Intervention and Innovation

Chapter of TRANSFORMING NEW ZEALAND. This is a draft. Comments welcome.

Keywords: Growth & Innovation; History of Ideas, Methodology & Philosophy;

Underlying much modern economic analysis is a faith in the efficacy of the market, which Adam Smith attributed to an invisible hand which promotes a beneficial end which is not the intention of those involved in the market transactions. Actually, his much cited ‘invisible hand’ includes support for domestic over foreign investment which suggests that the future customs officer was not quite the free-marketer his followers attribute to him. Indeed scholar Emma Rothschild, observing he mentions the invisible hand only three times in all his writings, suggests he was being ironical. Even so, Smith’s conjecture led economists to wonder to what extent the market promotes a common good.

There is a belief in some quarters that the market (almost) always gives a social optimum of some sort, based on Smith’s ‘by pursuing his own interest he frequently promotes that of society more effectually than he really intends to promote it’ (although, on occasions, the Business Round Table for instance, omits the ‘frequently’). However following much investigation by economists, the theoretical conclusion is that the market frequently does not, even using a loose definition of the interests of society, although practically the ‘invisible hand’ of the market may often be the best way we have of making resource allocation decisions.

This is a study is not of deep economic theory, although the book rests on it. However, to explain this chapter we need to plunge a little deeper than usual. The highpoint of the belief in the efficacy of the market comes from a theory summarised by the ‘Arrow-Debreu’ general equilibrium model (after Kenneth Arrow and Gerard Debreu) which demonstrates that under certain circumstances an economy based entirely on market transactions would be efficient in a certain sense. (It is not relevant at this stage in the book to note they did not prove it would be ‘equitable’.) Joseph Stiglitz remarks that their ‘great achievement was to find an almost singular set of assumptions which Adam Smith’s invisible hand conjecture was correct.’Modify the assumptions to make them more realistic and the conclusion breaks down. Over the years, economists have struggled with the policy implications of what happens when the assumptions do not apply. One option is to implement policies which give the assumptions wider application (as we saw in the previous chapter in terms of the extension of property rights to previously public resources as an application of the Coase Theorem). Another is to separate out activities where the market seems to work imperfectly (say the health system) although where appropriate using market mechanisms.

However Stiglitz with Bruce Greenwald has demonstrated that the notion of ‘completeness’ of markets is central to the success of the proof. To go a little deeper, the Arrow-Debreu model is usually taught as a one-off event involving a set of simultaneous market transactions. In practice markets operate through time. The Arrow-Debreu model handles this by setting up at the one off-events as ‘contingent markets’ where the economic actors agree to trade if certain (contingent) events (including shocks) occur. The actors then trade in all these contingent markets, and the outcome is – in a certain sense – efficient. A practical example is taking out insurance in case one’s house burns down. The homeowner pays the insurance firm a premium to take over the risk, and the firm does various things such as pooling risk (and ensuring there is an effective fire service) to mean it makes a profit on an average transaction.

Suppose not all these contingent markets exist – that is they are ‘incomplete’. The efficiency conclusion of the Arrow-Debreu model no longer holds. Is this a serious omission? The occasions prove to common and problematical – most obviously in the social economy. For instance one cannot privately insure at birth for a person getting a rare disease such as multiple sclerosis. The lack of such insurance may reflect a transaction (and information) cost, but for whatever reason the market is incomplete, and it is the government which covers some of the costs of such events, while leaving to the market cover for those events which can be insured for.

A more complicated case is a woman cannot insure for pregnancy, for the practical reason that she and her partner have considerable control over whether she gets herself pregnant or not. (The technical term for the phenomenon is ‘moral hazard’.) One can imagine an insurance contract on pregnancies over which the woman has no control, but monitoring the circumstances is unlikely to be practical – the transaction and information costs would be too high.

But the incompleteness of markets is not confined to social issues. They are crucial in the growth process. The markets for future technologies are obviously incomplete, insofar as we can only speculate on future revolutionary technologies, and not insure for them. (For example, how was IBM to know that the personal computer which it was introducing would kill the core of its mainframe business. Even if it had when it was developing mainframes, how could it have ‘insured’ against the PC destroying its main business activity?) Not only is there no place for unexpected technologies in the Arrow-Debreu model, but there is no place for entrepreneurs, who might be thought of as acting on the opportunities they see in incomplete markets.

