Innovation economics needs a new theory of innovation in groups, based on a contract-theoretic governance-centered approach, writes Darcy Allen.
This paper introduces a working paper I presented at a conference at the University of Queensland last week. My research more broadly examines and attempts to explain a real-world phenomenon — entrepreneurs, amateurs and enthusiasts coalescing and collaborating in groups at the beginning of new industries. Innovation economics does not explain this phenomenon well because it begins with an entrepreneur with a fully crystallised opportunity and proceeds from there (asking whether innovation should occur in firms or in markets, for instance). But the groups we see at the very beginning of new industries are neither firms nor markets — they act as commons. This is very obvious in bitcoin and blockchain technology right now (see for instance Backfeed, or Decentral Vancouver, or Melbourne Bitcoin Technology Center, or the recent Devcon Conference in London).
I propose that in these organisations entrepreneurs pool information about market opportunities, and govern those interactions through collective action common property rules (a la Elinor Ostrom 1990, 2005). This is an economising approach to overcome the radical uncertainty inherent in entrepreneurial discovery. But as market opportunities are revealed through the discovery process, entrepreneurs take these ideas and place them into different institutions because they become the economising governance structure to act on that opportunity. That is, ex ante the discovery of a market opportunity, entrepreneurs require a governance structure allowing multilateral asset specific investments (to overcome discovery problems) as well as collective action governance structures (to overcome opportunism problems) and that these costs are economised in a collective action innovation commons. Below I briefly outline the movement towards a new innovation economics built on governance and contracting:
Innovation is the process by which valuable new ideas are originated and subsequently adopted into the economy. It is the mechanism by which entrepreneurial firms compete in markets and is the engine that drives economic growth and development. It is also widely accepted that society faces an ‘innovation problem’ in the sub-optimal production of new ideas. The precise characteristics of this innovation problem, however, remain elusive. Where does the innovation problem emerge? And if, or how, is this problem ameliorated?
Together, Nelson (1959) and Arrow (1962) gave us the modern view of innovation as a public good investment problem. The economics of innovation, they explained, are of the competitive production of new information of uncertain value that is easily appropriated by others. Because the fixed expenditures of innovation activities are irrecoverable in a perfectly competitive market, a market failure was revealed deep in the engines of market capitalism. Innovation policy—which variously intervenes through intellectual property, R&D tax credits, and public science—is fully centred on this sub-optimal market failure argument.
But we can develop a more nuanced approach to the innovation problem by splitting the innovation problem into two complementary phases: discovering technical information; and discovering entrepreneurial information. Both are necessary to yield the societal transformations for which innovation is acclaimed — but they are of a fundamentally different character.
Invention is the process of discovering new technical information about how to make ‘things’. This part of the innovation problem is ascribed to the scientist or engineer. But discovering this new technical information is insufficient to yield the societal transformations for which innovation is acclaimed. It is innovation, not invention, which is the essential fact about capitalism. To solve the innovation problem, inventions must be matched with business models and entrepreneurial market opportunities.
Second, the entrepreneur must solve the innovation problem of discovering a specific market opportunity ex ante the innovating firm:
The entrepreneur, in a state of fundamental and radical uncertainty, must discover specific and applicable market opportunities. Inventions and innovations do not appear in synchrony. Nor is the process of transforming the former into the latter costless. Inventions do not come full labelled with innovative market applications. To discover market opportunities, entrepreneurs must coordinate, test and experiment with dispersed Hayekian knowledge. This process is clearly observable in the early stages of general purpose technologies (e.g. 3D printing, blockchain, drones), where entrepreneurs experience radical uncertainty over market demand, price points, customers, complementary investments, failed ventures, and so on.
The entrepreneurial innovation problem is solved in a state of high uncertainty — analogous to what George Shackle called ‘unknowledge’. Innovating firms do not yet exist because there are no crystallised, well-defined and specific market opportunities. To found the innovating firm, the entrepreneur must move from a ‘fuzzy’ low-information market opportunity, to a ‘specific’ high-information opportunity.
For example: taking a broad and fuzzy market opportunities (e.g. using bitcoin for remittances) to specific and actionable market opportunities (e.g. using bitcoin for remittances, with partner x, at price point y, with complementary exchange investment z, between country a and b, and so on). The question, then, is how this entrepreneurial stage is economically organised? Do entrepreneurs go alone, or in groups? What do these groups look like? How are they governed?
An entrepreneur may solve this discovery problem alone – with no contractual or organisational form extending from them. This is consistent with the enduring popular romanticism of the ‘lone genius’ as the prime mover of history, culture, society, and, as with Joseph Schumpeter’s innovating entrepreneur, the economy. But this assumes an entrepreneur takes an invention and solves the innovation problem of discovering market opportunities without utilising the entrepreneurial judgement of others.
This state of innovation autarky, however, is a poor organisational solution to the innovation problem:
… innovating alone is only taken in the absence of adequate organisation because—as Adam Smith (1775) taught us—autarky is a poor organisational solution to any economic problem. That specialisation enables gains from trade is no different in understanding innovation – the production of new ideas. The innovation problem, as we described above, is one of coordinating heterogeneous and dispersed Hayekian knowledge. Such information implies gains from specialisation and trade.
Then it is clear that the innovation problem involves organising with others to exploit specialisation and gains from trade:
Solving the early stage innovation problem, then, involves organising with others to form groups—communities, clubs, teams, departments, firms, networks, clusters, commons, and so on—in order to exploit specialization in the entrepreneurial discovery process. Effectively solving the innovation problem requires bringing ideas together and testing them under diverse conditions. Entrepreneurial ‘judgement’ (e.g. Knight 1921, Foss and Klein 2012) may be contained within the confines of the individual mind, or extended by coordinating with others (i.e. by utilising economic organisation). Organising through institutional governance structures may enable access to and coordination of knowledge. We call this coordination innovation contracting.
We now have an innovation problem that requires specialisation and exchange within groups:
… the root economic problem is to escape the limitations of innovation autarky so as to exploit the benefits of exchange and specialization. That is, solving the problem of how to govern multilateral idiosyncratic investments in innovation activities. Such contracting faces various hazards—relating to uncertainty, opportunism and asset specificity—which necessitates institutional governance structures. The question is one of economising on the transaction costs associated with organising innovation activities. Solving the innovation problem involves the organization and governance of specialized resources, capabilities, and information.
This paper goes on to study the organizational governance of innovation based on Oliver Williamson‘s transaction cost economics approach:
The new approach advanced here follows the new institutional approach developed by Williamson (1975, 1979, 1985) that operationalized Coase’s (1937, 1960) transactions costs in terms of uncertainty, asset specificity and opportunism. We apply this to the contractual context of entrepreneurs needing to make increasingly idiosyncratic multi-lateral investments, generating quasi-rents only if others in the group make complementary investments. Such an agreement exposes all parties to opportunism hazards, and the realisation of value is contingent on co-investment with others. Given the high levels of uncertainty affecting contracting, and thus the difficulty of using formal legal institutions, ‘private ordering’ by the contracting parties may mitigate contractual problems.
We now have a consistent representation of the early stage innovation problem as a contracting and governance problem (rather than a market failure problem). Solving the innovation problem—moving from innovation autarky to innovation contracting—requires the crafting of effective institutional governance mechanisms to induce mutual investment and subsequent cooperation to realize value. There are potentially important implications for innovation policy here. The question, once the governance of innovation is recognised, is the extent to which the institutions of innovation policy crowd out the ability of groups to create private orderings.