Who Needs a Theory of Innovative Enterprise? William Lazonick

Who Needs a Theory of Innovative Enterprise? William Lazonick Norwegian School of Management BI Oslo May 6, 2013 Innovative enterprise and economic ...
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Who Needs a Theory of Innovative Enterprise? William Lazonick Norwegian School of Management BI Oslo May 6, 2013

Innovative enterprise and economic performance By creating new sources of value (embodied in higher quality, lower cost products), the innovative enterprise makes it possible (but by no means inevitable) that, simultaneously, all participants in the economy can gain:

• Employees: Higher pay, better work conditions • Creditors: More secure paper • Shareholders: Higher dividends or share prices • Government: Higher taxes • The Firm: Stronger balance sheet AND • Consumers: Higher quality, lower cost products

The argument The failure of conventional economics to incorporate the theory of innovative enterprise into its analysis of the operation and performance of the economy has profound consequences that go far beyond how academic economists think about the economy. Sociologists and political scientists are constantly making arguments about society and politics that are influenced by their understanding of economics. The ways in which business executives allocate resources and government policy-makers implement regulations often reflect prevailing economic ideology. Meanwhile, every year, millions of college students who represent the (supposedly) informed citizens of the next generation are taught that an un-innovative state of economic affairs, known quite ludicrously as “perfect” competition, is the best of all possible worlds. The result is the perpetuation of a body of thought that is not only hazardous to our mental health but also dangerous to our material wealth.

Who needs a theory of innovative enterprise? • • • • • • •

Economists Social scientists Business academics Business analysts Business executives Government policy-makers Informed citizens

Economists o Economists need a theory of innovative enterprise in order to break free from the ideological grip of the theory of the “optimizing firm” that takes technology and markets as given constraints in making its production decisions and that underpins the misconceived belief in “ perfect ” competition as the ideal of economic efficiency. The optimizing firm and perfect competition provide critical foundations for the theory of the market economy, which lacks a theory of innovative enterprise and hence a perspective on how an economy can generate real productivity growth.

Comparing optimizing and innovating firms p = price; q = output; c = perfect competitor pmin = minimum breakeven price; qmax = maximum breakeven output

price, cost

How does the innovating firm transform high fixed costs into low unit costs? average cost

marginal cost

p

c

innovating firm

marginal and average revenue pminc

q

c

output

optimizing firm

qmax c

output

Technological and market conditions are given by cost and revenue functions. The “good manager” optimizes subject to technological and market constraints. Through strategy, organization, & finance, innovating firm transforms technologies and markets to generate higher quality, lower cost products. There is no “optimal” output or “optimal” price.

The US economy is a corporate economy, not a market economy THE FORTUNE 1000: USA 2008

Revenues

Profits

$b.

$b.

Per company, average

Employees Revenues no.

$b.

Profits

Employees

$b.

no.

top 50

4,968

158

9,876,792

99.4

3.2

197,536

top 100

6,584

239

13,716,319

65.8

2.4

137,163

top 200

8,342

219

18,369,532

41.7

1.1

91,848

top 500

10,688

99

25,612,023

21.4

0.2

51,224

top 1000

12,086

103

30,881,978

12.1

0.1

30,882

2007 top 50 4,902 2925009,628,749 98.0 In 2011 the US Fortune had $10.8 trillion in5.8 sales,192,575 $708 top 100 in profits, 6,549 and 25.1 366 million 13,541,346employees. 65.5 3.7 135,413 billion top 200

8,284

508

18,073,414

41.4

2.5

90,367

Mean $21.6 billion in sales, in51,203 top 500 per company: 10,602 645 25,601,644 21.2$1.4 billion 1.3 top 1000 and 11,975 724 30,845,377 12.0 0.7 30,845 profits, 50,226 employees.