Extraordinarily then, the Arrow-Debreu model has little role for the most central activities in the growth process– the innovation which comes from technological innovation and entrepreneurship. It is perhaps not so surprising that when the model’s principles were applied rigorously in the 1980s the economy stagnated.

The conclusion that markets do not work very well where they are incomplete does not automatically make a case for government intervention. In some cases there will be, in others it would be quite inappropriate – it is difficult to imagine the government filling in for opportunities that entrepreneurs fail to seize. Unfortunately the science of economics does not offer the template of general policies propositions to deal with market failure in the way that ideologists wish on it.

(As a footnote to this section we might observe that there is a political philosophy which tackles the issue of the role market from a quite different approach. The radical Right’s objective ‘liberty’ equates to the right to be able to transact in the market with the minimum of social constraints. This ‘liberty’ may be a legitimate political philosophy, but it would be an appalling use of economics science to say that it inevitably resulted in the highest economic welfare.)

Electricity and Incomplete Markets

Incomplete markets usually involve decisions through time. This is nicely illustrated by the electricity generation industry which was reformed in the late 1990s, with the state owned enterprise Electricorp split into four competing businesses, one of which (Contact) was privatised, while alternative private provision was also encouraged. This involved changing the management of the national transmission grid and the lines which supplied consumers, but these infrastructural components are not at the heart of this illustration.

The radical more-market reforms on the electricity system began in the 1980s. At that time there was also a cut back in investment, which might be attributed to the reforms. Indeed it could be argued that the entirety of the reforms of the 1980s were in part sourced from a desire to make the electricity system’s investment program accountable to the economy rather than engineers, who seemed to build stations irrespective of whether there was a demand for the power or not. The cutback in additions to capacity did not seem at first to undermine the security of supply, in part because the economy stagnated, in part because there was some ingenious tweaking of the existing system by engineers. But the security margins built into the supply capacity were also eroded.

There are two points of view to this erosion. One is the margins were far too large, and the new commercial environment which penalised excessive capacity (since Electricorp now had to pay interest on the debt it created but received no revenue form the under-utilised capacity) reduced them to realistic levels. The argument reflected the unsatisfactory ways the margins were designed. Some engineers, it was argued, would choose simply choose a margin and impose it, charging the cost in the price everyone had to pay. That could mean that some people were buying more security than they wanted or required, while others were not getting enough. It was thought the former outnumbered the latter, because professional pride would result in the engineers building substantial security margins.

The alternative point of view argued that reductions in security margins made the system excessively vulnerable to crises such as dry years (when there is not enough water in the hydro-lakes) and equipment breakdown.

It is not easy to assess the dry-year insecurity possibility. A power crisis arising out of a water shortage, as happened in 1993(?), may be proof that the margins are too narrow, or it may have been an infrequent rainfall crisis with which even the old regime could not have coped. In any case the economist has to ask whether the costs incurred during the crisis were offset by the savings from lower investment that the reduced margins allowed (and perhaps note that the costs may fall on different people from those who benefit). Either evaluation involves a statistical model which requires a very long run of rainfall data for quality probability estimates, unaffected by climate change. A sufficiently long data series does not exist, so we are unable to say with confidence whether the power crises are due to narrow margins or unusual rainfall.

There is at least one example of equipment failure which seems uncontroversial. The electricity crisis in the Auckland Central Business District in 1997(?), arose out of insufficient capacity in the supply cables, so that when one failed the remaining cables were overburdened and failed too. The disruption to the CBD was painful, and New Zealand became a laughing stock in some overseas quarters. Even so, one might argue that this was not a failure of market induced under-investment but a failure on the part of poor quality management to invest sufficiently.

These crises are rehearsed here as a prelude to looking at how in an Arrow-Debreu world they would have been resolved. In that world there would have been contingent contracts which would have enabled consumers to avoid the costs of possible shocks by some sort of insurance. Assuming that is what the consumers really wanted, someone would have taken over all the insurance contracts with the payments that were being made for, using some of the funds to put in an extra cable, and kept the surplus as a profit. The result would be ‘efficient’.

Note that because the cable involved a long term investment, the insurance contracts would have had to, in effect, be over a longish period, and not just renewable every year. As attractive as this solution is, there are no such long term contracts, possibly because they are too costly to make (i.e. they involve high transaction costs). So the option is irrelevant, and the market is incomplete, especially in terms of longer run outcomes.

