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Creating Innovative Capacity

Michael PorterA presentation to the World Productivity Congress (by teleconferencing link from Boston) Edinburgh, October 1999

by Professor Michael Porter of Harvard Business School

Today I want to talk about what I believe to be the next challenge in productivity in the world economy. This is the challenge of innovation : the capacity to move beyond current ways of doing things and current ways of operating companies, to move beyond 'best practice' to shape best practice.

In order to tell you why this is a critical issue, and also share with you some of the research we have done in this area, I need to back up a little bit. When we start to talk about innovation, we must realise that productivity, indeed the purpose of this organisation (the World Confederation of Productivity Science), is the central determinant of prosperity in the world economy. If we look at any nation, productivity determines wealth, productivity determines the wages you can earn, productivity determines the return on capital, productivity determines the standard of living of nations, productivity determines whether a particular geographic area like the UK, or France or the USA is prosperous or not.

Productivity has become an increasing preoccupation around the world, but there are a couple of dimensions of productivity that are not well understood. First of all, we know that in thinking about productivity we must think as much about the value of products as the efficiency with which we produce the products. So many of the productivity indexes that are calculated and published are indexes of unit volume productivity - yet that is not directly what matters. What matters is the value you can create with a day of work, or a dollar or pound of capital invested, and increasingly we need to think about value productivity. How much value you can create per day per hour per week.

And for advanced nations like the US, UK and many represented at this Congress, it is really the value side of the equation that is the essential determinant of success. It is unlikely that US firms are going to compete with firms in Singapore, for example, based on unit cost . Increasingly advanced nations must produce products that other nations cannot produce, using methods of production that other nations are not yet able to master. Any discussion of productivity must then reflect value, not just unit efficiency.

Productivity is really independent of the type of industry or sector. There was a view some years ago that you had to be in certain industries to be productive - that idea has hopefully been discredited for there is no industry that cannot produce higher value products, there is no industry that cannot exploit high technology. All industries today are high tech, all industries use information technology, new materials, new kinds of technology to dramatically improve the way they do things.

There are no low technology industries, there are only low technology companies: companies that have not yet woken up to the potential of technology to transform what they do.

Ownership of the company and where the company is owned is less and less important to prosperity. What matters to the prosperity of a nation like the UK - or the United States - is what companies choose to do in their location, not whether those companies are American, Japanese or UK owned. What drives the productivity of the UK is what the companies choose to do in the UK. If in the UK they choose to do very productive things and use very advanced technology to produce a lot of value per unit of work, then the UK will be prosperous as the wages will be high in that location. So increasing ownership of the company matters much less than the environment provided by a location that allows the company to operate in a productive way. One of the problems in the UK, is that too many companies are using the UK as a low cost production site rather than a high value production site - but perhaps that's something we can come to a little bit later.

Now given that productivity really defines competitiveness, why is innovation so important? Well, I think that what we see around the world - certainly in the US and in many other countries - is that in the 80s and 90s we went through a massive process around the world of trying to get our collective houses in order. We had a number of problems with the basics - cost, quality, efficiency and time to market. These required a revolution in operational improvement to address the deficiencies. This revolution was triggered by Japanese companies initially, but then companies all over the world started transforming themselves, introducing total quality, re-engineering, and improvements based on identified best practice. This 'getting the house in order' process also extended to government. Governments had to balance their budgets, create macro-economic stability, and generally get their houses in order. Governments needed increasingly to open up markets and introduce competition. There is a whole set of steps that governments around the world have been aggressively pursuing over the last couple of decades that have yielded great progress in many countries in the world economy.

What we face today are really the beginnings of the next competitiveness challenge, the next productivity challenge.

It is not near-term productivity, it is not getting the house in order that is the critical agenda any more. It is really building the capacity to drive productivity growth into the future : the capacity for innovation. It is building within nations the ability for companies to produce new products, new services, new processes, new ways of doing business that increasingly is the next critical stage of development, particularly in advanced nations. We know that productivity determines competitiveness and wealth. We know that prosperity is driven by today's productivity.

The challenge facing advanced nations is how to build the capacity for improving tomorrow's productivity - innovative capacity.

Today there are many nations that have got their houses in order, many developing nations have improved and are improving their efficiency and infrastructure. Developing nations are able to access technology from around the world, and are building an ability to compete in the world economy. This means that for advanced nations in particular, just producing the standard product with the standard process is not going to support a high and rising standard of living. Today, the really critical task for any nation is to be able to 'push the envelope', to move methods and products beyond the ones that go on to be diffused and produced in the developing world and in nations with lower wages.