Think organizations, not markets Market imperfections? (economic processes) Assumes that “perfect markets” are an ideal mode of economic organization – but market coordination does not generate innovation, which entails a social process that is uncertain, collective, and cumulative process STOP THINKING “PERFECT MARKETS”, START THINKING “INNOVATIVE ORGANIZATIONS” Market failures? (economic outcomes) Assumes an expectation that the market can generate desirable socioeconomic outcomes – but undesirable outcomes – e.g., an inequitable distribution of income – may reflect ORGANIZATIONAL FAILURES

Social scientists o Social scientists need a theory of innovative enterprise in order to imbed the analysis of the operation and performance of the business enterprise in social contexts that, depending on what I call the “social conditions of innovative enterprise”, may support or undermine innovative enterprise. The theory of innovative enterprise permits social science to link the evolution and interaction of economic institutions, business organizations, and industrial sectors in one integrated conceptual framework.

Institutions, Enterprises, and Sectors in Shaping Social Conditions of Innovative Enterprise Social Conditions of Innovative Enterprise

Economic Institutions Governance Employment Investment

reform enable and proscribe

Strategic Control Organizational Integration Financial Commitment embed

Industrial Sectors Markets Technologies

constrain

shape

Business Enterprises Organization

Strategy transform

Finance Competition

challenge

Strategy and organization within the firm Strategy and Learning

Innovative Skill Bases

Who allocates resources? Are they integrated with learning processes?

Functional Technical Specialists

Skilled “Semi” Skilled Unskilled

Production Workers

Hierarchical Integration?

Middle

Broad skill base: functional integration

How broad and deep are the skill bases that the learning process requires?

Top Executives

Managers

Deep skill base: hierarchical integration

Integration? Technical Specialists Office Workers

Skilled “Semi” Skilled Unskilled

Research agenda: how do innovative skill bases vary in breadth and depth across nations, industries, and enterprises at a point in and over time?

US managerial control confronts UK craft control United States

Executives

=Hierarchical Integration

Specialists XXXXXXXXXXXXXXXXXXXXXXXXXXXX

“Semi-skilled” workers =Functional Segmentation

Britain Executives XXXXXXXXXX

Specialists Craft Workers and Assistants

XXX =Hierarchical Segmentation

Organizational integration and international competition United States and Japan, circa 1980 United States

=Hierarchical Integration = Hierarchical Interaction

Executives ?

?

Specialists ?

?

XXXXXXXXXXXXXXXXXXXXXXXXXXXX

“Hourly” Operatives =Functional Segmentation

Japan

Lazonick: UMass Lowell

Executives Specialists

XXX =Hierarchical Segmentation

Regular Male Operatives XXXXXXXXXXXXXXXXXXXXXXXXXXXXXX

Females/Temporary Employees

German and Japanese business models compared =Hierarchical

Germany

Integration = Hierarchical Interaction

Executives Specialists Craft Workers

Japan

= Functional Segmentation

Executives Specialists

XXX = Hierarchical Segmentation

Regular Male Operatives XXXXXXXXXXXXXXXXXXXXXXXXXXXXXX Most females and temporary employees

Institutions and international competition: 1980s

Product quality

Product cost

High quality

Low cost

High cost

Japan

Germany

Italy France Low quality

United States (OE)

Britain

Followed by adaptation &globalization in 1990s and 2000s

WINNER OF THE 2010 SCHUMPETER PRIZE COMPETITION

The shift from the Old Economy business model (OEBM) to the New Economy business model (NEBM) has resulted in the stock market becoming much more central to the operation of the firm than previously Published in September 2009 by the Upjohn Institute for Employment Research 1. What is New, and Permanent, about the “New Economy”? 2. The Rise of the New Economy Business Model 3. The Demise of the Old Economy Business Model 4. Pensions and Unions in the New Economy 5. Globalization of the High-Tech Labor Force 6. The Quest for Shareholder Value 7. Prospects for Sustainable Prosperity

OEBM

NEBM

Strategy, product

Growth by building on internal capabilities; business expansion into new product markets based on related technologies; geographic expansion to access national product markets.

