level of technological activity. At one end of the scale are basic SMEs which undertake little or no R&D at all. These firms are by far the most common, representing about 70% of all SMEs in the EU. On the other side of the spectrum, the most innovative SMEs are the technology pioneers, which are involved in leading-edge research and technological breakthroughs. These firms only make up 3% of the SME population in the EU, but are responsible for the majority of technology-based innovation and job creation. Classifying firms into different categories based on technological capacity is useful to understand the wide variety of SMEs in existence, and can inform policies for maximum effectiveness in each type of SME. Highly innovative and high growth potential firms demand different modes of support than low research intensity firms which constitute the majority of SMEs. Science, development, and innovation (STI) support policies should focus on the specific needs of each group of companies and moving them up the “SME Research Stairway,” aiming at helping SMEs develop an innovation capability. CHAPTER 9. SMALL FIRMS / ENTREPRENEURSHIP 168

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 catalyze the technological breakthroughs and major innovations that can drive economic growth and transform the economy. At the other end of the spectrum, government action may be best focused on facilitating the absorption of knowledge and transfer of ideas between ﬁrms, networks, and industries. Although most SMEs are not involved in breakthrough innovation, they still play an important role in the restructuring of global value chains and improvement of industry best-practices through non-technological innovation and incremental improvements. In either 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 vibrant SME sector is an appropriate environment for entrepreneurial activity. Entrepreneurship may be 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 to create and develop economic activity by building risk-taking, creativity and/or innovation with sound management, within a new or an existing organisation” (European Commission, 2003). Whatever the definition of entrepreneurship, it is widely understood throughout the world that increased entrepreneurial activity can satisfy important policy goals including job creation, economic growth, and alleviation of poverty. Entrepreneurship is undertaken by people in all societies, for a variety of reasons and un- CHAPTER 9. SMALL FIRMS / ENTREPRENEURSHIP 169 der a myriad of circumstances. Indeed, the desire to solve problems and improve one’s quality of life is a fundamentally human trait, but certain environments foster entrepreneurship more than others. Social values, culture, government policies, political systems, available technology, economic conditions, customs, and laws all influence the prevalence of entrepreneurship in a society. Additionally, entrepreneurship is heightened during times of need, crisis, and opportunity. The business activities that are engendered during these situations, however, have vastly different objectives and carry unequal prospects for achieving national priorities such as job creation and growth. As the discussion above indicates, entrepreneurs can be broadly categorized by the objectives 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 merely searching 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 gap in the market which they view as an opportunity to make a profit. These entrepreneurs find niche sectors where improvements are needed and create marketable solutions. In the rapidly evolving 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 recent years is based on solving societal problems such as health or environmental issues, but not necessarily with the goal of large monetary rewards. So-called social entrepreneurs are motivated by altruistic ideals and are blurring the lines between making money and offering charity work. The potential for growth in these firms may not be as high as in purely opportunistic entrepreneurship, but their role in solving societal problems can provide valuable benefits to the 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 be distinguished, which has arisen to exploit the opportunities provided by the emerging knowledge economy. Characterized by their creativity and mastery of new technologies such as social media, so-called knowledge entrepreneurs are responsible for some of the most dynamic and successful businesses in the twenty-first century (Cooke and Porter 2008).

Entrepreneurship Examples Necessity Entrepreneurship After being laid off from a lighting and housewares manufacturer in 2008, Jeff Shay of Portland, Oregon decided to open his own consulting ﬁrm rather than brave the rocky job market. With 15 years of engineering and management experience under his belt, Shay used his skills to land consulting contracts with small and medium-sized manufacturing ﬁrms that were interested in sustainable 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, founders Mike Krieger and Kevin Systrom set out to design a fast and fun way to share digital photos. The service’s ease of use and interesting features soon led it to grow wildly in popularity. In April 2012, the firm was purchased by social media giant Facebook for approximately $1 billion (Stern, 2012). CHAPTER 9. SMALL FIRMS / ENTREPRENEURSHIP 170

Social Entrepreneurship In order to improve the speed and effectiveness of emergency aid responders, Assaf Shafran of Israel founded his social venture, IsraeLife, to provide a smart-phone based dispatching system to first responders like firemen and EMTs. The firm began as a non-profit enterprise, but moved to a profit-based model once 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 expanded into the US (Moran, 2011).

