HOW NEXT HAPPENS BUILDING OUR ECONOMY THROUGH INCREMENTAL INNOVATION
May 2011
MONTRÉAL :: NEW YORK :: PARIS :: QUÉBEC :: TORONTO :: VANCOUVER
TABLE OF CONTENTS
ECONOMICS AND STRATEGY......................................................................................................... 2 What Is Incremental Innovation? ....................................................................................................... 2 Embracing Incremental Innovation ................................................................................................... 3 How Firms Capture Competitive Advantage From Incremental Innovation ............................ 3 A Canadian problem ........................................................................................................................... 4 Questions For Discussion by The Symposium Panel ......................................................................... 4
THE EXPERIENCE OF INDIVIDUAL SECTORS ....................................................................................... 5 Smart Phones .......................................................................................................................................... 5 Aerospace .............................................................................................................................................. 6 Pulp and Paper ...................................................................................................................................... 6 Pharmaceuticals.................................................................................................................................... 6 Summary ................................................................................................................................................. 7 Questions For Discussion by The Industry Panelists .......................................................................... 7
PUBLIC POLICY OPTIONS .............................................................................................................. 8 Policies That Impact All Sectors .......................................................................................................... 8 Sector-specific Policies ......................................................................................................................... 9 Questions For Discussion by The Symposium Panel ....................................................................... 10
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ECONOMICS AND STRATEGY
WHAT IS INCREMENTAL INNOVATION? Innovation is the process by which an idea or invention is translated into a marketable good or service. By contrast, an invention is simply a new product or process or business model that may or may not have commercial potential. Successful innovation creates wealth from inventions. Innovation can be radical or incremental. The exact frontier between radical and incremental is subject to interpretation but largely depends upon the pre-existence of a market for the innovation. A radical innovation establishes its own market, and generally displaces an existing one relegating its incumbent companies to the history books. An incremental innovation is an improvement in the cost or functionality of a product in an existing market. The term “disruptive” is used to describe an innovation that causes turmoil in an industry, but does not create new markets. Radical and disruptive innovations capture the imagination. The Internet, the personal computer, the airplane, jet travel, and the automobile were all radical innovations whose impact spread throughout the economy. The smart phone, digital cameras, shopping centers and Amazon.com are also major innovations that are classified as being either radical or disruptive, depending on the extent to which they created new markets as opposed to creating turmoil in existing one. Both radical and disruptive innovations share the distinction of being game-changers. Most progress in society is achieved through incremental innovation which is far more frequent and economically predictable than radical innovation. 1 Indeed, radical innovations are typically followed by years of incremental innovations that profit from the game-change. For instance, incremental innovation accounts for the difference between the bulky personal computers of the 1980s and the powerful but slim tablets of today, between the dial-up Internet of the nineties and the high speed Internet of today. Incremental innovation delivers progress through a series of small and fairly predictable steps year after year. It is the bread and butter of most firms that progress well in their chosen markets. Although it involves a degree of uncertainty, it typically falls within the technological, financial, and management competencies of the firms involved. The risks associated with incremental innovation are highly unlikely to precipitate the sudden failure of a company. Indeed, in the long run, the mastery of incremental innovation separates the winners and losers. It differentiates between firms whose value reflects what they will do as opposed to those whose value lies in what they have done – the takeover targets. To a large degree, incremental innovation involves steadily tinkering with products and processes to improve them over time. It is about continuous learning involving researchers, product managers, suppliers, and most importantly customers. Each advance can be small, and indeed, is typically small enough that it has a marginal impact on the market. Over time, however, the small steps add up to significant changes and improvements.