This suggests there will be a tendency for a market driven electricity system to under-invest in capacity. The theory does not tell us whether the gap will be large or small. We turn to the empirical evidence for that. As I write in 2003, there is a widespread concern that the New Zealand electricity system will be unable to cope with a significant dry year in the next few years. Interestingly, the businesses expressing concern did not promptly seek long term contingent contracts to protect them against this outcome. Neither did households. Rather, they asked the government to get involved – and, generally, to intervene more rather than less. (However there were some who thought that privatising the existing power corporations would magically generate the margins.)

Among the policy options are directing the power generation companies to maintain certain margins, and subsidising future investment. A possibility is to reintegrate the state owned generation companies, so that there is a dominant state owned player in the market which would be responsible for medium term security of supply. Some engineers argue that fewer significant providers to the grid would also improve short term security. The import of such a move is that the reforms were predicated on a truly competitive market with a multitude of producers, but in practice – because of the costs of entry and economies of scale in generation – the electricity generation market is an oligopoly in which the businesses play games against one another, and sometimes against the consumer interest, to increase their profits. A more monopolistic market would reduce the gaming. (‘Gaming’ here is a technical term referring to when one oligopolist take actions in the context of the mathematical theory of games.)

The point is, as the designers of the next electricity reforms will find and the rest of us will subsequently learn, there is no simple pragmatic solution to where markets are incomplete over time (compounded in this case by technological issues such as economies of scale and the physics of electricity transmission). Ideological solutions do not work.

Research and Innovation

Research involves the conditions for incomplete markets in a fundamental way. If we knew enough about what was in the great warehouse of unknown technologies to construct contingent contracts, we would not have to search there. Thus the Arrow-Debreu model provides only the most limited insights into the process by which unknown technologies become a part of every day life. (However Arrow, wearing another – learning-by-doing – model hat, has contributed to its understanding.) Because the process is so mucky – so distant from the elegance of the market as demonstrated in the model – it is hard to investigate and understand, and there are no simple policies for the pragmatist to recommend. Yet, as we saw in Chapter 3(?), this process of technological identification and implementation is at the heart of economic growth.

That chapter suggested a way of thinking about endogenous technology. The unknown technologies are stored in an enormous, hard to explore, warehouse. Economic progress involves investigating it, identifying potentially interesting technologies, understanding them and implementing them where it seems appropriate (or profitable). The rate and effectiveness with which this is done is a major determinant of the rate of economic growth.

Insofar as economic growth is an objective, the aim has to be the optimum rate an effectiveness. The difficulties in doing this are obvious. The wrong parts of the technology warehouse might be investigated. Even if the right parts are explored, the enquiry may be inefficient and expensive, or the return from them may be less than the cost of exploration. And when the technologies are brought into the light of the economy, they may be insufficiently exploited.

Who is to make the decisions as to the level and direction of activity? In practice the searching end has been the responsibility of the public sector (although in recent years there has not been the requirement that the public funded work has to be done in publically owned institutions), while the commercial end has been left to private enterprise.

This roughly corresponds to the notion that as the technology moves downstream, it becomes easier to contemplate contingent contracts and the like. Thus a venture capitalist guesses that a particular potential technology may be profitable and invests on that guess, relying on a portfolio of them to pool the projects so that on average there is a suitable positive return for their risk.

However an unintended consequence of the division has been that frequently there was a lacuna between the two ends. (For instance New Zealand scientists first identified the deep-sea fish, orange roughy, but it was following Russian scientists who saw its commercial possibilities.) Recently considerable attention has been given to their integration (which includes public research institutions setting up private companies).

The structure does not settle what is to be explored and how it is to be funded. In a world of contingent contracts the decisions could be left to the market. The nearer the process is to commercialisation the more it can be. But at the fundamental research end the decisions are largely made by expert advice, public consultation and inertia. One of the (few?) legitimate justifications of the reforms of the early 1990s was that the DSIR had got locked into researching the technologies of the economy of the past. Even so, some of the redundancies seemed unwise. (The legend is they were about to layoff the only bee expert when the viroa(?) bee mite suddenly popped up. What had he migrated by then?)