No matter the industry, achieving success as an entrepreneur is a difficult task that few are able to accomplish. A growing body of evidence suggests that successful entrepreneurs have several 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 refuse to submit to failure even when the odds against success are overwhelming. The refusal to call it quits can be an advantageous trait in that the chances of a successful outcome are improved when one follows through on every possible opportunity. At the same time, however, it means that unrealistic goals will often not be achieved. On a related theme, successful entrepreneurs are often extremely attached to their firms, sometimes spending all their waking hours working to develop their businesses. Although this close personal attachment obviously improves the chances of business success, it also may cloud an entrepreneurs’ judgment when difficult choices 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 regarding uncertain 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 the part 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. Entrepreneurs with low levels of education or training, a lack of management skills or experience, or insufficient knowledge of new technologies are unlikely to succeed in the increasingly globalized economy. Additionally, even the most talented managers will fail if their firms lack access to finance or information regarding the latest market trends. Strategic linkages to larger firms, access to global distribution channels, and adequately priced inputs for business operations are other critical elements for entrepreneurial success in SMEs (Stevenson 2010). Due to the smaller scale of their operations, SMEs also suffer many challenges that larger firms are not as exposed to. For instance, SMEs commonly experience “limited managerial resources, immediate time pressures and lack of in-house expertise are barriers in accessing external resources” (Boldrini 2011). Moreover, small firms may lack the operational breathing room needed to make longer term strategic decisions, such as pursuing available business skills support services. Often times, entrepreneurs are “unaware of the benefits available and secondly 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 predictions about the possibility of a return on their investment. Markets with significant levels of uncer- CHAPTER 9. SMALL FIRMS / ENTREPRENEURSHIP 171 tainty about the future economic climate will see underinvestment as a hedge against uncertainties. Uncertainty may include a number of issues such as “access to resources and other infrastructural needs, features of the intended market, and whether others can unfairly appropriate value from the entrepreneur’s activities (i.e., through corruption and other criminal activities)” (Webb 2010). The level of uncertainty associated with a particular market or industry is affected by both the formal and informal institutions that guide investment and entrepreneurship within an economy. 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 legal and regulatory framework in place. On the informal side, the norms, values, and beliefs of the society define opportunities that are deemed legitimate and may be desired by a sizeable group. Together, appropriate formal and informal institutions can mitigate uncertainties and facilitate entrepreneurship. One of the most important variables that an entrepreneur will evaluate when making business decisions is their ability to obtain low cost credit. As many small businesses lack established credit histories, private sector financial institutions may be reluctant to make loans. Barth et. al. found that “Firms using international accounting standards have easier access to 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 international business standards, they can still suffer from “the higher level of public ownership of banks, the lack of competition and restrictive lending practices [that] are among the major problems” in the Middle East region. In Lebanon, for example, 3% of beneficiaries account for 75% of total private sector credit (Stevenson 2010). Despite the fact that many small businesses around the world are self-funded initially, access to financing at critical moments of growth is absolutely essential. A successful firm will not expand if they are unable to secure affordable loans and without 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 establish confidence in property rights, promote education, guarantee access to capital markets, safe- guard stable macro-economic conditions and make sure that the necessary physical infrastructure is in place” (Wennekers 2005). Many different areas of policy influence enterprise, and successful 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 difficult to achieve. A major challenge is formulating a system in which “value is created through product innovation, as opposed to unproductive or destructive forms in which value is created for customers at the expense of competitors (e.g., rent-seeking through market power or political power)” (Mcmullen 2011). Indeed, government support of certain industries or firms may prevent the entry of new players and stifle the competition necessary to develop international viable enterprises. Eliminating unproductive forms of regulation is another substantial 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 CHAPTER 9. SMALL FIRMS / ENTREPRENEURSHIP 172 business registration, and cumbersome regulations as being the most significant stumbling blocks to their growth (Aegis Survey, 2012). Simplifying the process of starting and growing a business 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, and constrain R&D investment (OECD, 2004). While there needs to be some rules in place to protect workers’ rights, excessive intervention can undermine the price signals sent by labor markets and hamper investment. Instead, policy needs to be developed through collaborative engagement with unions and employers in order to establish consistent and achievable standards for labor contracts while maintaining flexibility for businesses to increase or reduce staff based on market needs. An essential element of policy for SME development is encouraging a culture of entrepreneurship. Indeed, an entrepreneurial culture is one of the most important aspects of an innovative ecosystem. Governments must closely engage with media outlets, business networks, research communities, and directly with the general population to communicate the benefits of entrepreneurship and the opportunities it creates. Unsurprisingly, entrepreneurship training makes individuals more likely to launch new ventures and report higher levels of satisfaction and economic success. While this training can be delivered through academic communities and institutions which have entrepreneurship programs, it is also important to develop informal learning networks. Appropriate policy should have an understanding of the stakeholders involved and may coordinate the actions of different public and private actors. For instance, the EU includes a policy commitment to teaching entrepreneurship at all levels of education. Additionally, many countries have adopted specific “learning-by-doing” schemes where students are able to develop skills as they create and run micro-businesses. Another important component of human capital development, particularly in developing countries, is the concept of “brain circulation.” Strategies have been developed in many developing countries that promote the repatriation of educated diaspora in order to increase the talent at home. Individuals returning from abroad with specific knowledge and technical pro- ficiencies are important conveyers of knowledge to local firms and workers. These individuals are often returning from educational stints in developed regions like the US and Europe, and are able to harness their international networks in addition to the skills they have learned while abroad. It is very common for these individuals to exploit these advantages to begin successful entrepreneurial ventures once they have returned to their home countries.

Germany’s EXIST Program In order to increase the number of knowledge-based start-up companies and improve the climate for entrepreneurship at universities and research institutions, Germany recently established 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 entrepreneurship among university students and faculty. It does so by providing grants to universities to help them establish the infrastructure for providing skills and support for CHAPTER 9. SMALL FIRMS / ENTREPRENEURSHIP 173

technology and knowledge-based ventures. The second pillar is the Business Start-up Grants pillar, which provides funding to help students and researchers turn their ideas into business plans. Grants cover a range of associated expenses including living costs for up to 12 months, costs of material and equipment, funding for coaching, and even child support coverage. The third pillar is the Transfer of Research pillar, which provides support for speciﬁc challenges to high-tech, knowledge-based ﬁrms at the pre-start-up and start-up stages. One such challenge for entrepreneurs is proving the technological feasibility of a new technology or idea, which the program supports through subsidizing researchers’ wages and materials for this purpose. Once in the start-up stage, the program provides 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 dialog between industry, academia and government focused on iteratively developing policy in response to observed outcomes. Any support program must include the flexibility to support entrepreneurs 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, private financiers and funded ventures. The EU Research and Technological Development Framework Programme (RTD-FP) and the US Advanced Technologies Program (ATP) illustrate two different approaches to government led innovation. The RTD-FP is a multi-year funding program that brings together all research initiatives under one roof. By developing a long-term roadmap, it is able to shape the priorities of different actors and facilitate inter-organizational cooperation, which may strengthen linkages between sectors and improve the efficiency of commercial, academic and public research expenditures. By contrast, ATP drives innovation by funding competitions and providing grants to speed up the development and dissemination of high-risk emerging technologies, where funds are awarded based on merit. This system allows flexibility for new directions of innovation and affords more creativity to entrepreneurs, but lacks a comprehensive research agenda. Private accelerators and incubators also play an important role in promoting SMEs in many developed countries. In the US, numerous organizations such as KickStarter and Y Combinator have blossomed in cities across the country and support countless aspiring entrepreneurs. These companies provide funding and support services to entrepreneurs in exchange for some form of compensation.