We also have a critical problem in the world economy that is just being recognised : in the advanced nations, there is a slowing of growth of the workforce. Country after country will simply run out of workers. We are not going to enjoy the ability to grow economies simply because of the number of workers. This is particularly true in the advanced industrial nations like Japan, the US, and many of the European nations. Unless we can dramatically improve productivity in the future, not through incremental improvement but through true innovative activity, we will not grow the advanced economies in the next 10-20 years. The demographic footprint is already in the ground. We know how many workers the advanced nations will have and the answer is not enough to generate substantial economic growth without significant improvements in productivity. The kind of bumbling along in productivity that we have had to live with for the last couple of decades is simply not going to work for the next couple of decades. We need to step up the rate of productivity growth and requires innovative capacity.

Innovative capacity is also our best opportunity to create a really favourable world economic situation. If the pie is fixed and developed nations and advanced nations have to divide the same pie, the result is division and a lack of progress in the world economy. What we need in the world economy is an expanding pie, where new needs, new products and new services are being created all the time. Advanced nations can provide the innovative products and services, developing nations then have room to produce the perhaps somewhat less innovative products and services as diffusion takes place. We have to keep the pie expanding and that, fundamentally, again comes back to innovation.

So the question is: what creates the innovative capacity of a nation?

Why is it that certain nations are able to relentlessly innovate over long periods of time? To answer this question, we now have a substantial body of knowledge about the environment for innovation. What we have learned is that innovation in a nation is more than just science and technology. It has to do with the whole environment for competition in the nation and in that environment I suggest that there are four very different elements that really combine to create innovative capacity. One is the characteristics of the basic 'inputs'.

You cannot innovate if you do not have the inputs necessary for innovation : high quality scientific and technical personnel; a sound basic scientific infrastructure within the higher education system; a supply of risk capital and so forth. However, the inputs are not enough. You do not get innovation unless you also have sophisticated needs. It is very hard to be innovative if your local market is not demanding. There is a role for the customer; part of what makes a nation innovative is customers that are sophisticated, and demanding, looking for better products and services. So, there is a demand side to innovation, a buyer's side that we are beginning to understand better.

We also find that innovation requires an attractive 'climate' to encourage the levels of investment required for innovative activity. A critical component here is intellectual property protection.

We have also learned that innovation is dramatically influenced by the intensity of competition. If you don't have to compete at home, there is almost no chance that you will be able to compete abroad - much less be innovative. Innovation emerges increasingly out of local rivalry, and so those nations that have not opened their internal environment to competition are not very innovative - and we can all cite examples!

Finally we have learned that innovation requires what we call clusters. A cluster is a geographical concentration in a particular country - or region within a country - of a group of related and supporting firms. An example is the oil and gas cluster in Houston. In Houston, Texas, there is an enormous concentration of companies, and R & D, and suppliers and institutions - all in the energy, oil and gas business. And that concentration, that cluster, that juxtaposition of suppliers and customers and skilled people and specialists in university departments, is a tremendous engine of innovation. Houston is really the centre of almost all of the innovation in the oil and gas technologies around the world. Even though much of the drilling and most of the reserves exist outside of Houston -Texas is not a big oil producer any more - the cluster that has been built in Texas is an enormous innovation centre. Similar clusters exist for the automotive industry, for electronics and for many industries. An isolated company, one that is isolated from other institutions, other companies and other suppliers, is much less likely to be innovative. Innovation grows out of this concentration, it is like a critical mass effect. Clusters create information flows, incentives, spin-offs, new companies - an innovative vitality.

What we have set out to do in the last year or so is actually to take these broad principles of innovation and innovative capacity and try to test them statistically across the leading nations in the world economy. We have divided the innovation attributes referred to earlier into three broad categories:

1. the Common Innovation Infrastructure

There are certain things about a country that cut across all industries and affect innovative capacity. Things like the basic university system and intellectual property protection are good examples.

2. Clustering factors

On the right hand side of our chart there are individual clusters within the national environment, pharmaceutical, automobile, materials oil and gas, and a part of innovation has to do with a particular environment for innovation within those particular clusters or sub-sectors of the economy.

3. the quality of the connections between the two

It is good to have a science and research infrastructure but unless that science and research infrastructure is connected to companies, it is not very useful.

If we take all the many determinants of innovation, we can divide them into these three broad categories. What we set out to do was to measure those in a large sample of countries over the last twenty or thirty years. Although you can never measure some of the most important things - particularly in the area of innovation - it is possible to measure many aspects of the common innovation infrastructure : how many R&D personnel there are in the economy as a proportion of the workforce; how much money is spent on secondary and tertiary education; how much money is spent on R&D; how strong is the protection for intellectual property. We have been able to measure a number of these components across a wide array of countries over this twenty to thirty year period.

