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Innovation is one of five ‘drivers’ of productivity identified in recent Treasury work to develop a framework intended to help New Zealanders meet the challenge of lifting productivity levels and raising future living standards in a sustainable manner.

Innovation is a key element in economic growth

The case for innovation as one of the drivers rests on solid ground. Most of the huge rise in living standards in the developed world over the last two centuries (the era of modern economic growth) has come about through technological breakthroughs based on increased knowledge. Mostly this knowledge has been scientific but it has also been practical knowledge about production processes, and organisational, social, legal and marketing knowledge. The explosion in knowledge has gone hand in hand with tremendous advances in the education and skills of the broad population.

In the end, economic growth is about knowledge and ideas coming to fruition: inventing a new product, developing a new service, establishing a better way to manage a business and so on. Instead of rising living standards being limited by diminishing returns, increases in knowledge and innovation by entrepreneurs have allowed real incomes per head to rise by an average of around two per cent a year for at least the last century in the leading economies.

Adding to the case for a focus on innovation is the strong argument that new products and processes are an increasingly essential way for a developed country like New Zealand to prosper in a globalising world. Innovation is the means to compete with countries with low-cost labour that produce a wider and wider range of existing goods and services at very competitive prices.

Knowledge has special economic characteristics

In order to design good policies it is necessary to understand that knowledge and innovation have a number of special characteristics that differ from standard economic commodities. Most importantly, knowledge is non-rival, meaning that once an idea has been developed, others can use the idea at no additional cost. In addition, knowledge is characterised to varying degrees by the inability to exclude others from using a particular idea, by uncertainty in the results of research, and by lags between when ideas are first formed and when they can be used commercially. Knowledge is also cumulative in nature: it builds on past knowledge.

These characteristics create the potential for markets on their own to fail to deliver the best outcome. First, knowledge can ‘spill over’ to those who did not create it, resulting in a social return to knowledge creation that is greater than the private return. Secondly, the non-rival nature of knowledge suggests it ought to be made widely available once it has been created.

Government involvement is likely to be required for optimal investment in knowledge

Given these features, there is likely to be less investment in new knowledge and less spreading of it compared to what would be best for society as a whole. This is why there is an important and potentially quite active role for government to create the best conditions for innovation, ranging from subsidising public- and private-sector R&D, ensuring that institutions for intellectual property rights and higher learning work well, and encouraging strong links between private-sector firms that apply knowledge and public research organisations that create it.

The empirical literature on returns to R&D provides support for the existence of knowledge spillovers, as observed in a large and consistent gap between the private and social rates of return to R&D investment. New Zealand-specific evidence is limited, but also finds some evidence of spillovers.

A useful concept that helps identify strengths and weaknesses across a range of aspects of innovation is that of a ‘national innovation system’. Studying New Zealand’s national system of innovation can help uncover opportunities for beneficial changes in the roles and interactions of the government, research organisations, entrepreneurs and firms, and in the supply of skills.

The relative weakness in New Zealand’s innovation system is in the ‘D’ part of R&D, i.e. in the successful commercial application of new knowledge. Innovation requires firms to have a range of internal capabilities to be able to accumulate and apply knowledge, where that knowledge is either generated internally or absorbed from external sources. It also requires entrepreneurs to face positive incentives to innovate arising from product market competition, regulation and access to skills and finance. These are covered in more depth in other papers in the series.

While New Zealand’s innovation performance is improving it still has a significant way to go

Overall, New Zealand’s performance as an innovative economy presents a mixed picture. While it is improving, there is still a significant way to go before New Zealand’s innovation system is firing on all cylinders. On the positive side, New Zealand’s science base delivers research outputs at a relatively high rate compared with the OECD average. We have a relatively large number of researchers, and our R&D has been growing at a fast rate relative to most other OECD countries. On average, New Zealand firms have comparable innovation rates to EU firms across a range of measures.

On the other hand New Zealand is generally behind the global technology frontier – as indicated by the country’s low overall level of productivity and its low productivity level in a majority of industries compared to the UK – a medium productivity performer. Innovating firms are the key institution for translating knowledge into national economic success and lack of such firms (in both number and size) is a significant weakness.

The level of R&D, as a percentage of GDP, is very low in New Zealand compared to the OECD, particularly business R&D. This last feature means that public research organisations, principally Crown Research Institutes and universities, perform a high proportion of total R&D, and this increases the need to get high economic returns from them through excellent links with industries and individual firms. The level of patenting in New Zealand is also low.

A range of policies are needed to make the innovation system work well and help raise productivity

The government has recently undertaken a number of positive initiatives to enhance the innovation system such as the introduction of R&D tax credits for private firms and the appointment of what is effectively a ‘Minister of Innovation’. Given these, and New Zealand’s current situation, the key areas for policy to focus on to achieve a high-performing innovation system (that will help raise productivity) are:

  • Ensuring as much as possible that incentives (both market ones and government-influenced ones) encourage entrepreneurship, and knowledge creation and dissemination. Examples of these are the tax credits for R&D, the terms the government sets when it funds research, and flexible product-market and other forms of regulation.
  • Keeping in mind that innovation occurs within a wider context, and some factors could still present barriers, for example:
    • uncertainty about returns to innovation – for example through regulations or exchange-rate volatility;
    • innovators require a large market to gain good returns from the high fixed costs of innovation and this necessitates exporting (given New Zealand’s small size); but distance makes exporting so early in a firm’s life-cycle a big challenge;
    • strong competitive pressure that drives firms to innovate to survive may be lacking owing to New Zealand’s small market size and isolation;
    • capital-market under-development is likely to make it difficult for young, innovative firms to access funding, specialist networks and advisory services; and
    • low broadband provision may affect some firms and limit opportunities for innovation.
  • Improving links in the innovation system between firms, public research organisations, and training organisations to promote knowledge exchange, and the development of skills that help firms take up new technologies.
  • Strengthening mechanisms to help firms to become smart technological followers absorbing and applying relevant pieces of knowledge from both domestic and international sources.
  • Identifying areas of actual and potential strength in the economy so that investment in R&D, education and skills and support for firms to innovate and internationalise is concentrated in these areas. The idea here is that these different investments will complement and reinforce each other in a virtuous circle of further investment, higher productivity, and higher returns.

In the end, in order to raise productivity by a significant margin, New Zealand needs a large number of firms to raise their performance through smart new product offerings, better technology, the use of more skilled workers and improved organisational and human-resource practices.

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