New firm entry into specialized markets; sale of branded components to system integrators; accumulation of new capabilities by acquiring young technology firms.

Strategy, process

Corporate R&D labs; development and patenting of proprietary technologies; vertical integration of the value chain, at home and abroad.

Cross-licensing of technology based on open systems; vertical specialization of the value chain; outsourcing and offshoring.

Organization

Secure employment: career with one company; salaried and hourly employees; unions; defined-benefit pensions; employer-funded medical insurance in employment and retirement.

Insecure employment: interfirm mobility of labor; most salaried; broad-based stock options; non-union; defined-contribution pensions; employee bears greater burden of medical insurance.

Finance

Venture finance from personal savings, family, and business associates; NYSE listing; payment of steady dividends; growth finance from retentions leveraged with bond issues.

Organized venture capital; initial public offering on NASDAQ; low or no dividends; growth finance from retentions plus stock as acquisition currency; stock repurchases to support stock price.

Indigenous innovation in China Pioneering study of China’s emerging ICT sector, published in 2000 by the late Qiwen Lu Studies of Stone Group, Legend Computer (Lenovo), Founder Group, China Great Wall Computer summary in W. Lazonick, “Indigenous Innovation and Economic Development,” Industry & Innovation, 11, 4, 2004). In 2006, “indigenous innovation” became the centerpiece of China’s Medium and Long-Term Plan for Science and Technology See Lazonick & Li, “China’s Path to Indigenous Innovation” under revision

National institutions and business organizations in the innovation process Governance institutions and strategic control: What are the rights and responsibilities that govern the allocation of productive resources (labor and capital) in the economy? Where in the economy is control over allocation decisions located? What are the social processes that monitor, sanction, and reform such control? Employment institutions and organizational integration: To whom does society provide education, training, and access to research? Through what organizations? For what purposes? Who pays? How do people get jobs? With what expectations of rewards over what time frame? Are careers within or across firms? Investment institutions and financial commitment: How are financial resources mobilized in the economy for investments in productive resources? From what sources? On what terms? With what expected returns?

Business academics o Business academics need a theory of innovative enterprise in order to render “resource-based” theories of the firm dynamic, to add rigor to concepts such as “dynamic capabilities”, and to critique faulty ideologies such as “ maximizing shareholder value ” . The theory of innovative enterprise permits a critical evaluation within a coherent conceptual framework of many of the leading perspectives on the operation and performance of business enterprise that have emanated from business schools since the 1980s.

Approaches to Innovation and Theories of the Firm Social institutions National Innovation Systems Competitive Advantage of Nations Sources of Industrial Leadership

Social Conditions of Innovative Enterprise

Theory of the Innovative Enterprise

Industrial Sectors Business Enterprises Five Forces Competitive Advantage Transaction-Cost Theory Resource-Based Theory Agency Theory Disruptive Technology Game Theory Econ. of Industrial Innovation Knowledge Creation Theory of the Growth of the Firm Evolutionary Theory Dynamic Capabilities

Innovation theory and transactions-cost theory Critique of Oliver Williamson, The Economic Institutions of Capitalism (1985) in William Lazonick, Business organization and the Myth of the Market Economy (1991), ch. 5 and 6. Williamson, Markets and Hierarchies (1975) tries to the explain existence of firms by the concepts of “bounded rationality” and “opportunism “ – but these two concepts predict markets, not hierarchies -- he had to introduce the concept of “asset specificity” to predict hierarchies, despite the existence of “bounded rationality” and “opportunism” – but “asset specificity” is given to the firm: Williamson has no theory of innovative enterprise