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Economics and strategy.…
EMBRACING INCREMENTAL INNOVATION Our views of innovation are generally shaped by the glamorous radical innovations and the flamboyant entrepreneurs who create new markets with major breakthroughs. Great companies result from radical innovation - Bombardier with its skidoos, the Cirque du Soleil, and Research in Motion, with the Blackberry that combined cellular telephony and email. Part of their popular appeal is that their founders create or transform industries starting from the position of being outsiders. Who, after all, would have thought that a street performer could create an entertainment giant based entirely on artistic and acrobatic innovation? The “home runs” of radical innovation not only have huge popular appeal, but they also form the substrate around which much of our public policy on innovation is designed. This should give us cause for concern since incremental innovation leads to product and productivity improvements and to better business models – areas where Canada lags structurally. 2 Incremental innovation may be steady and sometimes tedious. It is about the fuel efficiency gains in automobile engines, improvements in the density of pixels on a TV screen and the number of semiconductors that can be crammed onto a chip, the reduced cost of an Amazon shipment and better applications for smart phones. Over time, the impact of these small improvements accumulates exponentially. The pace of incremental innovation also varies across industrial sectors. For example, Moore’s law 3 states that the number of semiconductors on a chip doubles about every two years. It has held true since the mid seventies, and is associated with an annual rate of change of around 40%. Airplanes have increased their fuel efficiency over the past fifty years at between 1% and 2% per year and should continue at that pace. Despite the romantic appeal of radical innovation, its incremental cousin drives the economy and its outcomes are somewhat predictable. It should, therefore, be at the core of public policy and at the forefront of firm strategies.
HOW FIRMS CAPTURE COMPETITIVE ADVANTAGE FROM INCREMENTAL INNOVATION Incremental innovation does not conform to the classic and somewhat naïve linear model of innovation that takes an invention from the R&D center and brings it to market. Incremental innovation is about staying competitive and responding to signals from the market place and learning by trial and error. On the product side, it is about listening to customers and to suppliers and integrating their suggestions into the product, often with little contribution from R&D. It is also about picking up ideas from competitors. More importantly, however, it is about testing new ideas in the market place. The feedback from the market steers incremental innovation but to have efficient feedback, market entry for modified products must be relatively easy. The same grounded approach is observed on the process side and on improvement in business models, as managers continually seek to drive down costs and increase efficiency. Continuous improvements come from listening to equipment suppliers and to workers, identifying bottlenecks and waste, and then optimizing current methods, often by tinkering with pilot runs. Public policies to stimulate innovation tend to be R&D focused. Indeed, most of the efforts are directed at supporting private R&D through tax credits or industry assistance programs. 4 Publicly funded research in universities and research institutions similarly focuses on R&D and radical or disruptive innovation which 3 L/Doc en cours…
Economics and strategy.…
may explain why it has delivered so little in terms of commercial impact. In fact, the major contribution to of publicly-funded research to innovation is to develop highly skilled graduates, who then take leading-edge knowledge to their employers. This important role of the public sector is somewhat unrecognized in the innovation debate since it unfolds on a long-term horizon.
A CANADIAN PROBLEM As expected, we see wide differences in the incremental innovation performances of Canadian industrial sectors. Few business people want to admit that their own sector is lagging. But the truth of the matter is that, on aggregate, the Canadian private sector has an incremental innovation problem, and this is reflected year after year in the national data on our productivity performance. The figure below is taken from a wellpublicized report by the Council of Canadian Academies. 5 It indicates not only that Canadian productivity systematically lags behind that of the United States, but has also been losing ground over the past twenty-five years, despite numerous innovation policies promoted by governments. The Council of Canadian Academies report clearly traces this poor performance to a structural weakness in business innovation. Canadian businesses are as profitable as their American counterparts but they owe their success to other factors than being innovative and arguably are leaving profits on the table. Canada US Productivity Gap 1947 2007 100
GDP per hour worked, Canada as % of US
Real GDP per Hour Canada as % of U.S.
