The foundations of innovation and entrepreneurship theory

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Josef Schumpeter has made a key contribution to the grounds of theory of industrial change. In his work "The Theory of Economic Development" (first published: 1912) Schumpeter makes an attempt to formalize and explain theoretically phenomenon of social and economic transformation.

The author addresses economic development in a narrow and specific sense. While economic system can grow or evolve in a cyclic way around the equilibrium, adapting itself to influences of non-economic nature, the changes caused by the system itself occur in it from time to time displacing its stationary course completely. Therefore, the economic change or economic development in Schumpeter's definition is not the small one that occurs in the course of the system's slow cyclic movement along the predetermined path, but the one that shifts the whole system to a completely different path.

The author points out that the theories of social development which existed by that time were in most part speculative due to lack of solid scientific ground, and represented philosophical ideas rather than appropriate support for empirical evidence. He also suggests that the economic theory in Ricardo's sense addresses only processes occurring under conditions of stability, while they are unable to explain the dramatic shifts which have their roots in the nature of economy itself.

Schumpeter's theory is further focused on the mechanism of economic development (i.e. how it goes about) rather than analysis of the particular changes that has formed the current state of things in economy. The change in its essence, according to Schumpeter, is a "new combination" of resources (materials, manpower, etc.) when it appears at once (not via step-by-step adjustment) and differs considerably from combinations existed before. The author names five types new combinations:

New good,

New method of production,

New market,

New source of supply of raw material and

New organization of an industry.

Although a new combination may be based on invention, it does not have to. Often it exploits the obvious opportunity that was there all the time.

It is problematic to get access to the resources required for these new combinations because its components are taken from some "old" ones. Therefore, there should be a special way enabling these novel and risky projects seize the materials, production means and manpower rotating in the "circular flow" (in contrast with investing surplus profit into the next cycle of the same activity). This is achieved through credits given out by banks, which become important actors of transformation enabling change through supply of "purchasing power".

The central role in Schumpeter's theory of economic development is given to entrepreneur, an active agent of change, who acts upon the opportunities existing in the industry and creates new combinations. Entrepreneur is not a special social class, culture or nationality, rather the state of mind of an individual, willing, ready and able to step aside the usual way of looking at things and create new routines. Entrepreneurial behavior is complex and is driven by different objectives compared to managers acting in the circular flow. Being entrepreneur is not a directly rewarding path and always means going against the stream of ones own habits and views of the community.

Thus Schumpeter's theory is distinct from the traditional economic theory in three crucial aspects. First, it describes the process of disconnection of the system from the predetermined path, opposed to circular flow process in the traditional model. Second, the focus of the theory of change is system's dynamics rather than describing it in any particular moment (statics). And third, the agent acting in Schumpeter's model is entrepreneur vs manager in the traditional theory.

Evolutionary economy: E. Dahmén (E. Dahmén, 1988)

E. Dahmen studies the innovation system in more detail. His theoretical framework views industrial dynamics from Schumpeterian angle, i.e., is focused on transformational change and its agents in a micro-system. Important concept this approach is based upon is opposition of artifacts of "new" and "old" states once the transformation happens. This opposition further defines the transformational pressure which can be either positive and create opportunities for the agents of the "new" or negative and bring the necessity to adapt themselves for the agents of the "old".

Usually the market situation balances between these two extremes and the proportion of positive and negative pressure depends on how developed are the entrepreneurial infrastructure which is to support the transformation as well as institutions such as capital markets, labor, laws, etc.

Author introduces two elements of his theoretical approach describing the industry dynamics: "development block" and "structural tension". Development block implies a system of complementarily developing parts that shapes the future of the given industry. Borrowing ecological terminology, it is similar to economical eco-system which with mutually influencing and co-evolving elements. In the young developmental blocks there can be one particular element which development rate is limiting the whole system at every time point. In such an unbalanced system the structural tension emerges which drives the development of this critical part so that it outruns the overall system's development rate. Once this limit has been overcome, some part else becomes critical and this process continues until the system reaches the balance.

Developmental block is a unit of research of the industry in dynamics which evolution can be traced through long enough time horizons and investigated keeping in mind economic down- and upturns, entrepreneurial and institutional environment.

This perspective can be used strategically as well: in order to increase the developmental potential of a given geographical region one may manipulate the developmental blocks which exist there to either fill the gaps in their progress by promoting the development of their parts or acting proactively by promoting new developmental blocks.

Path dependence: B. Arthur (B. Arthur, 1990)

Brian Arthur has investigated the point where conventional theories diverge from dynamics approach and how they supplement each other in forming of modern economics.

Traditional theory has economic equilibrium as its outgoing point, where optimal resource allocation is achieved. The equilibrium is reached by means of negative feedback (the more of the cause - the less of the effect). All disturbances occurring in this system are smoothed out. At the same time one can observe multiple industries that are ruled by positive feedback (the more of the cause - the more of the effect) and these relations the industrial dynamics theories are describing.

