Research

The two faces of entrepreneurship part two: Innovative entrepreneurs bring new wealth to the economy

All entrepreneurship is not the same. Innovative entrepreneurs create and commercialize new products, services and business practices, in contrast to the replicative entrepreneurs — those who open businesses that support a growing population, such as restaurants and dry cleaners. Experts at the W. P. Carey School of Business and Arizona State University caution that the two kinds of entrepreneurs impact economies in very different ways at different stages of economic development. Because of this, the dynamics of entrepreneurship should be weighed carefully by policy makers.

2006-09-13

All entrepreneurship is not the same. Take Arizona as an example. It is known as a hot spot for entrepreneurs, based on the overall number of companies four to fourteen years old with at least five employees and a pattern of employment growth. A closer look at the numbers, however, reveals that most are replicative entrepreneurs — those who open businesses that support a growing population. Included among these replicative enterprises are dry cleaners, video rental stores, and fast food restaurants.

But entrepreneurs come in two stripes. In contrast to the replicative entrepreneurs, the innovators create and commercialize new products, services and business practices. The existence of innovative companies and entrepreneurs varies significantly across the country and changes over time. Silicon Valley and Boston's Route 128 have been the exemplars for innovative entrepreneurship over the last 25 years.

However, other significant pockets have evolved in Seattle, San Diego, Austin, Philadelphia, and the Research Triangle area of North Carolina. Experts at the W. P. Carey School of Business and Arizona State University caution that the two kinds of entrepreneurs — replicative and innovative — impact economies in very different ways at different stages of economic development. Because of this, the dynamics of entrepreneurship should be weighed carefully by policy makers.

A primer: entrepreneurship and the stages of economic development

As most commonly used, the term economic growth is defined as increases in Gross Domestic Product (GDP) per person, explains Arthur Blakemore, chairman of the economics department at the W. P. Carey School. "Since national income grows in step with GDP, this measure is used as a proxy for the standard of living," he said. "Over a period of time, wages and employment also tend to grow with improvements in GDP per person. Thus, a great deal of attention is paid to economic growth."

Growth generally follows a fairly common process across countries and geographic regions, he added. "In the early stage of development, resources flow out of very basic agricultural production into other economic activities, most often manufacturing. Since manufacturing enjoys higher levels of productivity relative to rudimentary agriculture, the flow of resources increases the output produced per person in the economy and, correspondingly, the standard of living improves."

Blakemore explained that neither the manufacturing process nor the products being produced at this stage need be cutting edge for the standard of living to improve. In fact, he said, these economies have a comparative advantage in production techniques and goods that are relatively labor intensive because of their low labor costs.

"The manufacturers rely entirely on replicative entrepreneurship at this stage," Blakemore said.

"They borrow techniques from others and often use vintage capital equipment. Inevitably, the replicative process introduces new sophistications allowing this economy to progress further while at the same time, new low-cost competition enters from other developing areas and takes over the less sophisticated production."

Economies can enjoy spectacular periods of economic growth at this stage of development — think China right now — because few resources need be used in innovation. They merely need to adopt what has already been invented and make use of their comparative advantages. But in later stages of development, economies tend to lose their comparative advantage in manufacturing and move resources from manufacturing into services.

The production that does remain in agriculture and manufacturing becomes more cutting edge in nature. As economies approach the technological frontier, Blakemore explained, economic growth rates decline as replication can no longer increase GDP per person. "That's because a given production process without innovation can only produce the same amount of output per worker that it always did," he said. "At the frontier, without innovation, economies can merely maintain a certain GDP per person.

Furthermore, even maintaining that standard of living becomes challenging, because newly developing low cost producers enter the market. If economies are to grow beyond this standard of living, the far more difficult process of innovation must take place." Therefore, to grow the standard of living, a region must increasingly transition to the innovation phase. But how does this happen?

The face of the innovative entrepreneur

Albert Cannella Jr., professor of management at the W. P. Carey School, says that sometimes the difference between an innovative venture and a replicative one is subtle. "Innovative entrepreneurship may cover what's been tried and has failed in the past, for example," he said. Marketing Professor Rajiv Sinha agrees.