Despite an enormous effort to improve the selection of priorities, and some gains, parts of the selection system still seem dominated by the second rate who tend to think within the boundaries set by the conventional wisdom. (The first rate can get it wrong too: Lawrence Brash discourage James Watson and Francis Crick pursuing the identification of the structure of DNA.) I must declare an interest here. An application of mine for research funding was turned down by a committee, not one of whom was competent in the field (but it was a very politically correct committee) on the basis of advice from one referee (despite strong support from the remaining five, including the overseas ones). Hardly suggesting a degree of competence, the grumpy referee confused the Population Census, with the Household Survey which the project was to use, and the committee seems to have followed suit. (When I first published this story, I was deluged with similar ones, although the tellers were not prepared to go public because it might compromise a future application.) The happy outcome was that the project was eventually funded by another committee. This aside is justified in that it suggests that competing funding agencies – even two rather than the usual monopolistic one – may improve the quality of selection. (There is almost that arrangement with New Zealand On Air and the New Zealand Film Commission both funding films/video. Some time after I first wrote this I realised there is also some overlap in their subject compass between the Foundation on Research Science and Technology and the Royal Society’s Marsden Fund, even though ultimately both are funded by the government. )

The current approach to New Zealand research funding and direction is too isolationist. Each year New Zealand makes only a small contribution to the world’s additions to knowledge. Large chunks of the technology blue prints are practically exogenously released from the warehouse, because they are produced overseas. Because it is impossible for researchers to get complete intellectual property rights over their ideas – even following considerable tightening in the international TRIPS(?) Agreement (Trade in Intellectual Property Services(?)) – it is very advantageous for New Zealand to import these ideas. However, the existing New Zealand policies pay little attention to international technology transfer, instead focussing on creation of knowledge in New Zealand.

As a practical example, consider that the world spends more than the New Zealand GDP on cancer research. What is the likelihood of a local breakthrough in research that is genuinely significant? Now there are some niche areas where New Zealand may have a comparative advantage (melanoma has an unusually high incidence here; there may be certain conditions that those with Polynesian genes are more prone to; perhaps some indigenous natural resources have curative properties to be exploited.) But is there any point in New Zealand generally pursuing cancer research? (We may discount the possibility of a New Zealander finding the miraculous cure much promised by journalists. Such a funding strategy would justify space research.) Even so, New Zealand needs cancer research as a part of the process of transferring the foreign findings for practical application in New Zealand. This may involve a different approach to cancer research from the existing one, although the New Zealand laboratories would still be involved in fundamental research so that local scientists understand what is going on overseas, and are professionally credible with foreign scientists. And of course, if one of the pharmaceutical research groups strikes it lucky, then we should consider developing the product.)

The technological implementation process cannot be funded entirely from public sources – there is not enough funds. In any case, the return to the economy from the new technology will go, in whole or more often in part, to those who apply it. How to ensure that potential technologies are applied productively – avoiding not commercialising identified orange roughy? There are two potential mechanisms: competition and is financially rewarding success. (They need not be the same thing: Crick and Watson were competing against Linus Pauling for the scientific glory, although they subsequently received financial rewards too.) Unfortunately the two mechanisms are in conflict.

The tension arises because the rewarding process discourages competition, a result of the distinction between the idea and its application. The standard market reward requires the giving an intellectual property right to the applier, such as patents and copyright. However this action may inhibit others from competing against them, since they may not be able to use a new technology which depends on an existing patented technology . Indeed the patent holder has an incentive to use litigation defend the patent and discourage competition. Getting the balance between the competition and reward mechanisms probably differs from industry to industry – or even application to application. There can not be any universal policy rule. On the other hand, a government cannot (should not) operate on an ad hoc way for each situation.

The tendency has been to give intellectual property rights as far as possible, although there may be important caveats. (I rather like the principle that the patented technology must be leased out to other businesses at a fair rent – although easier said and done). Sometimes the right seems slightly nutty. A copyright to a literary work for 70 years after the author’s death is unlikely to provide much incentive to writers while they are alive, as long as there are no contingent contracts by which they can sell the right before they die. (One hastens to acknowledge that the writer’s immediate family may have suffered greatly from the creativity and there is an equity for their receiving royalties through their lives after the author’s death.) It might make more sense to use the royalties to subsidise living writers (even if the mechanism to do so is likely to be clumsy and conservative), but the path from the present situation to a better one is likely to be unfair. (As I wrote this it occurred to me that a state agency – the private sector wont do it – could offer to authors to take over their after death royalties in exchange for a lump sum in their life time? Rigorous analysis often suggests innovative conclusions.) Ultimately though, the reality is whatever New Zealand may want to do over property rights, it cannot get too far out of line with international practice, no matter how irrational it may be.