90
80 THE THE GAP GAP IN IN TH THE E PAST PAST SIXT SIXTY Y YEARS YEARS
Peak Year – 1984 (93%) 93%
CATCHING CATCHING UPUP
70
FALLING BEHINDBEHIND FALLING
60 1947
1951
1955
1959
1963
1967
1971
1975
1979
1983
1987
1991
1995
1999
2003
2007
Source: Canadian Council of Academies, Report on Business Productivity
QUESTIONS FOR DISCUSSION BY THE SYMPOSIUM PANEL
How extensive is the Canadian productivity problem and to what extent is it linked to our failure to adapt to disruptive innovation or to the difficulties or unwillingness of Canadian business to espouse incremental innovation?
What are the conditions that will encourage businesses to enhance incremental innovation as a competitive strategy?
To what extent does our public policy framework take into account the specific factors that influence incremental innovation and to what extent are some of these dimensions neglected? 4 L/Doc en cours…
THE EXPERIENCE OF INDIVIDUAL SECTORS Each industry has its own mode of behaviour when it comes to incremental innovation for the following reasons. First, incremental innovation can be driven by broadly based transformative technologies that affect all industries - the Internet, biotechnology, material sciences, computers, sensors, etc. However, industry sectors are impacted in different ways and speeds. For example, the Internet impacts telecommunications a lot more than it impacts oil and gas extraction. Second, market conditions differ significantly from one industry to another and incremental innovation may be affected by factors such as the degree of competition and in local markets, the density of customers. Indeed, the recent Council of Canadian Academies report on innovation suggests that the existence of a large number of small local retail markets in Canada, a reflection of our geography, explains a significant part of the difference in productivity between the Canadian and US retailing sectors. Third, the conditions that support or hinder innovation can vary significantly between sectors. Some sectors are highly regulated while others are not, creating highly different conditions for experimentation. Fourth, in some industries governments are important buyers, and their procurement policies create unique conditions for incremental innovation – some advantageous and some deleterious. Fifth, price controls are still important in some industries, such as the pharmaceutical industry, and can have a tremendous impact on innovation. We have singled out four industries in order to explore the wide range of conditions that can affect incremental innovation: smart phones, aerospace, pulp and paper, and pharmaceuticals. Although these industries have all encountered disruptive innovation, most of their innovative activities are incremental. Our purpose is to compare them, and to draw insights on how public policies can stimulate or hinder incremental innovation.
SMART PHONES Smart phones represent a relatively concentrated, global industry that faces rapid technological change and where competition is intense. Incremental innovation occurs at a fast space. New products are launched several times a year. Cost competition is also fierce and most of the equipment is made in low-wage countries. As Nokia’s difficulties have shown, 6 any players that hesitate or slow down can be hit hard and lose market share. On the surface, the industry is lightly regulated. It must, however, abide by a large number of standards, (frequencies, emissions, etc.). It also faces tough intellectual property issues, and must accept government oversight on security grounds. Government does not play a critical role as a buyer. R&D and marketing are probably the industry’s two major expenses, and R&D is generally supported generously by government financial incentive programs.
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AEROSPACE Like smart phones, aerospace is also a global industry but with important manufacturing clusters. It is highly technological, but the pace of change is much slower than for smart phones. The industry sells big-ticket items, and price competition is not as intense as in the smart phone market. Products have to be certified - a costly process. Components and materials also have to be traceable. New products are launched at a sedate space. Typically firms maintain a portfolio of five to ten major products each with a fifteen to forty year lifespan. Products are continuously upgraded, and the search for cost savings starts as soon as a new product is launched. Product development is generally structured around a few major programs that receive a wide array of financial support from government, from tax credits to soft loans and technological challenge grants. The industry also receives extensive financing support for nondomestic sales. It is subject to post-market regulation. In particular, product failures and accidents are the object of highly disciplined investigations by regulatory agencies.