Transforming transaction-cost theory into innovation theory

Financialization and shareholder value Financialization of the corporation: the evaluation of the performance of a company by a financial measure such as earnings per share rather than by the goods and services that it produces, the customers it serves, and the people whom it employs. Ideology that legitimizes financialization: “maximize shareholder value” (MSV) • MSV emerged in the US in the early 1980s as a corporate response to the failure of conglomeration, Japanese competition, and the erosion of savings by inflation • by the end of the 1980s MSV was the dominant ideology in business schools and corporate boards in the US ©William Lazonick

Jensen: Disgorge the free cash flow “Free cash flow is cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital. Conflicts of interest between shareholders and managers over payout policies are especially severe when the organization generates substantial free cash flow. The problem is how to motivate managers to disgorge the cash rather than investing it at below cost or wasting it on organization inefficiencies.” Michael C. Jensen*, AER, 1986, p. 323. •At the time Jensen was a newly appointed Professor, Harvard Business School and Chief Academic Cheerleader for Maximizing Shareholder Value

Disgorge the free cash flow!!

Maximizing Shareholder Value • Agency theory argues that it is only shareholders who make productive contributions to the economy without a guaranteed return • Agency theory argues that since we live in a “market economy”, all other types of economic actors get a return, determined by the forces of supply and demand, that is guaranteed, i.e., they are paid upfront or by contract • Agency theory is WRONG – we live in an economy in which big government and big business play essential roles in the allocation of resources to investments in innovation • Innovation theory argues that taxpayers and workers invest in innovation without a guaranteed return

Business analysts o Business analysts need a theory of innovative enterprise so that they can engage in in-depth research on the sources and sustainability of the innovative performance of successful firms and uncover why unsuccessful firms fail to be innovative. The theory of innovative enterprise can contribute to a significant improvement in “industry studies” carried out within academic institutions, business enterprises, and government agencies.

Schumpeter on “historical experience” Schumpeter, History of Economic Analysis, 1213: “Nobody can hope to understand the economic phenomena of any, including the present, epoch who has not an adequate command of the historical facts and an adequate amount of historical sense or of what may be described as historical experience”. By “historical experience”, Schumpeter meant the ability of the researcher to integrate theory and history. That is, for theory to be relevant to real-world phenomena, it must be derived from the rigorous study of historical reality.

Integrating theory and history • One derives theoretical postulates from the study of the historical record, and uses the resultant theory to analyze history as an ongoing and, viewing the present as history, unfolding process. • Through this iterative methodology, theory serves as an abstract explanation of what we already know and as an analytical framework for identifying and researching what we need to know. • The theory of innovative enterprise is both a product of the comparative-historical study of economic development and a process for the integration of new knowledge into a more rigorous and relevant perspective on an evolving economic reality.

E-Resources for Industry Studies (e-ris) • The Internet revolution has transformed the possibilities for researchers, armed with academic methods and resources, to acquire a deep empirical understanding of innovation processes and their potential contributions to sustainable prosperity. • No longer do we have to travel to specialized libraries to gain access to company reports, news sources, and government data. • No longer do we have to devote weeks to sifting through reams of newspapers or rolls of microfiche to try to find relevant material. • No longer do we have to spend considerable time and money photocopying journal articles that we think that we may need. Research that once cost thousands and consumed months can now be done cheaply and quickly from our computers if the researcher can access the necessary e-resources – and if one has a theory of innovative enterprise with which to analyze all this information.

Business executives o Business executives need a theory of innovative enterprise so that they can make long-term decisions to invest in and sustain the innovation process. For example, if business executives were equipped with a theory of innovative enterprise, they would find it difficult to adhere to an ideology that the companies over which they exercise allocative control should be run to “maximize shareholder value” – an ideology that is destructive of innovative enterprise. They would also find it impossible to justify their own levels of pay, and the manipulative practices in which they engage to benefit themselves.

A surprising critic of shareholder value John F. Welch became CEO of GE in 1981 Mr. Welch published his memoirs in 2001 But it took Jack some eight years, and a massive financial meltdown, to get his most critical thoughts on corporate management out of his gut.