The Entrepreneur

Formal definitions of entrepreneurs usually describe them as ‘undertakers’, who having identified an opportunity, combine together various factors of production in an enterprise, to harvest it. They do so for the sheer brio (what Joan Robinson ‘animal spirits’) or for financial rewards (or not) from the surplus from revenue after the factors are paid (known as a ‘super-normal profit’).

An weakness of this definition – even applied to traditional economies – is that typically the opportunity is related, at least in part, to technology implementation. Joseph Schumpeter placed the innovation, as does this study, at the centre of the growth process. The entrepreneur exists in a world of uncertainty and of incomplete markets, not in the world of the Arrow-Debreu model with its insurable risks from contingent contracts. Schumpeter shrewdly – before Arrow-Debreu models existed – described their role as disrupting the economic equilibrium, with each disruption lifting the economy to a higher level of output. (Schumpeter details of this process through an account of the business cycle, but it lies largely outside this study, even if it informs it.)

Entrepreneurs then, are at the heart of technology implementation. They make mistakes, but on average they benefit the public by introducing new technologies. Some entrepreneurs go bankrupt, possibly more than once, rising again like a phoenix to have another go. It is important, therefore, that we do not automatically disqualify bankrupts from re-entering business, an attitude which arose in the safe stable immediate post-war era when the most likely reason for bankruptcy was incompetence, with dishonesty coming second. In a high growth economy based on technological innovation, honest competent business people can go bankrupt through bad luck.

Individual entrepreneurs still exist. Many small and medium sized businesses continue to be entrepreneurially led by an individual (or sometimes a couple of people – even married partners). But today they do not dominate the economy in the way that the traditional theory implied. (Perhaps they never did.) Instead, many of the entrepreneurial activities are undertaken by collectives of people embodied in corporations. They are not direct beneficiaries of any resulting super-normal profits – which in principle are the corporation shareholders’, in exchange for their taking on the uncertainty of financial return. However the corporate decision-makers’ careers and future remuneration are likely to be dependent upon the quality of their entrepreneurial decisions.

One might want also to classify as a kind of entrepreneurs in the Schumpeterian sense, those workers who tweak their machines or production processes to run them a little more successfully. There are also entrepreneurs in the non-market sector. ‘Political entrepreneurs’ is a common term for politicians who seize on (or create) a previously unidentified public concern and build a following. Even some of the activities of a housewife may be entrepreneurial in a certain sense, although the diffusion into benefiting the entirety of society may be slower or less common.

Like Joseph Schumpeter, I celebrate the entrepreneur in all her and his various manifestations, but I think it foolish to talk about an ‘entrepreneurial’ society. However it does make sense to talk about a ‘more entrepreneurial economy’. Eschew the claim that New Zealanders are the most entrepreneurial people in the world as silly chauvinism. Yet there can be no doubt that many New Zealanders are entrepreneurial. In the past their skills were directed away from enhancing economic performance to other activities: finding profitable opportunities in government regulations; seeking opportunities offshore; creating complicated financial arrangements which shifted wealth around but did nothing to enhance the production of the country; operating in politics; getting involved in Mr Asia type drug running ventures. The task is to channel those talents into generating economic growth and social wellbeing, by ensuring that the relevant market opportunities are there to be seized, and can be pursued more easily than the less socially useful alternatives.

The entrepreneur is but one of a number of occupations (or activities in the entirety of an occupation) that enhance the nation’s welfare. Researchers, teachers and doctors are not mainly entrepreneurial, even though they have vital roles in identifying, transmitting and applying knowledge, and their activities create a social benefit. Nor are most managers and business people. Entrepreneurs depend upon savers, who are not as entrepreneurial. One needs to think of an economy as a sporting team, or an orchestra – without second fiddles, the performance of conductors would be limited.

The largest chunk of the orchestra of the economy are the workers. They prove to have a much more important role in the economy, than recent policy thinking has given them. They deserve at least a chapter to themselves.

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