PULP AND PAPER This industry is structured by continent, although it is not escaping a slow trend toward globalization. The Canadian pulp and paper industry faces heavy competition from lower cost producers that benefit from warmer climates. Global demand for products is barely changing. The industry’s products are highly commoditized, although manufacturers regularly come up with innovative papers, - more opaque, greener, recycled, special uses, etc. Nevertheless, the bulk of its revenues come from commodities, justifying significant efforts by the industry to lower costs through continuous improvement. Recently, the industry has also innovated in its forestry practices, to meet rising environmental expectations. The industry faces a patchwork of regulations that can impact incremental innovation: logging practices, workers’ rights, health and safety, waste disposal, etc. R&D as an input to incremental innovation is a factor, but not as much as change management and investments in new equipment for process innovations and in marketing for product innovations. The industry has probably received less government support for its incremental innovation than more technology-oriented industries.
PHARMACEUTICALS The pharmaceutical industry is mired in paradox. By definition, it is a very innovative industry. By definition, its easy-to-copy products – well defined molecules – have a commercial life span under intellectual property protection of ten to fifteen years before being commoditized by generic manufacturers. New products are highly regulated, making their development a very costly undertaking and a very risky one. Most products do not pass the regulatory thresholds for safety and efficacy. Governments are major customers in almost all countries, and tend to be very selective in their decisions to reimburse new products. In particular, they frown on authorizing many products in a therapeutic category, disparaging the late-comers as being “me-too” products. They also delay drug listings to achieve short-term cost savings, shortening their already limited lifetimes as viable commercial products.
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The industrial model that has come out of these various constraints and hurdles is under tremendous pressure at the moment. The market is characterized by a relatively limited number of new products, sold at very high prices, and with relatively little direct competition – typically two or three at most per indication. The products that make the cut can earn billions of dollars in annual revenues. They are “blockbusters” and pay for all the also-rans and the failures. However, fewer and fewer products achieve blockbuster status, throwing the industry in disarray and raising fundamental questions about the industrial model. Drugs that offer only marginal benefits, a typical output from an incremental innovation path, are rejected on the grounds that they do not bring sufficient additional benefits to end-users. The industry model is shaped by governments in their dual role of safety and efficiency regulators and of payers. It is a model that is tilted toward radical innovations; new molecular structures targeting new mechanisms of action. In support of that philosophy, governments in many industrial countries are pouring more funding into fundamental research in life sciences than in any other sectors. In Canada, expenditure probably approaches $2 billion per year channeled mostly through university research centres. Overall, the weak environment for incremental innovation biases public research and the industry towards major payoff projects and to high prices for successful drugs.
SUMMARY
Pace of change Height of regulatory barriers Challenges posed by standards Importance of IP protection Need for R&D Lack of financial incentives from government Lack of strategic purchasing by government Innovations from Canadian university research University: development of talent Barrier to incremental innovation
Smart Phones
Aerospace
Pulp and paper
Pharmaceuticals
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M H H H H H H M H H
QUESTIONS FOR DISCUSSION BY THE INDUSTRY PANELISTS
To what extent does your company rely on incremental innovation – the continuous improvement of products and processes - as opposed to other strategies, such as radically different new products or processes, diversification, M&A, etc., to achieve its value creation objectives.
How do public policies impact the level of effort put into incremental innovation?
Which public policies are most critical, positively and negatively in your own industry? 7 L/Doc en cours…
PUBLIC POLICY OPTIONS The Council of Canadian Academies report has highlighted the need for a fundamental review of our current innovation policies. Several initiatives are underway to generate new ideas. If we set aside the pursuit of radical innovation – the search for breakthrough projects at the edge of the technological frontier, what can we say about the influence of the current public policy framework on the decisions of Canadian businesses to emphasize incremental innovation strategies? A broad range of public policies affect innovation. The major instruments used by governments are tax incentives, intramural research, support for university research, demonstration projects, subsidies to innovators and to customers of innovation, government procurement, support for higher education, development of standards, intellectual property protection, and competition laws. To structure the analysis, we have distinguished between industry-wide policies and industry-specific policies.
