Policy rationales and objectives for innovation in firms

Innovation in firms can play a critical role in the economy and society by supporting economic growth, employment, and poverty reduction, and by contributing to solutions to social challenges. Policy may aim at correcting for market failures (e.g. failures arising from informational imperfections and positive externalities of knowledge creation) that negatively affect the performance of innovative businesses. Yet public intervention can be subject to policy failures. Therefore, the public policies’ achievements need to be scrutinized ex ante and ex post. Specific rationales pertain to policy interventions that address various conditions for innovation in firms: i.e. access to labour, regulatory framework, access to knowledge, access to finance, and market development and access.
Importance of innovation in firms to economic growth and social welfare
Innovation in firms is a driver of economic growth and an important basis for developing solutions to economic and social challenges, such as climate change, ageing societies and poverty (OECD, 2010a). Innovative businesses can play a critical role by supporting economic growth and employment (see Contributions to growth and jobs), and contributions to social challenges (see Addressing environmental challenges and Addressing social challenges). To name but a few examples, innovation in firms can contribute to addressing environmental challenges through the introduction of new technologies and non-technological innovations that limit global greenhouse gas emissions and help to limit climate change and maintain biodiversity. Innovation can also allow firms to increase their output and tap into new markets, factors which can be associated with job creation and with increased labour productivity, and economic growth.
Approaches to public policies
Market failures requiring policy intervention 
Policy might be implemented to correct for a set of market failures that negatively affect the performance of innovative businesses. A major underlying justification for public intervention is that the market will otherwise invest less in innovative activities than the socially desirable level (Nelson, 1959; Arrow, 1962). The main reasons why this might occur include: 
 
  • Imperfect appropriability of knowledge creation due to positive externalities. Due to the non-rivalry nature of many knowledge creations (i.e. the fact that the use of one piece of knowledge does not prevent its simultaneous use by another party), knowledge can generate spillovers: not only does the innovator benefit but also other agents, such as competitors and follow-on innovators (see Economics of knowledge). Unless otherwise compensated (e.g by monopoly rights created by the IP system or grants for conducting innovation), this means that the social rate of return for knowledge production may exceed the private rate of return and, therefore, investment in the production of new knowledge would be below the socially optimal level. 
  • Informational imperfections. Information asymmetries occur when one party to a transaction has access to relevant information that the other party does not. These information asymmetries may discourage agents from conducting market transactions despite the higher value that could consequently be created. The extent of information asymmetry associated with investments in innovation is typically larger than that associated with other investments, such as those in physical capital (e.g. property, plant, and equipment). This is because i) innovative investments are relatively unique and their value is often, by nature, uncertain, and ii) because the imperfect appropriability of innovation typically deters innovative firms from disclosing information about their innovative activities and knowledge. Certain institutions, such as the patent system, may help to mitigate this asymmetry by providing some guarantee to suppliers of knowledge that disclosing knowledge will not undermine their ability to consent to the transfer or sharing of knowledge (see IP and markets for finance).
  • Multiple other market failures can hinder the success of innovative firms. For instance, there might be a lack of access to finance for innovation or a lack of a suitable support infrastructure (e.g. research institutions with the capacity to support firms in their innovation). 
System failures requiring policy interventions
The challenges facing innovative firms can be identified from a systems failure perspective:
 
  • Network failures. These deal with problems in the interaction among actors in the innovation system. They relate to such phenomena as weak links between system actors, lock-in/path dependency failures (which refer to the inability of complete [social] systems to adapt to new technological paradigms) and transition failures (the inability of firms to adapt to new technological developments).
  • Institutional failures. These include the failure to configure public institutions, such as universities and research institutes, so that they work effectively within the innovation system. This also relates to institutional failures in the governance of innovation systems themselves. These challenges might be addressed by specific measures but also sound a note of caution for ambitious policy interventions. 
  • Framework failures. These refer to deficiencies in regulatory frameworks (e.g. health and safety rules) and in other background conditions (e.g. culture and social values) that can have a negative effect on innovation and economic performance. 
Limitations of policy interventions
Not all potential failures in innovation systems make government intervention required or even desirable. There is no guarantee that government policy can address each market or systemic failure in a way that effectively improves the outcome (in welfare terms, for instance). Furthermore, governments’ means and scope of action can be very limited. Even when governments may potentially improve welfare, they do not always have the means to do so in practice (Dixit, 1996). 
 