Technology Incubator: Y Combinator As Y Combinator demonstrates, the seed development of entrepreneurial talent is an activity that can be undertaken by the private sector in addition to government and angel investors. Y Combinator is a for-proﬁt company that developed a model for startup funding where they offer support to aspiring entrepreneurs in exchange for a small percentage CHAPTER 9. SMALL FIRMS / ENTREPRENEURSHIP 174

of equity in the firms they support. Generally, company founders receive a combination of mentoring and seed funding in the range of $30,000, as well as access to a shared work space. For this support, Y Combinator is paid in the form of firm equity, usually in the 5-10 percent range. While there is a very high level of risk involved—most start-ups fail within the first year of operation—the direct cost to the company is low enough that they are able to remain profitable. At the regional level, technology incubators like Y Combinator help entrepreneurs build professional networks and discover new opportunities for future enterprises, 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 organize networks for potential collaborators to build relationships. These intermediary actors can come 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 support in the implementation of business and innovation strategies” (Diaz-Puente 2009). They also serve as important channels for knowledge transfer and lateral technology transfer that help all firms in a sector improve their global competitiveness. Overall, SMEs are critical aspects of every innovation system and are central to all of the other topics discussed throughout this policy guide. More often than not, the reason these ventures are unsuccessful is due to a lack of funding or failure to pay off debts. Although briefly discussed in sections of this chapter, the next chapter delves further into the financing aspect of SMEs and discusses the policy instruments used to facilitate credit for high-risk ventures. CHAPTER 9. SMALL FIRMS / ENTREPRENEURSHIP 175

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 and medium-sized businesses seeking to develop specific ICT applications. Its funding is targeted at projects which produce new know-how or bear high technological and commercial risks.” In addition, to direct funding the Tekes Foundation also coordinates technology programs which “promote development in specific sectors of technology or industry, and to commercialize the results 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 increase 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 cooperation with regional councils. In a population of 40 million, 77 TDCs were created, “37% of which were linked to local entities—regional agents that operate at sub-regional or local levels and work on the development of a limited area within the region (e.g. town and city halls or local associations)—and 47% were linked to business associations. A third group of specialized TDCs (16%) were linked to foundations, non-entrepreneurial associations and universities, and are specialized in dissemination, promotion and assistance in a given topic or technology.” (Diaz-Puente 2009) The continuing high levels of unemployment in Spain indicates the extent 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 labor pool. In the United Kingdom, rather than try to promote a particular industry or change the operation of firms, there has been a focus on building partnerships between government and commerce to reduce the barriers for firms. This policy has taken the form of a Regulation and Small Business Policy Directorate, which in consultation with business develops “evidence for regulatory burdens and priorities for their reform.” This consultative process takes place along with the “‘Think Small First’ initiative [which] introduced some flexible exemptions to certain legislative provisions for small businesses, for example providing that (a) companies below five employees were exempted from the stakeholder pension, (b) union recognition was deemed not necessary for companies below 20 employees, and (c) certain accounting standards were made applicable only to firms with more than 50 employees.” (OECD 2004) Recognizing that multiple 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 a broad engagement of the private sector which links existing networks of academics, businesses and non-governmental organizations. Government is uniquely positioned to act as a convener of other actors, and leveraging this ability will generate the most efficient returns. CHAPTER 9. SMALL FIRMS / ENTREPRENEURSHIP 176

Appendix 9.B Small Business Administration and SME incubation in the U.S.

The Small Business Act of 1952 created the Small Business Administration (SBA) with the goal to “aid, counsel, assist and protect, insofar as is possible, the interests of small business concerns.” 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 that use their own funds and money borrowed with an SBA guarantee to invest in SMEs. These SBICs were the forerunners of modern venture capital firms and developed much of the experience needed to be able to accurately model the returns from investment. Secondly, the SBA funds Small Business Development Centers in partnership with state and private organizations at hundreds of academic centers and entrepreneurial hubs. These centers are critical for the development of networks of entrepreneurs and improving the overall human capital capacity of regions. The final area of support is through direct financial support including loans and research 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 through grants to small businesses. The initial legislation split the funding into two phases. Phase I 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 goal being a commercializable product, process, or service. Once a project moves through Phases I and II of the SBIR program, the hope is that it will have sufficient market traction to completely rely 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 credit guarantee programs (Hyung, 2009). Previously, the Korea Credit Guarantee Fund (KCGF) had been 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 in high-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, policymakers implemented a new system of risk assessment that was specifically geared towards understanding the specific uncertainties associated with high-tech firms. The new technology appraisal method, known as the Kibo Technology Rating System (KTRS), evaluated future variables such as technology development and commercialization potential, profitability forecasts, and marketability. CHAPTER 9. SMALL FIRMS / ENTREPRENEURSHIP 177

Figure 9.6: KOTEC Loan Program Statistics (KOTEC 2011)

Through close cooperation with Korean Universities and employing a staff of more than three hundred science and engineering experts in eight different technology areas, the new technology appraisal scheme has yielded positive results for KOTEC’s loan guarantee portfolio. The figure below shows the outstanding loan guarantees and contributions from government as well as private financial institutions from 2004 to 2008. After the implementation of the new technology assessment methodology, government leverage needed to maintain the outstanding loan amounts decreased significantly due to greater private sector confidence and investment. KOTEC’s credit guarantee program illustrates how financing for high-tech SMEs can be accomplished in an efficient manner while reducing risk to the public (Oh, 2011; Hyung, 2009).

Appendix 9.D Fostering entrepreneurship in Chile (Start-Up Chile)

Chile is often held up as a model of economic liberalization and has recently been at the forefront of targeted interventions into promoting small business growth. These include an expansion of the tax credit businesses can earn for paying for new capital expenses that is specifically targeted at small firms. Marshall (2010) shows that there has been a positive impact of capital investment as a result of the tax credit. He also discusses the possibility of achieving an economically similar impact by reducing corporate tax rate for firms that exhibit the 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 every year 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. CHAPTER 9. SMALL FIRMS / ENTREPRENEURSHIP 178

The recent rounds have a length of 24 weeks, and have already created promising firms such as Taggify which recently attracted an additional US$ 750,000 from the GoC venture capital firm. Taggify’s business model of offering contextual ads to web properties is competitive with innovation from the United States. Chile also gains by promoting immigration and being able to target small funds at the initial stages of innovation, which historically are the most difficult for entrepreneurs to secure. While a large number of ventures are likely to fail, the small individual prize sizes mean only a few successes could validate the entire program. More importantly, the imported entrepreneurial talent who do succeed will be providing a service in exposing a network of individuals who by virtue of working in a start-up venture will more likely launch subsequent ventures. The key takeaways are that start-up Chile is only a viable option because of the underlying favorable climate for business development and creation. Without a well-regarded framework for enterprise featuring low taxes and an easy registration process, greater incentives would have been required to get entrepreneurs to emigrate (Marshall, 2010).