POLICIES THAT IMPACT ALL SECTORS Tax reductions are often on the top of the agenda for business groups. Corporate tax reductions increase the return on capital on all investments and do not discriminate in favor of incremental innovation via continuous improvement. On the other hand, more generous R&D tax credits would encourage incremental innovations that are R&D intensive. However, the benefits are concentrated in technology-intensive sectors. Many incremental innovations, particularly the process-oriented ones, benefit less from such credits, since their main inputs are often trials and pilots, marketing expenditures, and change management. Intellectual property policies and Competition laws affect all industries. There have not been major calls recently for change in either, to stimulate innovation and more specifically incremental innovation. These frameworks are increasingly harmonized globally and on the whole, Canadian policies appear to be in line with best global practices with the pharmaceutical sector as an exception. For example, Canada lacks orphan drug protection, patent term restoration and long periods of data protection that apply in other jurisdictions. Human resources are critical to an innovation culture. Canada scores relatively well among OECD countries on educational performance, including higher education. Companies that excel at innovating must stay close to the leading-edge of technology and know-how. They need the well-educated workforces provided by our universities and colleges. Our decentralized system ensures a good distribution of graduates. Advanced training programs tailored to specific industrial needs also seem to respond to industry needs. Universities also conduct research. Much of it is “public domain” research. The results are diffused in the global commons, and contribute to the advancement of knowledge without any particular Canadian bias. But what about collaborative projects with the private sector that are being heavily promoted as underexploited avenues for innovation? In contrast with the US, few operational linkages have been established between industry and academia. Notable exceptions are the coop programs developed by the University of Waterloo and the Université de Sherbrooke. Lack of linkages and integration between universities and firms are often mentioned as lost opportunities for fully benefitting from our institutions of higher learning.
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Public Policy Options.…
Government funding has focused mostly on support of public research but these investments are largely disconnected from commercialization. Translation of even a modest proportion of this research into commercial products and services is not happening. A good indication of the indifference of the academic establishment toward commercialization is the very low level of attention paid by the granting councils to financing proof of concept projects. Moreover, to the extent that it is innovation-driven, government-funded research generally pursues radical innovation rather than incremental innovation. Intra-mural government R&D has, paradoxically, been closer to the private sector. The decentralization into sector-specific institutes and the formal outreach policies pursued by government have led government research organizations such as the National Research Council to work more closely with private sector firms. Government laboratories have made critical contributions, such as the development of Canola in the prairies and of the SAGD process in the Oil Sands. Government as a strategic purchaser: Targeted procurement policies are often promoted but the challenges associated with execution should not be underestimated. Government procurement is subject to intense regulatory and political constraints. In the 1980s, several provincial governments attempted to use the purchase of personal computers for schools to stimulate a homegrown computer industry with disastrous results. The Federal government industrial offset policy used in defense procurement seems to be working better, although its efficiency as a policy tool has not been the subject of any rigorous scrutiny. On the whole, governments have difficulties in avoiding a focus on price as a key decision criterion. For instance, in vaccines where government is the dominant purchaser, it has used its monopsony power to drive prices down instead of using it to stimulate innovation and strengthen an industry that has significant export potential.