Measuring the cluster specific conditions for innovation in a particular country is very difficult. Each cluster has it's own measures. In order to come up with an indirect or a proxy for 'clustering factors' we chose to look at the percentage of R&D in a nation actually funded by industry. The idea was that if companies are funding R&D it is a sign that companies feel they are in an environment where that R&D is worth spending. This is a kind of indirect measure of the vitality of the cluster specific innovation environment in the country. Conversely, if a much of the R&D is being funded by government, it suggests that vitality in the industrial sector for innovative investment is not so great and government is trying to 'prime the pump'.

Measuring the quality of linkages is again very hard to do across countries consistently. What we chose to use in this particular study was the percentage of R&D performed by universities - not funded by universities, but performed by universities. We have found around the world that the university is the most open environment for innovative activity. If you can get a lot of innovative activity occurring within universities it tends to spread and diffuse widely throughout the economy,. This is much more powerful in spreading ideas than if the R&D is being conducted only in companies or only in government laboratories.

In a piece of research that I did jointly with Professor Scott Stern at MIT, we took these measures of innovative capacity to try to see whether they explained the innovative output at the national level in a sample of countries over the last 25 years, We looked at the 17 OECD countries, and we also looked at eight emerging countries like Taiwan and South Korea, to see how they 'measured up'. We looked at the 1973-1996 period (which is as up to date as you can get many of these measures) and we tried to relate the measures of innovative capacity to a measure of innovative output, using as a measure of output the number of international patents per capita of population. What is an international patent? An international patent is a patent that has been filed not just in the home country of the company but also in another country. In the case of all non US countries, to be significant, that other country has to be the US. We therefore looked at patents that had been filed in the UK but also filed in the US. We looked at patents that had been filed in Sweden but also in the US. For US companies, we looked at patents that had been filed in the US but also in another major country - such Germany, UK, Sweden.

Why use this measure? An international patent is a sign of some commercial significance. It is rare that somebody will go to the trouble of filing a patent in another country if that patent is the latest version of a perpetual motion machine! The patent must be significant before someone makes the high investment needed to file in another country. Also we found that by having the US patent office involved in every patent that we counted, we created a consistent measuring system for the quality of the patent. If a UK patent can also be filed in the US that says something about the quality of the patent. Since we were trying to measure innovations that were at the world frontier of technology, the US patent system is an effective filter. We also were able to verify that although patents do not measure all innovations, they are highly correlated with other kinds of innovative activity. If we look at the correlation, for example, between patents and world export share in an industry, or if we look at the correlation between patents and productivity, we find a high correlation. Thus, although we have not measured trade secrets and copyrights, we are quite confident - and the literature is quite clear - that the patenting rate at the national level is a pretty good proxy for how much original innovative activity is going on.

We then built a regression model, a cross-section time series regression model, over the 17 countries in the 25 years to really estimate what determines the rate of international patenting per capita. Again we did not look just at the absolute number of patents, because that is not going determine wealth. What is going to determine your wealth is the intensity of the patenting in your economy relative to the size of your economy and the size of your population. That is why we looked at per capita international patenting as our measure of innovation, and what we are trying to find out is what really drives international patenting over long periods of time at the national level. In essence, we looked at those measures of innovative capacity such as R&D personnel, R&D spending, percentage of R&D in universities etc, and related these to international patenting.

What did we find? Well, we found some very interesting things. First of all we found that those measures that I described to you earlier explain 99% of the variation across countries in international patenting. If you spend a lot on R&D, if you have intellectual property protection, if you have a lot of scientists and technologists in your workforce and so on, that determines what your patenting rate is, and the explanatory power of this model proved to be extraordinarily high.

So, we can explain innovative capacity. It relates to a set of policy choices and resource commitments that a nation makes. However, we found that no single factor was dominant. R&D personnel, R&D spending and businesses share of R&D spending were the three largest variables in terms of their impact but other factors are statistically significant and materially affected innovative output. This suggests a need for a whole national innovation strategy. Simply pumping up your R&D budget is not enough! Currently in the United States there is a major policy discussion about doubling the R&D budget but our results suggest that this would not make a huge difference. If you double your R&D budget without having more scientists and engineers in your workforce, without protecting intellectual property you are going to waste the investment.

We have also shown that scientific output alone is not enough. We can show the citations per million people, ie the academic citations generated by researchers/investigators based in the country, and we see that nations like Sweden, Denmark, Canada and the US have a lot of citations. This means that scientists and engineers in these countries are publishing in refereed academic journals. If, though, we look at the number of patents per 1000 citations, this shows the effectiveness of a nation in taking a citation and converting it into a patent - something that is commercially relevant. For some countries, there is a big difference between how good they are at publishing and how good they are at innovating, at least as measured by international patenting. For example the US, Germany and Japan are very good at converting citations into patents whereas the UK is quite low. The UK is quite high on patenting, number 6 in this league table, but actually quite low on patents per citation.