Appendix 9.E Lessons in business support services from Malaysia

Beginning in the 1970s, Malaysia began to take steps to improve the competitiveness of its domestic SMEs. The Bank Pembangunan Malaysia Berhad was created to provide training in soft skills 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 to obtain 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 value chain. Malaysia benefits from having an integrated policy decision making process. In the 9th Malaysia Plan which covered 2006-2010, the government took concrete steps to leverage SMEs for additional growth in two discrete areas: partnerships to enable firms to integrate into global outsourcing networks; and entrepreneurship skills building programs. Recognizing the importance of making international links and developing a reputation as an efficient location for private outsourcing, the government undertook “collaborative ventures among MNCs, government-linked companies (GLCs) and SMEs to facilitate technology transfer and skills development and marketing” (Habaradas, 2008). It is critical that these international programs benefit 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 to purchase new hardware and software to improve business processes (Lee, 2007). By encouraging technology and knowledge diffusion via global firms, Malaysia is able to strengthen the quality of domestic human capital and lay the groundwork for new start-ups with the ability to compete on an international footing. In concert with these joint ventures, assistance to entrepreneurs such as “advisory and outreach services, have been expanded to equip SMEs with new and improved management and business practices, methods in production, quality improvement, marketing and distribution” (Habaradas, 2008). The lessons from Malaysia illustrate the importance of a comprehensive plan for SME improvement that is integrated CHAPTER 9. SMALL FIRMS / ENTREPRENEURSHIP 179 within the larger economic development strategy (Habaradas, 2008; Lee, 2007; Bin Yusoff, 2010). CHAPTER 9. SMALL FIRMS / ENTREPRENEURSHIP 180

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High Risk Finance

10.1 Introduction

The benefits of innovation have been widely discussed in earlier chapters of this book. These benefits to society and spillover effects of innovation provide strong arguments for government support of research and development, especially considering the market failures that accom- pany many forms of innovative activities. While government-funded research is an important component in an innovative economy, particularly at the more basic levels, most innovation in advanced economies is funded by the private sector. Within the private sector a large portion of research is conducted by established companies, while a smaller but arguably more innovative amount of research is conducted by small, knowledge-intensive companies. This Chapter focuses on the challenges of financing a subgroup of these companies, knowledge-intensive startups, 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 believes brings something new and original to the marketplace. These startups are responsible for an outsized share of innovation in developed economies compared to their small size and relative weight in research and in the economy as a whole. Though they have the potential to be highly successful, they also have a high rate of failure. It is for this reason that they are considered high-risk investments. Many of them will fail, in fact, but successful survivors can make high returns for their investors. They also create substantial benefits for the economy and the public. In the U.S., startups have been responsible for virtually all new job creation over the past 30 years (Kane, 2010). High-risk financing bridges the gap between an individual with a great idea and a viable company with a new product on the market. Often, those with new and innovative ideas do not have the resources to develop a new product on their own, including both funds and the necessary set of business organization and management skills. This is especially true in sectors that require highly specialized knowledge and resource-intensive development such as biotech or information technology. High-risk financing fulfills a good part of this need and makes innovation by individual entrepreneurs and small businesses possible. This chapter first discusses how small startup firms are financed in developed economies and then examines the specific challenges to promoting high-risk financing in emerging markets.

183 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. The first is a loan, where a bank (or another lender) provides financing for a given term that must eventually be paid back by a business with interest. The other type of financing is equity financing where an investor provides money for a startup in exchange for shares of the company. Often this equity-based financing is invested and managed by angel investors or 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 startup company should carefully assess its circumstances before choosing a type of financing. Banks do 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 autonomy of the management of a company, but it also has the potential to drain a company of financial resources, which must go toward loan payments, diverting capital from being reinvested into the new company (Ben-Ari and Vonortas. 2007). During the early stages of new innovative companies, which usually have few or no sources of revenue and require large initial capital investments to develop their products, loan payments have a high opportunity cost. For this reason, loans are usually most appropriate for companies that already have steady revenue streams. For startups that are in their nascent stages and are focused on developing their first products, 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 restrictions on management decisions. The interests of entrepreneurs and the investors may not always converge. Entrepreneurs may choose to pursue strategies that bring in more funding such as issuing shares to more investors, while current investors may wish to limit those options in order to maintain the value of their current investment. This divergence has the potential to create friction between entrepreneurs and investors. However, input and direction from investors can often be helpful to a new company. The management of a small startup company may consist of entrepreneurs who may be more competent in an area of technical expertise than business management. For these individuals, guidance from investors can be very important to the success of the company.

10.2.2 Equity Investors Provide Useful Expertise Though entrepreneurs may not enjoy relinquishing control to investors, venture capitalists provide managerial expertise that, in general, improves the performance of startups (Hall and Lerner, 2009). Most venture capital funds employ compensation schemes for their managers that depend heavily on the performance of the fund’s portfolio. This encourages fund managers to strictly monitor progress at a new company, particularly in the early stages when a company has developed very few assets that can be liquidated in a bankruptcy. However, some studies have not found a correlation between incentive pay and fund performance (Gompers and Lerner, 1999). CHAPTER 10. HIGH RISK FINANCE 185

