Economists have long grappled with a perplexing question: how exactly is wealth created in a competitive market? Despite its ability to explain resource allocation and pricing, traditional economic theory does not provide a comprehensive answer. In fact, it overlooks the crucial interplay between markets and firms in fostering innovation and generating new wealth – a relationship that becomes all the more complex when new ideas – let alone groundbreaking ones – enter into it, along with their associated risks.
What is needed now is a new theory of wealth creation that integrates innovation into the economic value theory – focusing on entrepreneurial reputation and innovation viability, and details how markets and firms can together foster innovation.
Within the landscape of innovation, transactions frequently unfold over extended timeframes, challenging the concept of spot prices, the in-the-moment market price of an asset. Suppliers often provide resources (materials, expertise) upfront, but payment may only come later, once the innovation is developed and brought to market. For suppliers, the relevant prices are not the market-determined spot prices, but rather the negotiated forward prices – the agreed-upon prices for future payment.
This time lag between the provision of resources and payment at forward prices introduces two significant risks. Firstly, there is reputational risk, which questions the entrepreneur’s trustworthiness and their likelihood of fulfilling their full payment obligations. A first-time entrepreneur with no prior record might face higher reputation risk compared to an entrepreneur with a history of honoring contracts. Secondly, there is a viability risk, which assesses the innovation’s potential for success in the market. Does it offer real value to consumers, or is it destined to fail? A “revolutionary” new product with limited scientific backing or unclear market demand would have a higher viability risk compared to an incremental improvement on an existing product.
Bringing these uninsurable risks to the forefront of the value theory demonstrates how innovation quality can affect suppliers’ forward prices, which in turn influences how an entrepreneur organizes production – either through direct transactions or through firms – to maximize the wealth created by innovation.
Innovation quality is not simply a measure of technical novelty or advancement. It encompasses the inherent risks associated with an idea, particularly the entrepreneur’s reputation and the innovation’s potential for success. Understanding this broader definition is crucial when examining how markets and firms interact to foster innovation.
We can categorize innovations into three quality levels. Low-quality innovations – for example, an unproven health supplement with questionable scientific backing, developed by an unknown entrepreneur – carry high reputational and viability risks. These are not likely to be commercially viable, irrespective of whether production is through markets or through firms.
Then there is average-quality innovation, such as a fitness tracker with improved design developed by a novice entrepreneur. These might offer some value but lack true transformative potential and so the risks (and rewards) are thus moderate. Finally, high-quality innovations, ideas that have the potential for breakthrough and significant market disruption, often come with high reward and potential for economic success – imagine the development of a new battery technology by a serial entrepreneur.
Economic theory often emphasizes market primacy, but this view has limitations when considering uninsurable risks associated with innovation. There is a more nuanced reality in the interplay between markets and firms. Markets excel at handling innovations with low and moderate-risk profiles, particularly those led by established entrepreneurs. However, markets struggle with high-risk, low-quality innovations. These are often prevalent in emerging economies, where high reputational and viability risks can drive supplier forward process to economically prohibitive levels.
Firms can offer a strategic advantage by acting as risk buffers. By holding collateralized cash, they can negotiate lower forward prices with suppliers across a wider range of innovations, not limited to just high-quality ones. This ability to absorb risk through cash reserves is particularly relevant for entrepreneurs in emerging economies – and it allows a broader range of ideas to reach the market.
Transnational agencies, like the World Bank, can also play a crucial role in this process of providing financial support to entrepreneurial entities in developing regions. One key approach is through strategic cash injections, which can help bridge the gap between promising ideas and market realization. These injections serve multiple purposes in fostering innovation and economic growth. Firstly, they can help entrepreneurs overcome a critical capital restraint by providing initial funding to get new ventures off the ground. This is particularly relevant in emerging economies where traditional sources of funding like bank loans or venture capital are often scarce.
A society’s overall risk tolerance and openness to new ideas can significantly impact the innovation environment.
Furthermore, when these agencies enable the establishment of firms with adequate cash to protect suppliers against uninsurable risks, it signals confidence in both the entrepreneur and their idea. This can have a multiplier effect, attracting additional investment from private entities who perceive the project as less risky due to the World Bank’s involvement. Additionally, these cash injections can be tailored to specific sectors or initiatives deemed critical for a particular emerging economy’s growth strategy. This allows for a more strategic approach to wealth creation, fostering innovation in areas with high economic potential and also aligning with the company’s development goals.
Of course, ensuring the effectiveness of that cash is equally important. This can be accomplished through a comprehensive approach that includes facilitating knowledge, mentorship programs, and networking opportunities. The World Bank and agencies like it can also focus on capacity building by equipping entrepreneurs with the necessary skills via training and management programs, for example regarding financial management, operations, scaling, and marketing strategies. Equally important is the implementation of robust safeguards to combat corruption and ensure the funds reach their intended beneficiaries and are used for the designated purposes. And finally, transparency and accountability are paramount and can entail regular audits and tailored reporting requirements.
Beyond Firms and Markets: The Broader Ecosystem
Academic institutions serve as crucial knowledge generators, by conducting basic and applied research and by educating and training the next generation of innovators and entrepreneurs. Many universities act as technology transfer hubs, facilitating the commercialization of research findings through partnerships with firms, thus bridging the gap between research and market application.
Governments are able to shape the innovation landscape through various policies and initiatives. They can stimulate innovation by providing R&D incentives, particularly in areas with high societal benefits but limited commercial potential, such as clean energy technologies. Tax breaks for startups can help attract investment and nurture promising new ventures while strong intellectual property laws protect the ideas and inventions of innovators. Striking a balance between protecting innovation and ensuring access to knowledge is crucial. Additionally, government investments in infrastructure, such as high-speed internet and advanced research facilities create the physical and digital foundation necessary for innovation to flourish.
Venture capitalists, angel investors, and incubators provide vital funding and mentorship to entrepreneurs, particularly those pursuing high-risk, high-reward innovations. Venture capitalists tend to invest in promising startups with the potential for high returns, while angel investors typically focus on smaller amounts in early-stage ventures. Incubators provide a supportive environment for fledgling businesses, offering office space, mentorship, and other essential resources to help startups grow and succeed.
Lastly, cultural norms and societal values play a less tangible but still important role in shaping an entrepreneurial ecosystem. A society’s overall risk tolerance and openness to new ideas can significantly impact the innovation environment. Communities that encourage experimentation and celebrate risk-taking are more likely to foster a vibrant culture of innovation and entrepreneurship ecosystem.
By implementing policies that encourage collaboration, knowledge sharing, and support for early-stage ventures, we can further empower a wider range of individuals to contribute their ideas and talents. This approach recognizes that innovation potential is not limited to a select few with well-established reputations or access to traditional sources of funding. As we move forward, we must acknowledge the complexities of innovation, and embrace them, including the role of firms and the democratizing power of cash. This will not only support a wider range of entrepreneurs but also drive a more diverse economy – a development that will benefit society as a whole.
© IE Insights.