Besides, policy failure (i.e. the failure of a policy to achieve its goals) may arise from a wide range of factors, such as inadequate policy design, implementation, and governance failure. These policy failures may be due to contradictory goals, limited capabilities and information constraints that may limit governments’ ability to intervene effectively. Indeed, government is subject to sometimes even more stringent informational constraints than are private actors. These policy failures imply that government interventions can be counterproductive. Therefore, the soundness of the foundations and the achievements of government intervention need to be scrutinized ex ante and ex post. The choice of policy instrument should also reflect potential constraints (e.g. research grants require a more knowledge-based approach by governments than IP support).
Specific rationales for public policies.
Access to finance
Beyond the market failure affecting R&D investment associated with R&D spillovers, the main rationale for public support regarding access to finance is the possibility that investments in innovative activities are liquidity constrained due to capital market imperfections. Capital markets can be inefficient and potentially profitable projects might not be financed. Innovative firms may be particularly affected by these market imperfections, since they are involved in an innovation process whose outcomes are uncertain, deal with a public good (knowledge) whose returns on investment are not perfectly appropriable, and own assets whose nature may be intangible and difficult to measure (e.g. patents and copyrights).
 
One of the main reasons for capital market imperfections is the risk arising from information asymmetries between lenders/investors and firms, and higher transaction costs. Lenders are not easily able to separate potentially successful businesses from less successful ones, and therefore may provide less funding than the company needs and require a higher interest rate. This, in turn, can increase the risk of the borrowers and create a greater share of higher risk firms in the pool of borrowers (adverse selection). On the other hand, lenders can’t be sure that once the funds are loaned, firm managers will not take excessive risks or misuse the funds (moral hazard). One way for lenders to overcome the problems associated with information asymmetries is by requiring collateral. However, providing collateral might not be possible for innovative firms, especially if their main assets are intangible. Therefore, these firms are likely to be credit constrained, despite their project quality and growth potential.
 
In this context of market imperfections, public policies can facilitate access to finance through a wide range of instruments, including the provision of public grants. Yet crowding out can occur, if diminishing marginal returns from R&D cause grant holders to reduce their own funding for R&D expenditures one-for-one with public funds. For some firms, government funding may just be a cheaper source of finance than funding raised from capital markets (Lach, 2002).

Access to knowledge

One of the key drivers of innovation in firms is knowledge exchange between and among explorers and exploiters, particularly for the exploitation of new, science-based knowledge. Yet several system failures may affect this knowledge exchange and the consequent interactive learning (Potter, 2005). These system failures include a lack of infrastructure for knowledge generation and transfer (e.g. universities and science parks), a lack of capability in firms to absorb external knowledge (e.g. workforce skills for identifying and collaborating with partners, and using external information about promising markets and technologies), a lack of complementarity between the knowledge exploration and exploitation sub-systems (e.g. lack of fit between university research and the specialties of firms), and a lack of intellectual property protection, leading to a high risk of involuntary knowledge leakage during technological collaboration between firms.
 
These system failures imply the need for policy attention to knowledge transfers and networking problems in innovation systems. Examples of policy approaches include facilitating knowledge exploitation through licenses, patents and university spin-offs, encouraging mobility of staff between universities and industry, and supporting technological collaborations between firms.
Access to labour
A lack of skilled labour and a mismatch in supply and demand for skills can hinder innovation in firms. 
 
Policy objectives can include enlarging the size of the highly skilled workforce, facilitating its mobility in order to optimize the use of human resources, facilitating the cross-fertilisation of ideas and learning, and addressing structural mismatches in supply and demand for skills.
Market development and access
The rationale for demand-side innovation policies based on public procurement, standards and regulations is linked in general terms to the need to stimulate innovation in areas where societal needs are pressing (e.g. health, environment) and where government action can complement market mechanisms with, ideally, minimal financial outlays. But specific rationales pertain to individual demand-side instruments. For example, innovation-oriented public procurement can be designed to help counter gaps in the supply of risk finance for innovative businesses. Procurement processes can also help accelerate the emergence of technologies for which there is an urgent, time-bound societal need. By contrast, the rationale for government action in the area of technical standards is somewhat different, corresponding to public-good characteristics possessed by such standards. The development of standards is likely to experience some degree of market failure. By itself, the market may provide too few standards. Creating standards entails fixed costs, while the gains may not be appropriable by the individual firm.
Shortcomings of the regulatory framework
Framework failures, including deficiencies in regulatory frameworks (e.g. intellectual property rights, product market regulation, contract enforcement, and standards), can have a negative effect on innovation in firms. Policies may limit these barriers to innovation in firms by establishing appropriate intellectual property system, creating standards, and simplifying administrative framework. 
References
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