The primary method of control employed by investors is releasing funds in short stages. If performance is poor or a venture capital company wants to enforce a change in a company that it has invested in, it will withhold funding. Venture capital firms will usually grant greater autonomy to companies that are performing well and place underperforming companies on a tighter leash by providing small installments of funding or even by taking over the management of the company. The funding duration is also usually very short when a company is new and its assets are intangible, such as knowledge retained by employees. Once an asset becomes more tangible, for instance through the acquisition of a patent, venture capital companies will lengthen funding cycles (Gompers, 1995). When assets are tangible, the “salvage value” 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 that venture capital tends to outperform other types of funding. Venture capital, according to some studies, encourages greater innovation over typical investing. One study found that venture capital funding will create three times as much patenting activity as an equivalent amount of corporate R&D (Kortum and Lerner, 2000). Innovative firms that receive venture capital also tend 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 as information asymmetries, can also create tension and raise the price of capital. Entrepreneurs tend to know their product (or potential product) better. As they are intimately involved with the development process of the product, they have a better grasp of the timeline for a completed product and whether it will be viable on the market. Investors usually have less technical expertise in the field than the entrepreneur, which creates an information asymmetry or “trust gap”. This trust gap can create communication challenges in the relationship between investors and entrepreneurs, as entrepreneurs attempt to keep their investors informed about progress in product development and the timeline for return on their investment. Investors may 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. Since entrepreneurs have a better understanding of the potential product and the probability of success, investors will be at a disadvantage. Providing too much information to investors also poses risks to entrepreneurs. Disclosing a new idea in too much detail may allow others to steal or copy it. The low quality of information that faces investors during investment decisions increases the risk of investing in a project with low potential for future returns and therefore will raise the cost of capital for investments in innovative companies across the board (Hall and Lerner, 2009). These information asymmetries and high failure rates are more pronounced in innovative startups compared to new businesses in more established fields. This raises the price of external capital for innovative companies over what other startups would pay. For this reason, the cheapest option for funding R&D is using internally sourced capital, such as existing revenue streams 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 CHAPTER 10. HIGH RISK FINANCE 186 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 corporations do this internally with new startups that are wholly owned by the corporation, but in 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 match equity and debt-based financing at different stages of the company’s development depending on the needs of the company at the time (Ben-Ari and Vonortas, 2007). Each step in developing a new product—from idea, to research, to prototype, to a marketable product—requires larger amounts of capital. Advances in product development must be synchronized with new infusions of capital. When this does not happen, funding gaps threaten the survival of startup companies. The initial funds for the very early stages of developing a concept into a business (known as the seed stage) will likely come from an individual’s own finances or from a group of closely related people.1 This amount of money is variable depending on personal wealth, and in most cases in the 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 volatile early-stage companies. In most cases, these investments come from wealthy individuals known as 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 company into the post-seed startup stage. Once funding requirements reach into the $1-2 million stage, the investments are starting to become large enough to attract the attention of venture capital funds. Venture capital funds are different from angel investors in that they are not personal investments; rather they are most often limited liability corporations where the money from investors is controlled by professional managers. Venture capital funds have been gradually shifting their focus, investing in less risky, later-stage companies that require higher amounts of funding (NVCA, 2011). In 1995, investments in seed companies represented 15% of venture capital investments. By 2010, this number has shrunk to 7% (NVCA, 2011). Part of this could be due to the higher management costs of monitoring multiple small investments versus fewer larger investments. Another reason could be that venture capital funds have become risk averse. The change in 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. Angel investors, perhaps in an attempt to help plug this gap, have gradually shifted into post seed funding. In 2002, 47 percent of angel investments went to seed companies, while 33 percent went to post seed companies (Sohl, 2003). By 2010, this had shifted substantially: 31 percent of 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 CHAPTER 10. HIGH RISK FINANCE 187

Figure 10.1: Angel and Venture Funding fraction of venture capital fund investments (EVCA, 2010). Whatever the cause of this shift, it has left seed and early-stage companies with less opportunity to receive external funding.

Inventive Private Sector Solutions for Financing in the UK While government support is often essential for overcoming funding gaps where there are high risks that discourage private investment, new investment methods for private capital may play a part in making those funding gaps easier to overcome. In response to the global credit crunch, several UK firms are experimenting with ways to provide capital to new businesses. A business called Crowdcube is banking on a concept called crowdfunding, where an entrepreneur presents a business plan to a website with thousands of potential investors and each investor is able to review the business plan and decide how much he or she wants to invest. This results in a large number of people each making small investments in a new business. This is in contrast to the traditional angel or venture finance model where a dedicated team of a few individuals reviews a new business and makes a large investment. By allowing individual investors to review the business plan on their own time, it avoids the lengthy and costly review process that takes place with traditional equity finance. It also allows a greater number of individuals to make small investments in new businesses who might not otherwise be able to and it spreads the risk for potential failures. Individual investors may not have the skill of dedicated angel and venture investors in reviewing business plans and picking successful winners; however, providing a way for them to participate in financing a new business may bring significant amounts of new capital into play. ( ) Another UK company focuses on providing crowdfunding through debt rather than equity. 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 its members to provide loans through an auction. Each potential lender bids an interest rate at which he or she is willing to provide a loan, and then the lender with the lowest interest rate will be selected to make the loan. Just as in CrowdCube’s model, Funding Circle encourages lenders to make at least 20 small loans to spread the risk around. ( CHAPTER 10. HIGH RISK FINANCE 188

) 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 will be able to invest and potentially profit from new startups. However, most investors will be at a greater risk for losses since they will not have the experience to evaluate what businesses might be successful and the information available on a website may not be as good as what angel and venture investors receive when they invest in a company. This is a inventive way of investing that, if it proves to be successful, may open new doors for both private investors and entrepreneurs.

10.4 Exiting

The ability to recoup investment is of crucial importance to investors. The goal of an equity investor is not to become a business owner. Rather, the primary goal is to buy shares in a company with potential, support it and help it grow, and then proﬁt off of the investment by selling shares after company value has increased. Equity investors tend to be patient, but they will eventually want to sell their equity to realize their proﬁts, which can then be rolled over into 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 by another company), an initial public offering (IPO), or bankruptcy. Selling the startup to a larger company or another group of investors is one of the most straightforward ways to recoup investment. Often small investors such as angel investors take a company through the seed stage and then sell their equity to a larger investor that can provide additional funds to continue to grow the company. A larger company may also purchase a startup for its intellectual property or product line. A purchasing company might want to buy a patent to improve 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 difficult for a purchaser. In contrast to an initial public offering on a stock market, the purchaser cannot benefit from a market valuation of the company. The buyer must resort to other methods such as making comparisons to similar publicly traded companies. Stakes in private companies are also less liquid than publicly traded companies, making it more difficult for purchasers to sell their equity. The risk associated with purchasing a private company that is illiquid 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 an IPO, a company must list itself on a stock exchange and comply with the requirements of the particular exchange, such as minimums for market capitalization, share issuance, and historical earnings. A publicly-traded company must also comply with public reporting requirements and accounting standards that vary from country to country and are typically much more CHAPTER 10. HIGH RISK FINANCE 189