The UK is good at academic publishing, but not so good at delivering the publishing into a commercially significant innovation.

The general findings show that how R&D is actually funded and conducted makes a difference. We found that R&D funded by business tends to be more productive than R&D funded by government. Indeed, we found that if you have a lot of R&D in a country funded by government it actually has a negative effect - it actually works against the overall innovative vitality of the economy. We also found that the university system does matter, so if there are high levels of R&D in universities, it is a positive driver of innovative output.

We made two other very important findings both of which had actually been discovered by other researchers. We found that the status quo yields diminishing returns. If a nation holds its R&D budget constant, holds the number of scientists and technologists in their workforce constant, holds the level of intellectual property protection constant, there is a diminishing output of innovation. For a nation to be innovative today, it has to keep 'upping the ante' in terms of investment in innovative capacity.

If you just try to 'hold the line' in this knowledge-driven global economy, you actually fall back.

Indeed, some of the nations that have been falling back are the ones that are just holding their spending constant, holding their policy environment constant.

Finally, we found that international patenting is strongly linked to productivity growth and exports in technology intensive sectors. As part of the analysis, we took our regression model (which determined the weights attached to each of the various measures of innovative capacity), plugged in the actual conditions in each country, and then calculated an index which we called the innovation index, or index of innovative capacity. In the 70s, the US and Switzerland were on the top of the heap, way above other nations in terms of innovative capacity with a bunch of other advanced nations in a pack down below. By the end of the period, we see a convergence process. A number of other OECD nations move up into the status of innovative leaders. Japan is a very striking case, and Sweden, Germany, Denmark have all moved up substantially and become truly innovative economies at least as measured in this way. The UK, France and Italy unfortunately have treaded water, and moved sideways and so since the 70s have lost relative position as innovation centres.

We can look at the change in ranking across countries over both the 1980 and 1995 periods and it is interesting to see that the Scandinavian countries, Denmark and Finland, have really moved substantially up the innovation ranking. They have increased their investment in innovative capacity, in their people, in intellectual property protection, in R&D spending, and in the university system, where some of the established economies like the UK, the Netherlands, Canada and even Germany (which has been affected by unification) have slipped back in terms of the ranking.

What is particularly interesting though is if you look at the future. Here, we essentially projected the innovative capacity of all these nations assuming that the current policy environment in country stayed the same . So if we took the current trajectory of R&D spending and R&D personnel and played it out ten years into the future, we asked ourselves what would happen, and what would the relative innovative environments look like. What we see is that the Scandinavian countries continue to move up, Japan moves up, but the US - if we continue our current trends in R&D spending, in R&D personnel - is going to decline in innovative output. This is not a forecast, but it does suggest that in the US we are making some extraordinarily bad choices right now. We did in fact carefully check this model to see whether the model in the 70s was the same as the model in the 90s and we found that it was. There really has been no difference in what explains innovative capacity from the 70s through to the 90s. The same fundamentals seem to apply. This makes it more of a concern that some nations are not taking the right steps to really build their innovative capacity for the future.

We also looked at emerging nations like India, China, Malaysia, Taiwan, Korea, Singapore, and Israel to see what their innovative output looked like - and what we found was a little bit of a surprise, and a little bit of something we already knew. We found that Taiwan has become the closest to a real innovative nation of any of the newly industrialising countries. South Korea and Singapore were falling somewhat behind. Interestingly, we found that China, India and Malaysia are so far nowhere - insofar as I mean they are not producing innovation at the world frontier. They are not patenting in the international economy. Right now, they are 'fast followers' taking advantage of low cost labour; they are embedding technology but they are not yet innovating. Korea and Taiwan, however, are starting to move dramatically up in terms of their international patenting. We should no longer think of them as just fast followers. They are becoming innovators now, and looking towards the future. Returning to the US, (though I should say in passing that the UK would look very similar in terms of some of the policy choices) why is the US projected to go down?

What is going on in the US economy? Even though we seem to be at our peak now in terms of innovative vitality, why might we not be the most innovative nation in the future? Well it relates to the policy choices that we are making in the US right now. The reason that the US has been so innovative is that for the last 30 years we have had a steadily rising level of R&D, a steadily rising level of R&D personnel in our economy, a steadily rising commitment to higher education, a steadily rising commitment to intellectual property protection. Throughout most of the 80s we had a tremendous national commitment to innovative capacity. Yet in the first half of the 90s - and this continues today - the US is actually cutting back on the basic foundations of innovation: R&D spending, especially basic R&D, R&D personnel and so forth.

Consider the training of scientists and technologists in the workforce, the percentage of all Bachelors and Masters degrees awarded in science and engineering. While most countries a