“It is a dumb idea” In March 2009, John F. Welch, Jr., ex-CEO of GE told a Financial Times reporter: “On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy…your main constituencies are your employees, your customers and your products.” The reporter probably had a look of shock on his facem because Welch saw fit to reiterate: “It is a dumb idea. The idea that shareholder value is a strategy is insane. It is the product of your combined efforts – from the management to the employees.” Francesco Guerrera, “Welch rues short-term profit ‘obsession’,” Financial Times, March 12, 2009.

The “dumb idea” is the dominant US managerial ideology • As put forward by agency theorists, MSV is ostensibly a theory that supports the interests of shareholders • But MSV was embraced as an ideology of top corporate executives – legitimizes corporate resource allocation that ignores the interests of taxpayers and employees in the name of superior economic performance • Yet both taxpayers and employees contribute to the innovation process and have a claim to returns if and when they occur • Public shareholders do not generally invest in the innovation process – they invest in shares that are already on the market

Government policy-makers o Government policy-makers need a theory of innovative enterprise so that that they can make coherent decisions concerning investments in human and physical infrastructure and provide subsidies that support the innovation process. The theory of innovative enterprise is essential for understanding the role of “ the developmental state” in the performance of a national economy. It also undermines the “ free market ” case for deregulation – which serves to support predatory behavior.

National Institutes of Health budgets 1938-2011 Total NIH spending, 1936-2011 in 2011 dollars=$792 billion NIH budget for 2012=$30.9 billion

Source: http://officeofbudget.od.nih.gov/approp_hist.html

The developmental/entrepreneurial state • The government often makes investments in physical and human infrastructures (including S&T knowledge bases) at stages at which these investments are far too early, too big, and too uncertain for businesses to undertake • Lazonick: “Strategies for Promoting US Competitiveness in World Markets”: e.g., railroads, land-grant college system, agricultural experiment stations, aeronautics (modern airliner, jet engines), computers, the Internet, life sciences, nanotechnology, clean technology • Mazzucato: The Entrepreneurial State makes this argument more generally, building on the theory of innovative enterprise

Informed citizens o Informed citizens need a theory of innovative enterprise so that they can elect politicians who recognize that innovation, supported by the developmental state, is fundamental to economic development. At the same time, these informed citizens would understand that the policy challenge is not only to support innovative enterprise but also to find ways in which it can contribute to equitable and stable economic growth.

Informed citizens need to understand inequitable growth?

http://www.motherjones.com/politics/2011/06/speedup-americans-working-harder-charts

The Great U-Turn Gini coefficient for all US families, 1947-2009 0.460 0.440 0.420 0.400

more equality

0.380

growing inequality

0.360

20 07

20 03

19 99

19 95

19 91

19 87

19 83

19 79

19 75

19 71

19 67

19 63

19 59

19 55

19 51

0.340

19 47

Gini coefficient

Gini coefficient

Concentration of income at the top Shares of total US income of highest income households, 1913-2010

Incomes of “named” executives, including percent from exercising stock options, United States, 1992-2010

Drivers of the stock market: Innovation, speculation, manipulation 1600

Stock-price movements September 1982-October 2009 SPECULATION

1400

November 1987=100

1200

MANIPULATION

1000 800 600

INNOVATION (NEBM) MANIPULATION (OEBM)

400 200

Source: Yahoo! Finance

S&P 500

NASDAQ

Sep-10

Sep-08

Sep-06

Sep-04

Sep-02

Sep-00

Sep-98

Sep-96

Sep-94

Sep-92

Sep-90

Sep-88

Sep-86

Sep-84

Sep-82

0

US corporations finance the stock market (not vice versa)

Buybacks push the S&P 500 Index to a new peak in 2007

©William Lazonick

Top corporate repurchasers, #1-25, 2001-2010

William Lazonick Ken Jacobson Lynn Parramore Series of five articles, April 1-5, 2012 http://files.alternet.org/uploads/pdfs/99corpsv2.pdf

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