Figure 10.2: Venture Capital Exits burdensome than the requirements for privately-held companies. The added burdens of IPOs mean 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 available to the public for purchase. This allows a company to raise a large amount of funds quickly which do not have to be repaid to the investors purchasing the shares; however, it subjects a company to a number of constraints faced by publicly traded companies, such as complex accounting 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 venture capital fund because it usually yields the highest return on investment. Unlike a takeover or private sale, where shares and ownership are transferred immediately, venture capital funds retain their shares for an average of a year after the IPO (Megginson and Weiss, 1991). An immediate sale during the IPO would signal that the asking price for the stock is too high and that the company is overvalued. Venture capital funds hold on to their shares and their board positions 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, IPOs accounted 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 divested through bankruptcy (Sohl, 2011). The early stage focus of angel investors means that companies are usually not mature enough for a public offering when an angel investor is ready to exit. Private sales are also better suited for early stage companies because the intangible intellectual assets are not likely to be well understood or valued by the public. Experienced investors, such as venture capital funds, will more likely provide greater value in a private sale as 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 that will 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 CHAPTER 10. HIGH RISK FINANCE 190

financial crisis when business bankruptcies peaked in the US in 2009, bankruptcies remained in 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 for five years (SBA, 2011). On average, the percentage of business angel investments that have ended in bankruptcy has remained below the average for small businesses in general. This indicates that there may be two factors that distinguish success rates for angel investor-backed companies from that of small businesses in general. The first is that angel investors are more likely to invest in businesses that are more likely to succeed. The second is that angel investors provide 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. This can discourage entrepreneurs from taking a chance in the ﬁrst place. Making it possible for people to recover from a failed business will help mitigate this risk. The easier it is to obtain funding for a new project after a failure, the more likely an entrepreneur will abandon a project that has a lower chance of success (Landier, 2006). If decreased access to future capital makes failure too costly, entrepreneurs will tend to commit themselves to lower performing projects for longer periods of time. Though this tends to decrease the failure rate of ﬁrms, it also diverts capital toward lower performing projects and away from those with the highest chances of success. Consequences must adequately discourage reckless use of funds without discouraging risk-taking altogether.

10.4.4 Ease of Exit The ease of recouping investment is a very important factor in determining the level of venture capital investment in a country (Black and Gibson, 1998). A key reason for the high level of venture capital funding per GDP in the US is due to its robust IPO market (Black and Gilson, 1998). A well-developed IPO market provides the best means for extracting as much profit as possible from an equity investment. This provides investors with a greater degree of confidence that they will be able to profit on their investment once they decide it is time to sell. Venture capital tends to lag behind in emerging markets due to the lack of an established equity market and therefore a market for IPOs. They also in general lack the liquidity through which 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 emerging market. This leaves room for some innovative solutions from policymakers and business leaders that will provide alternative avenues for venture capital funds to maximize the return on 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-developed markets with a strong base of innovative businesses and high-risk investors. These markets are CHAPTER 10. HIGH RISK FINANCE 191 not without their own problems, as shown with the gaps in financing for startup companies and the shortage of investors willing to support companies at the seed stage. Emerging markets also face broader problems that are highly connected to the development of legal institutions, courts, open business environments, government transparency, and good governance. The premise that factors like corruption, poor public institutions, and the weak rule of law hurt investment potential is the basis for several World Bank efforts, such as the Doing Business report. These issues are frequently discussed in literature on emerging markets and other development-related resources, but they are particularly relevant when it comes to high-risk financing. Investors do not like risk. They despise uncertainty. Investors only choose to take on risk if they believe the potential reward outweighs that risk. The technology and market risks they undertake in a knowledge-intensive startup are already quite significant but it is what they consider within their sphere of influence. Any factor that increases risk beyond that level, especially where it takes the elements of uncertainty—such as in terms of the broader socioeconomic context—discourages investment if it is not counterbalanced by an increase in potential return. In any market, risk does not lie in the quality and viability of an innovation alone, 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 demand for its product dries up or capital flees for safe haven investments. Emerging markets have other environmental conditions that are not present (or are less prevalent) in developed markets, and investors considering investing in emerging markets will be faced with added risk as a 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 inventions or else it will not be able to capture all of the value from its intellectual property. When a company 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 the invention’s development. The creator of the invention then becomes an unwilling subsidizer of a competitor. A country must have enforceable intellectual property rights to protect the money and resources a company invests in research and development, or else investors in the company will 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 risk and discourage investment.

10.5.2 Taxation Capital gains taxes directly affect the rate of return that equity investors achieve from their investments (European Commission, 2002). Targeted breaks in capital gains taxes for angel and venture ﬁnancing can increase returns and help offset the costs of the increased risk of CHAPTER 10. HIGH RISK FINANCE 192 investing in early stage companies. The United States saw a meaningful increase in early stage angel investments after it introduced temporary but steep cuts in capital gains taxes for 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 investing in small businesses in an attempt to get capital ﬂowing again following the credit crisis. The Enterprise Investment Scheme will cut the tax burden on seed stage investments by 50 percent and will eliminate capital gains taxes completely on some types of business investments for a short 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 make use of best practices that have proven their effectiveness in other countries; however, dramatic changes impose costs on businesses and also increase uncertainty about how to comply with a new law and how it will be enforced. The law must also be applied evenly and predictably. Laws that are rarely enforced provide opportunity 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 other motives for enforcing a law (such as extracting a bribe, or assisting “favorite” parties). This also 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 areas of work such as construction, handling chemicals or substances, and using certain types of equipment. Delays in obtaining a license can hurt a business through slowing work, idling resources, and ultimately increasing the time it takes for a product to reach the market. Demands for illegal facilitation fees in order to obtain a license more quickly pose unpredictable costs for businesses and damage trust in a government’s ability to govern fairly. Any unpredictability in regulation and enforcement increases risks to businesses and creates an environment that is unattractive to investors. An effective and impartial court system is also necessary for a healthy business environment. The ability to recoup an investment is a primary concern of any investor. Whether it is an investor trying to enforce a contract with a company or a bank attempting to obtain loan repayments, an effective court system is needed to protect an investor. Delays in adjudication draw out legal disputes and increase uncertainty for businesses. Foreign investors also need to 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 this as a potential liability. While changes in the business environment are never easy, because they require reforms in the private sector, the bureaucracy, law enforcement, and cultural practice, they are necessary to attract both international and domestic investment. For international investors, the reputation of a country and the experience of other investors are inﬂuential in an investor’s decision-making process. For domestic investors who know the local landscape and are well informed about local factors that may increase the risk of an investment, the investment potential in foreign markets also comes into play. CHAPTER 10. HIGH RISK FINANCE 193

Capital is becoming increasingly mobile, and investors will attempt to seek out an investment that yields the best return for the least amount of risk, regardless of whether the opportunity is at home or abroad. Capital flight is often seen as a vote of no confidence in investment opportunities in a country’s economy, while strong capital inflows generally indicate investor optimism. A country must reduce risks posed by corruption, a weak rule of law, informality, and poor public institutions in order keep capital from fleeing its borders and to attract new capital from abroad. Considering the very significant risks of funding an innovative, knowledge-based business, any added risks regarding the business climate and the environmental 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 in a company in an emerging market, a government may need to intervene by subsidizing financing or absorbing some of the risk of the investment. These sorts of programs are commonly found in developed markets in North America and Europe since these governments have long recognized the valuable role of small businesses and startup companies in creating job growth and 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 government in 1946. Because most of these financing support programs have taken place in developed countries, 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; however, the mechanisms that these programs used to boost investment should be more broadly applicable.

