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Innovation and Productivity: Using Bright Ideas to Work Smarter - TPRP 08/05

Innovation and the firm

Firms must be centre-stage in order to meet the challenge of using innovation to significantly lift New Zealand’s productivity

The challenge for the New Zealand economy is to improve its productivity performance. This can really only happen if New Zealand firms produce more higher-value, higher-skill-intensive, more-knowledge-intensive goods and services. Innovation is a major part of this process. It is about firms introducing new technologies, processes, and goods and services. It goes beyond the R&D undertaken within the firm or in public research institutions, and requires the successful commercial application of new knowledge. Arguably the relative weakness in New Zealand’s innovation system is in the last of these components. To deal with it requires a "change of gear" from investigator-led R&D to market-led innovation. This is no simple task, and requires firms to have a range of internal capabilities.

Fabling and Grimes (2006) investigated data from the New Zealand Business Practices Survey 2000, and found that innovation-related activities are central to improved firm performance, particularly through capital investments in up-to-date technologies, R&D practices, practices that reward employee performance and market research.

A useful way of thinking about the role knowledge plays in innovation is to consider what processes drive a firm’s innovation performance (and ultimately productivity), and the factors that influence each of these processes. This discussion is not intended to be exhaustive, and does not cover in any depth the incentives that entrepreneurs face to innovate arising from product market competition, regulation and access to skills and finance. These are covered in greater depth in other papers in the series.

Innovation at the firm level depends on creating, absorbing, and applying knowledge

Figure 1 below sets out the drivers of a firm’s innovation performance: the ability to accumulate knowledge and the ability to apply that knowledge, where knowledge can be accumulated by either creating new knowledge or absorbing existing knowledge. These different processes are discussed in turn below.

Figure 1 – Firm-level processes that drive innovation
Figure 1 – Firm-level processes that drive innovation.

Knowledge creation

Knowledge creation is the firm itself coming up with new ideas. The most obvious method of knowledge creation is formal R&D, defined by the OECD’s Frascati Manual as follows: “Research and experimental development (R&D) comprise creative work undertaken on a systematic basis in order to increase the stock of knowledge, including knowledge of man, culture and society, and the use of this stock of knowledge to devise new applications.” (OECD 2002). However, firms can also create knowledge informally, such as through on-the-job idea generation. Factors influencing knowledge creation within the firm will include the amount of R&D it performs, the effectiveness/efficiency of that R&D, the firm’s internal capabilities, and incentives for informal innovative activity.

Higher productivity firms tend to have strong internal capabilities. These include having a skilled workforce, and being good at adopting newer technologies, applying improved organisational and management practices, and generating and managing knowledge. Greater investment in these complementary inputs puts firms in a better place to produce innovative goods and services and increase productivity. However, these internal capabilities are difficult to acquire and take time to develop. As a consequence, a firm’s whole history of choices about technology, skill and internal organisation have an enduring influence on its ability to upgrade. Despite new firm entry and exit of old firms, this constrains dynamic change. In addition, wide productivity differentials between firms in an industry will slow the rate of diffusion of innovations across firms in the industry.

Knowledge absorption

Most knowledge is created outside any particular firms so the internal capabilities of firms to absorb this knowledge are critical

Absorption is important because the vast majority of new knowledge is created outside any particular firm. Firms may be able to apply some external knowledge immediately, but in most cases they will require internal capabilities to (a) find knowledge that has been created elsewhere, (b) make sense of it, and its applicability to the firm, and (c) adapt it to the New Zealand context in a commercially viable form. Sources of knowledge outside the firm include universities, Crown Research Institutes, other domestic firms, and overseas sources.

New Zealand’s 2003 innovation survey found that the three most important sources of ideas for firms’ innovation were businesses within the same industry, customers and suppliers

The Statistics New Zealand Innovation Survey 2003 found that the three most important sources of information and ideas for firms' innovation were businesses within the same industry, customers and suppliers - perhaps because these groups are the most likely sources of information about recent innovations, consumer preferences and demand, and information about new inputs. In contrast, the survey found that universities and other research institutions were much less important sources.

New Zealand's productivity growth will be improved by accelerating the rate at which our firms catch up to the global technology frontier

For a small country like New Zealand, the majority of world knowledge is created outside of the country – for example, less than 0.2 percent of OECD R&D expenditure occurs within New Zealand. Our productivity growth will be improved by accelerating the rate at which New Zealand firms catch up to the global technology frontier. New knowledge (in the form of innovative products, technologies, and business practices) can flow from overseas to New Zealand firms through a range of channels such as trade, investment and people flows, and as “embodied” knowledge, such as through imported capital equipment (DeLong & Summers, 1991). However, this knowledge transfer does not happen quickly or completely, and is impeded by our distance from overseas sources. Taking steps to help firms locate, adapt and absorb knowledge from abroad therefore offers opportunities for improving technology catch-up.

Knowledge application

Finally, knowledge application is the process of using accumulated knowledge to create value for the firm, through commercialisation of a new good or service, or implementation of a new production technique for example. This process is by no means trivial, and is likely to require different capabilities to those involved in knowledge creation or absorption such as entrepreneurship, good business management, marketing skills, and so on.

Studies of individual firms provide valuable insights into how firms innovate successfully, and why some do and others stick to their old ways

Mason (2005) is a study of firms and their search for high value-added production. It takes an in-depth look at the factors influencing innovation by firms in four UK industries. The main factors motivating firms to move to high-value-added production were the higher profit margins available, and the opportunity to avoid the intensity of competition associated with lower-value-added products. However, firms faced barriers in moving up-market through capital constraints, market uncertainty and skill deficiencies, with the relative importance of these varying sharply between industries. Mason found that movement towards higher value-added products was incremental. Firm responses reflected a strong degree of path dependence, flowing from past choices about physical, human and organisational capital in the firm.

Other studies add further flesh to this picture of how innovation actually takes place at firm level. A European project explored in some depth how innovation occurs in low- to medium-tech (LMT) industries[8]. The case studies in this project highlight a number of characteristics of innovation in such industries. Innovation in production or distribution activities is usually incremental. Improvements are often driven by technology developments by upstream suppliers, or by downstream adjustments needed to meet customer requirements, or by the needs of distribution systems. External knowledge held by upstream or downstream organisations plays an important role in triggering product or process innovations. This requires relatively close coordination, networking and communication amongst firms.

LMT firms are also typically characterised by limited or no independent R&D capacity. The processes of innovation are therefore significantly influenced by the practical knowledge and experience of firms, the processes of learning by doing and using, and the capacity to recognise and utilise external knowledge. Even for successful LMT firms, it is a process of continuous development and customisation. But others, lacking capability or will or both, tend to stick to their previous low-productivity paths.


  • [8]The project findings are described in Hirsch-Kreinsen (2005)
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