This contradiction does not mean that only one of these explanations is correct: there definitely are industries ruled by decreasing returns, such as commodities (e.g. electricity), depending on resources, while industries involving manufacture, especially knowledge-intensive products are dependant mostly on a positive feedback rule.

The mechanism of these increasing returns involves certain factors, which define the way the industry will be develop at a certain point, further reinforcing themselves and making the industry locked in a certain development path, not always an optimal one in economic terms. The first trigger starting the positive feedback loop is often a kind of small difference that let one of existing alternative to stick out: "selectional advantage". When the market has swung towards one of the possibilities its advantage is cumulatively reinforced by such factors as standards, customer networks, gained experience etc. Although it is possible to turn the situation back once the process started it gets more and more difficult to do the longer way industry has gone along the once chosen way. Usually for the industry to reshape next time the transformational change is required.

Such cause-effect relations were ignored by earlier theories because: 1) The knowledge-based industries where such effects are observed are new; 2) This explanation is viewed as "distasteful" by many economists (including Schumpeter), because it appeared to be too complex and did not have sound model describing it, therefore could not be analyzed completely; 3) To accept it simply felt scary; 4) It requires non-linear random-process theory, which did not exist until recently. Mathematical model describing the processes ruled by positive feedback emerged in 1980s making the theory under discussion legitimate.

The strategies suggested for entrepreneurs acting in an industry ruled by positive feedback is being more aggressive in searching for improvements instead of keeping low profile.

The next two articles explore means the innovations go about letting the change happen. One of the pre-requisites of innovation is knowledge formation process, because new combinations appear when different knowledge sets are combined (Tidd, Bessant). S. Laestadius looked into knowledge formation in mature industries.

E. Rogers in his classical work described the process that is following the appearance of a new combination: the innovation diffusion process through decreasing of the uncertainty.

High-tech vs. low-tech knowledge formation: S. Laestadius (S. Laestadius, 1998)

R&D intensity statistics - is it a good measure of economy's innovativeness? If not just R&D spending, what else reflects the innovative potential of the industry? To answer these questions S. Laestadius explored the paper production industry which constitutes the basics of Sweden's economy.

Paper production requires huge initial investment, but roughly low investment down the line. It is performed using very complex machines, both huge in size and technically sophisticated. Knowledge in this industry is accumulated in disembodied form (plant culture) and embodied form (process and engineering skills improvements, experience put to use) which enable the plant raise the productivity considerably. Next round of purchase of the machines is based on this accumulated knowledge, making it a user-driven development of machinery by the producer.

Thus, origin of knowledge formation varies in different industries. Unlike industries where the most part of knowledge formation happens in the form of analytical activities and regarded as R&D in the mature industries, like paper production, it is formed in the course of synthetical activities involving installation, adjustment and process development which does not count for R&D, although it requires equally qualified work. Although in Schumpeterian sense these two types of knowledge-formation activities are equally can be a base for innovation as soon s they lead to new combinations.

More deep view into paper industry shows that it innovates actively nowadays in the direction of increased use of recycled fibers and energy-saving processes.

Diffusion of innovations: E. Rogers (E. Rogers, 1995)

In order to be adopted innovations must be diffused, i.e. accepted and spread among big enough portion of the society. Innovations are diffused "through certain channels over time among the members of a social system". Diffusion is a process involving social exchange.

The diffusion of innovation is tightly bound to the process of taking control over uncertainty. The technology is a process design with known cause-effect relations on the way to its outcome which, therefore, reduces uncertainty about how this technology works, but at the same time creates a new type of uncertainty for the user: What does it mean for me: an advantage or a problem? Thus, for the innovation to be adopted the individual should invest some effort to reduce the second kind of uncertainty by collecting and analyzing information about it, which is referred to as "innovation decision process".

Communication may be fulfilled through mass media as well as interpersonal interaction which proved to be the more effective facilitator of message spread compared to media. Interpersonal communication in its turn is the most effective among the members of the same social group.

As regarding time dimension, there are slowly- and more rapidly adopted innovations. The rate of diffusion depends on: 1) How long is the innovation-decision process which depends on how active the individual in searching information about the individual advantages/disadvantages in case of innovation adoption, 2) The attitude of the individual which can be everything between two extremes: striving for every new gadget and extremely conservative, 3) The character of innovation itself (its relative advantage, compatibility, complexity, trialability and observability), i.e. if it is clear, compatible with previous experience, etc.

Social system influences the diffusion process through norms (certain patterns of behavior characterizing the community). Compatibility of what an innovation offers to the community members with their values and beliefs is very important for successful innovation's adoption. Message should be suited to receiver's needs. The message spread may be facilitated through so-called opinion leaders (community members with high potential to lead the other member's informally) and change agents (individuals influencing the community intentionally in the direction of innovation's adoption).