Publicly Funded Venture Capital in U.S. States Several U.S. States have devoted public money to venture capital funds to help promising new businesses grow and create jobs for their residents. One of the first examples of these state funds is the Massachusetts Technology Development Corporation ( ), established in 1978 by the state legislature to invest in new technology-based enterprises. An independent board comprised of experienced venture capitalists manages the fund and 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 funding gap that exists between angel investors and venture capital funds. Over the lifetime of the fund, the MTDC has invested around $83 million into 133 companies that currently employ 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 the state: it has an average internal rate of return of 16.5% that allows the MTDC to reinvest in new firms without added state support (MTDC, 2011). The State of Connecticut formed its venture capital fund, Connecticut Innovations in 1989 ( ) and through its return on investments, Con- CHAPTER 10. HIGH RISK FINANCE 194

necticut Innovations has operated without further ﬁnancial infusions from the state since 1995. The fund operates as an independent corporation with a board that is appointed by 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 funding stages. The fund has leveraged private sector investments in excess of $1 billion and has led to the creation of 5,000 jobs in the state. The State of Maryland created the Maryland Venture Fund in 1993 to target early stage seed companies. The fund has brought in 62.5 million in revenue over the life of the life of the fund while only costing the state $41 million to run. Since 1993, 23 of its investments have either gone public with IPOs or have 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 other means to encourage private investment in early stage companies such as providing economic incentives, assisting the development of angel networks, and providing investor education. A more in depth explanation of these programs can be found in this document from the National Governors Association ( ).

Yozma: Israel’s Big Bet Over the past 20 years, Israel has experienced one of the most dramatic transformations from a financially constrained economy with low levels of innovation to a dynamic and highly innovative economy with the highest R&D expenditures as a proportion of GDP in the OECD (OECD, 2011). In order to achieve this, the government undertook a bold economic liberalization scheme to shift more capital into the hands of private investors and underwrote the venture investments of experienced foreign venture capital funds in Israeli startups so that domestic investors could learn from the best. In 1993, the Israeli government 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 venture capital 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 the profits from the government’s shares if the startup started turning a profit without bearing the risks of losses from those shares if the investment failed. This was a bold and potentially risky strategy since it shifted the rewards for success to the private investors and placed a greater the burden for losses on the government and tax payers. But it also brought experienced foreign investors into the Israeli market to make investment decisions on Israeli firms and teach local investors how the best VC funds 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 (High Tech Industry Association). These measures helped form local venture capital funds, but it was not until the early 2000s that reforms channeled enough funds into these companies CHAPTER 10. HIGH RISK FINANCE 195

that risk ﬁnancing in Israel really took off. A series of privatizations and reforms to state pension funds shifted capital away from state bureaucracies and into the hands of private citizens and investors. These venture capital funds created in the 1990s through Yozma became an avenue for investment for these new streams of capital (Gilder, 2009). The Israeli government’s bet on bringing foreign venture capital ﬁrms into the country has paid of tremendously: from 1991 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 development jumped from 2.97 percent to 4.76 percent. This number has since declined a bit since the global economic crisis, but it still remained the highest in the OECD in 2011 at 4.25 percent (OECD, 2011). Israel’s venture capital spending per capita is the highest in the world at $142, around twice the amount in the United States (Vilpponen, 2011).

10.6.1 Research and Development Subsidies, Microfinance, and Small Business Support Germany, both through its federal and länder governments, supports innovative companies through subsidies for research and development. While these subsidies do not specifically target high-risk financing, by subsidizing some of a company’s costs, the lower operating costs should make a company less risky and should make any private investment in a company go further. An analysis of the effectiveness of the R&D subsidy on innovation found that it did increase innovation in the companies that took part in the program in general (Schneider and Veugelers, 2010), but it did not increase innovation at Young Innovative Companies (an EU 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 sufficient reason to continue the program, but the authors suggest that a more targeted program might better address the specific needs of a startup. Evaluations of business support programs in Italy provide support for the notion that targeted support is more effective. While Italy’s programs do not focus specifically on innovative or new technology based firms, they do provide an opportunity to evaluate the differences between automatic and selective support. In a study of several of Italy’s business support policies, those programs that used a selective review process to award funding resulted in greater business growth and job creation than those programs that distributed funds through an automatic qualification process (Colombo et al, 2008). Further, younger firms grew and created more jobs than established firms. The study found that selective funding was most effective when 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 the statistical model used in the study attempts to compensate for selection bias (ie. those that are more 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. Because government program managers have evaluated the company on a number of criteria, this may signal to investors that the company is a worthwhile investment when it is successful in the selection process. In this way, the selection process is acting to mitigate the information CHAPTER 10. HIGH RISK FINANCE 196 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 institutions require a large customer base, because the value of an individual loan is so small. They do not specifically target innovative firms, nor do they necessarily target firms at all. In many cases microfinancing 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 people in 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, its effect on highly innovative small businesses, a small subset of businesses in general, would be even further diluted. Additionally, administration costs for microfinance have to be kept to a minimum because the small values and the high volumes of the loans require a highly efficient loan distribution system in order to keep administrative costs from eating away at profits, or in most cases for microfinance loans, to minimize losses. This prevents an MFI from providing the type of business 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 providing finance to innovative businesses. A successful example of a research subsidy mechanism is the Small Business Innovation Research (SBIR) program in the US ( ). The program requires that agencies that spend over $100 million annually on R&D to devote 2.5 percent of their budget to SMEs with fewer than 500 employees. The program was initially conceived with a three stage funding process. The first stage provides up to $150,000 for 6 months 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 based on the results of stage I. Stage III does not provide any funding, instead the agencies or commercial entities that will benefit from the R&D are expected to pay for the research from non-SBIR funds if they see merit in the research (SBIR, 2011). A critical reform to the program in 1995 allowed for an expedited review process for stage II if a company was able to obtain outside matching funds. They also receive bridge funding of $30,000 to $50,000 between stages I and II to prevent any funding gaps in the interim. This resulted in the program attracting 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 benefits that would not have resulted from private funds, had support from government grants not been present. It found overall that the program was socially valuable and a good use of public funds (Link and Scott, 2000). While developing countries may not be able to take the same approach due to small research budgets, the important feature in improving the performance of this program was minimizing gaps in funding. For funding projects that are taking place in stages, minimizing gaps is an important part of program design. CHAPTER 10. HIGH RISK FINANCE 197