"There are really two parts that go into innovative entrepreneurship," Sinha said. "One is the invention — coming up with a new idea for a good or service. But the other is successfully converting that idea into a product or service and commercializing it." In that sense, Cannella says, an electric car that really worked and was well-adopted by consumers would be an innovation. Even though electric cars have been produced (invented) before, they have yet to be successfully commercialized.

Innovators also might look quite different from one another, says W. P. Carey Dean Robert Mittelstaedt. "There are innovators who develop new technologies, like we're seeing right now with biotechnology. There are innovators like Michael Dell who pair existing technologies with a creative business model. And there are entrepreneurs who find innovative ways to improve applications of new and existing technologies, as Innovative Solutions & Support Inc. did when designing flat-screen displays for airplane cockpits," Mittelstaedt explained.

The common thread among each type of innovator, Mittelstaedt says, is that they all continue to innovate to sustain their business. "Motorola began by making converters and has transitioned from there to car radios, to mobile radios for World War II, to TVs, to stereos, and to cell phones. Faced with new low cost producers for its existing product line, the company would have failed had it not continuously innovated."

But for the entrepreneur looking to innovate, whether by developing a new good or service, employing a new business model, or applying existing technologies in new ways, the question is: how do I come up with that innovation? According to Phillip Regier, deputy dean of the W. P. Carey School, "Sometimes innovation is consciously pursued, other times a person or company falls into it."

"The Phoenix company TGen, for example, quite consciously pursues innovation through state-of-the-art research. Right now they're trying to take the latest developments in medicine and transfer them to the bedside to serve a global population," Regier said.

In contrast, Regier added, "Another Phoenix company, JDA Software, was created when its founder realized that then-available supply chain management software for retail companies wasn't sophisticated enough. He took that realization and turned it into an innovation, which now serves a global population."

The role of the innovative entrepreneur in the economy

According to Sinha, innovative entrepreneurship impacts the economy at three levels: at the aggregate level, at the consumer level, and at the firm level. "The positive effects of innovation percolate through the economy," he said. At the aggregate level, Sinha says that innovative entrepreneurship, like its replicative cousin, benefits the overall economy by creating new jobs and increasing income, raising the potential for new investments.

In fact, Sinha says, new research demonstrates that it is the gazelles — innovative companies that have experienced annual growth rates greater than 20 percent for four or more years — that create the largest number of new jobs in the U.S. At the consumer level, the effect of innovation is the added value for consumers — the improved products or services available to them at lower costs.

At the firm level, innovators can out-compete other companies that are not innovators, because of the cost advantages that innovation produces. Furthermore, firms that produce innovative goods and services are also more likely to adopt new innovations.

Cultivating innovative entrepreneurship

If innovative entrepreneurship is the key to increasing standards of living, then the "$50 million dollar question," as Regier calls it, is: how do you cultivate innovation? Arthur Blakemore, professor and chairman of the W. P. Carey School's economics department, says that minimal regulations, a competitive and economically efficient tax system capable of supporting an appropriately competitive infrastructure, openness to trade and competition, and facilities for R&D are all necessary factors in an innovative economy.

"It's not likely that policymakers can directly guide innovation, but they can provide the kind of environment that fosters it," Blakemore said. Furthermore, "R&D is very important. Clearly all of the most famous clusters of innovation — Silicon Valley, Route 128 in Boston, the Research Triangle in North Carolina — they all have universities in proximity producing basic R&D that can ultimately be commercialized," he said.

According to Cannella, the famous clusters of innovation have another factor in common: a critical mass of companies involved in innovation. "Silicon Valley became the innovation mecca it is today almost by accident. HP started there in a rented-out garage, and its presence attracted other companies, which attracted others, and so on," he said. This type of clustering produces what is called network externalities, Blakemore said. Innovative firms accrue production advantages from their proximity to other innovators. The clustering provides synergy, a knowledge base, a talent base and an efficient means of transferring information.

Mittelstaedt notes that the presence of large innovating companies is important. "If you want to cultivate innovative entrepreneurship, you have to have large innovative companies, because they spawn start-ups. A lot of innovative entrepreneurs get their technical experience working for a large company. Once they come up with the innovative idea, they leave the company to go out on their own," he said.