SECTOR-SPECIFIC POLICIES Demonstration projects: This approach is widely used in the US and in Europe but the Canadian government has frowned upon it and has been unwilling to challenge Canadian businesses to tackle emerging industrial markets. Government has a strong bias against “selecting winners”. Combined with regional policies and a limited number of Canadian contenders in most sectors, the federal government has not used the “industry challenge” approach which is prevalent elsewhere especially in the US. Although some challenge programs target disruptive innovation, the vast majority aim to push the envelope, a true incremental approach. Financial support to innovators: Most of the financial support from governments has been traditionally channeled through non-specific SR&ED tax credits, to the tune of $4 to $5 B a year. Direct support programs, which often take the form of reimbursable loans, are concentrated in selected high technology areas, such as aerospace and green technologies. They currently add up to less than $500 M per year in disbursement at the Federal level. The total is an order of magnitude less than is committed through the nondiscriminatory SR&ED tax credit program. “Modernization” programs in mature industries, such as pulp and paper, automotive and shipbuilding have been used but, the overall objective of these programs was to provide a temporary lifeline to industries subjected to a particular economic shock as opposed to stimulating incremental innovation. Buyers’ subsidies: Several countries have used this approach to stimulate the use of green technologies. The federal government let lapse its “auto-eco” subsidy program which targeted fuel efficient cars. On the other 9 L/Doc en cours…
Public Policy Options.…
hand, several provinces have customer-incentive green programs, with subsidies for automobiles and home insulation. Raising standards: The US government has also raised standards to nudge industries to improve the performance of their products. Mileage standards, widely decried by the automobile industry and somewhat diluted by intensive lobbying, have been used to improve the fuel efficiency of cars sold in the US. Canada has more or less followed, with some Provinces opting for the more aggressive California standards. Standards have also been used to improve the performance and reduce the environmental footprint of electrical and domestic appliances, from light bulbs to refrigerators. However, “raising the bar” policies are often developed and implemented in an adversarial context, muddling their important contribution to innovation. Diffusion: The adoption of new technologies and, more broadly, of state-of-the-art processes throughout the economy is defined as diffusion. Government agencies such as the BDC, support companies that want to modernize with accessible loans. The Canada Small Business Financing Program facilitates modernization loans, which should favor incremental innovation. Healthcare: The ever-rising costs of health care are generally assumed to be a major threat to the soundness of our economies. According to a recent C.D. Howe study, 7 healthcare will consume close to 20% of Canada’s GDP within a few decades. Surprisingly, healthcare has not generally been the object of innovation targeting policies, beyond the twelve-year $2.5 Billion Canada Health Infoway. On the whole, the hospital sector and primary care provided by doctors have remained firmly embedded in a traditional model that frowns on competition and on true “private sector” involvement. Although health economists generally believe that pharmaceutical innovations have significantly improved the productivity of the healthcare system, much of the debate about drugs and most of the ensuing public policies have surprisingly focused on cost containment. With the notable exception of Quebec, very little thought has been given by governments to creating an environment that stimulates pharmaceutical innovation and improves overall productivity. Dysfunctional pharmaceutical access polices may have contained the cost of drug plans but may have failed to optimize the positive contribution of innovative drugs to the cost efficiency of healthcare delivery. In particular, governments are not encouraging incrementally innovative drugs. They limit their listing on formularies on the ground that the added benefits are not significant enough. 8
QUESTIONS FOR DISCUSSION BY THE SYMPOSIUM PANEL The above review suggests that a wide range of innovation policies is being used in Canada. However, no overarching approach appears to be able to tackle the significant productivity challenges facing the Canadian economy. This leads us to formulate the following questions to the panel:
To what extent do our current policy efforts in innovation contribute to solving Canada’s productivity problem?
How can we improve our public policies to lever incremental innovation more effectively and to accelerate the pace of the Canadian economy? 10 L/Doc en cours…
Public Policy Options.…
Which public policy area covered by the innovation agenda is most in need of change?
See http://www.impgroup.org/uploads/dissertations/dissertion_22.pdf and http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1404015 2 http://www.fin.gc.ca/ec2005/agenda/agc3-eng.asp 3 http://www.intel.com/technology/mooreslaw/ 4 See http://www.nrc-cnrc.gc.ca/eng/ibp/irap.html 5 http://www.scienceadvice.ca/en/assessments/completed/innovation.aspx 6 http://www.reuters.com/article/2010/09/10/us-nokia-ceo-factbox-idUSTRE6892KB20100910 7 http://www.cdhowe.org/pdf/WorkingPaper_327.pdf 8 Wertheimer, Albert I. and Sntella, Thomas M., Pharmacoevolution: the Benefits of Incremental Innovation, IPN Working Papers on Intellectual Property, Innovation and Health, International Policy Network, London, 2005 1
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