Public Support Programs for High-Risk Financing in Finland Finland has developed a publicly-funded system of institutions designed to support new startups and help carry them over the valley of death. Though these institutions overlap in several areas, each institution plays a role in supporting young companies at a particular funding gap. The system provides the potential for a startup to rely on government support or government-facilitated support starting at pre-seed business planning and continuing all the way until the company has moved beyond early stage development and is of a size that is more attractive to private venture capital. This approach involves a strong role for the government, but seems to work well in Finland, which has a high number of high tech innovative companies and spends the second highest amount of its GDP on R&D in the OECD. Finland has also achieved one of the highest venture capital expenditures in Europe at roughly $60 per capita. For comparison, the U.S. spends $67 per capita (Wagner and Laib, 2011), and estimates for venture 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 by the Parliament that engages in a wide range of activities from investing in venture funds to individual business ﬁnance. Sitra in recent years has focused its efforts on the earliest pre-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 entrepreneur purchase consulting services to create a business plan and evaluate the feasibility of a company’s R&D goals (Maula and Jääskeläinen, 2007). Tekes, The Finnish Funding Agency for Technology and Innovation, is primarily geared toward supporting new knowledge-based enterprises through research and development grants and loans, but also provides up to 80 percent of the startup capital, up to 100,000 Euros, for new businesses through unsecured loans. This type of loan can help overcome one of the most difﬁcult points in the valley of death through providing necessary funds at the earliest stages of a company when private capital is scarcest. Further, Tekes provides technical assistance to potential applicants and provides loan support for developing business models (Maula and Jääskeläinen, 2007). Finnvera is Finland’s Export Credit Agency, which, in addition to helping secure Finnish companies against the risks of internationalizing and expanding exports, engages in venture capital investments and the support of SMEs. Finnvera supports innovative CHAPTER 10. HIGH RISK FINANCE 198

knowledge-based startups through a subsidiary called Avera which makes direct investments in companies without private partners. Avera targets its funding to bridge the gap between R&D funding and venture capital funding. Avera funding frequently follows Tekes funding to sustain businesses that are attempting to commercialize a product and attain private sector venture funding. The size of the investment, up to 500K Euros, is large enough 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 new companies through making equity stakes in venture funds. Its purpose was to partner with private equity and encourage the creation of new venture capital funds in order to boost the involvement of private capital in early stage financing. After encountering difficulty in convincing private investors to co-invest with a government controlled entity in venture capital funds, FII began investing directing with private investors in new companies on a matching basis. When making co-investments with private investors, FII typically lets the private sector partner lead on the investment and does not accept a board seat in the company. About half of FII’s funds are invested in venture funds and half are invested directly in companies (Finnish Industry Investment). Finland’s public support of young innovative startups features significant government support at the early stages, but then shifts government involvement to encouraging private capital formation and investment once a company moves beyond the seed stage. This focuses government support where market failures are the greatest, but it also relies on government officials picking winners and losers among applicants for support. The success of this model depends on the experience and capabilities of the government institutions implementing these programs.

10.7 Conclusion and Recommendations

In presenting recommendations for promoting high-risk financing, it is important that we not put the cart before the horse. In emerging markets, angel investors and venture capital funds are limited primarily by a lack of what investors “perceive to be promising entrepreneurs and high-potential firms suitable for investment” (OECD, 2004). Quoting from an OECD report on promoting innovative SMEs, “the most fundamental requirement for facilitating funding for innovative SMEs is to create an economic and institutional environment that is conducive to entrepreneurship and innovation” (OECD, 2004). Developing opportunities for investment must 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 investment into seed companies and early-stage startups less likely. Foreign investment aimed at expanding 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 market since the firm has already proven that it can flourish against the added challenges in such a market. Investors need less encouragement to invest in successful companies, so these recommendations will focus on developing small businesses that have not yet proven themselves. CHAPTER 10. HIGH RISK FINANCE 199

Support companies at the seed stage: The riskiest stage of investment is at the very early pre-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 support to help deserving companies bridge the gap. Government money should be used to leverage private funds so that the impact of public investment is maximized. Potential methods for doing this are matching requirements, loan guarantees, subsidies, and tax credits.

Mitigate the costs of failure: By making it possible to recover from failure, entrepreneurs can learn from their mistakes and try again. Government programs that subsidize funding for startups should develop appropriate penalties for failure that balance the need to make failure costly enough to provide disincentives for reckless borrowing with the need 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 create 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 to compete. True competition can only take place when everyone plays by the same rules. Enforce the rule of law consistently and equitably, and vigilantly protect intellectual property rights.

Provide training and require monitoring and mangament assistance: Capital alone will not make a business successful. Part of the value of angel investors and venture capital funds is the management assistance and monitoring that they provide. Combining debt-based financing with the management and oversight typically found in equity-based financing will make loans a more productive method for financing startups.

Be selective and choose which companies to fund on merit: Programs that distribute funds based on a review-based meritocratic selection process are more successful than those that provide funds based on criteria that confer automatic eligibility. This helps ensure the efﬁcient use of public funds by directing funds toward only the most promising ﬁrms and by limiting bankruptcy losses. The vetting process before funds are awarded helps decrease the information gap and risk that investors face when they are deciding whether to invest.

Systematize seed and venture capital financing: Entrepreneurs need to know what to expect when they start a business and how they are going to obtain funding at each stage along the way. Systematize financing by organizing institutions and private investors so that the methods for financing are clear at each stage of development. This will make financing easier and more practicable for both entrepreneurs and investors alike and avoid ad hoc arrangements that can make transactions more cumbersome and unpredictable. CHAPTER 10. HIGH RISK FINANCE 200

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