The presence of a well-funded university involved in R&D is also a critical factor for an innovative economy. "States with innovative economies, including California, Massachusetts, and Texas, have invested a lot more in higher education than other states. A highly trained labor force and a culture of lifelong learning are important factors in the cultivation of innovative entrepreneurship," Sinha said.

But only one-third of all R&D expenditures are made in the services sector, which now makes up 70 percent of the U.S. economy. Manufacturing, once the backbone of the U.S. economy, now only makes up 17 percent of all economic activity in the U.S., though two-thirds of all R&D is still focused there. "Clearly," Sinha said, "we need to do more to cultivate innovation in the services sector."

In addition to serving as centers for R&D, Regier says that universities also must do well at educating innovative entrepreneurs. "There are two types of education that innovative entrepreneurs need to be successful: on one hand, they need a really solid technical understanding; and on the other hand they need an education that stimulates creativity and imagination." Those two types of education, Regier says, are somewhat opposed to each other. "We can deal with that paradox, though," he said, citing the W. P. Carey School's new dual business and bioengineering degree as an example.

Sinha says that "Innovation involves changing the status quo with respect to customer experiences, product performance, business processes, alliances, and the channels of distribution or the way the product or service is ultimately delivered to consumers. Thus, teaching innovation is not just about teaching students how to develop new goods or services, but how to explore their ideas, and develop their latent potential for innovation. "I try to get students to explore their ideas, to see market trends, look for consumer acceptance. I try to get students to think in a systematic way pertaining to all the aspects of innovation mentioned earlier," Sinha said.

The future for innovative entrepreneurs in Arizona

Sander van der Leeuw, professor and director of ASU's School of Human Evolution and Social Change, just finished work on a four-year interdisciplinary study funded by the European Union that looked at the role of innovation as a driver of urban growth, and at innovation in Italian business districts. Innovation and competitiveness increases when companies that are similar or complementary operate in a cluster environment, the study found. Proximity to other companies enables innovators to see a bigger picture.

"You invent a widget that you need," Van Der Leeuw postulated, "but within your network others see possible modifications" — changes that make the widget valuable in ways that you never imagined. So the size and nature of your network is of importance in determining whether your invention will indeed succeed in the marketplace.

But far-flung cities like Phoenix, which are bound together with highways and cars, tend to compartmentalize people and businesses, he said. That serendipitous encounter with someone who looks at your widget with fresh eyes is less likely to occur. So, Van Der Leeuw says, the important question is: how does a business network form? Who links up with whom? Do they compete or cooperate, or both? And who opts out?

Innovation can be stimulated strategically, he believes, and universities and local governments can play important roles. For example, an entrepreneur in Spain was able to energize a regional economy that had consisted mostly of cobblers. He lined up government support to establish an institute that helped the cobblers learn new techniques and provided the technologies that enabled them to develop new products. He came up with the investments that served everyone but that no one could afford. A university might perform that function, he speculated.

"It seems that there is in Phoenix a disconnect between the part of our economy (building, services) that grows by accommodating the influx of new inhabitants, and the part of our economy that creates new value by means of innovation," he said. "I'd like to explore which kinds of links exist between the two, and then to see whether we can increase innovativeness through focused action, such as creating some of those missing links between the two parts of the economy."

In the end, there's really no tried-and-true prescription for creating an innovative economy. But it's clearly important to engage the methods that are known to work — from building necessary infrastructure to supporting higher education and offering tax incentives — to ultimately raise standards of living.

Bottom Line:

• Innovative entrepreneurs create and commercialize new products, services and business practices, in contrast to the replicative entrepreneurs — those who open businesses that support a growing population, such as restaurants and dry cleaners.
• The two kinds of entrepreneurs impact economies in very different ways at different stages of economic development. Because of this, the dynamics of entrepreneurship should be weighed carefully by policy makers.
• As economies approach the technological frontier, economic growth rates decline because replication can no longer increase GDP per person. Therefore, to grow the standard of living, a region must increasingly transition to the innovation phase.
• There's really no tried-and-true prescription for creating an innovative economy, but it's clearly important to engage the methods that are known to work — from building necessary infrastructure to supporting higher education and offering tax incentives.

Economics Entrepreneurship Faculty