Lesson 6: Incentives, Innovations, and Roles of Institutions

Introduction

This lesson uses examples, video clips and a risk-reward mini activity to teach the relationship between innovation and economic growth.

Objectives

At the competition of this lesson students will be able to:

• Differentiate between invention and innovation.
• Provide examples of the costs and benefits of innovation.
• Explain the relationship between innovation, productivity and economic growth.
• Explain the role of entrepreneurship in economic growth.
• Identify institutions that encourage entrepreneurship.

Economic Concepts

Invention	Incentives	Entrepreneur
Innovation	Investment	Residual claimant
Technology	Economic growth	Profit
Productivity

Key Ideas

1. Review:

ERP-3: People respond to incentives in predictable ways.
Choices are influenced by incentives, the rewards that encourage and the punishments that discourage actions. When incentives change, people’s choices change in predictable ways.

• Economic growth is a sustained increase in a nation’s production of goods and services.
  • Increases in productivity, as the result of investments in human and physical capital, raise incomes and standards of living.
    • (Figure 1 – population and innovation graph – North)
  • Innovation – the successful introduction of technological advances – and education are the major sources of increases in productivity.
• Evidence about the relative well-being of people in nations with different institutions – the formal and informal rules of the game that shape incentives and outline expected and acceptable forms of behavior in social interaction – tells us that institutions matter.
  • Institutions that foster economic growth are those that reward entrepreneurship for innovations that increase productivity.

2. Technological progress makes possible wealth-enhancing increases in productivity.

• Technology is, fundamentally, a collective body of knowledge – what human societies know and have recorded. It is not simply a collection of tools, scientific equipment, or artifacts.
  • In its basic form, technology consists of instructions for the production of goods and services. The recipes are based on human knowledge of natural phenomena; as we learn more about the physical world, we can devise better recipes and better manage our limited resources for production.
• Technological progress occurs not at the point of invention – the discovery of new knowledge – but at the point of innovation – when an increase in productivity arises from the market-proven application of new technology.

3. Innovation is inextricably linked to entrepreneurship.

• Innovation occurs only when entrepreneurs recognize the implications of new technologies (knowledge) and put them into productive use.
• The institutional framework of an economy may facilitate or inhibit this transfer of knowledge to production. The Soviet Union, for example, produced many inventions, but few innovations.
• Economic growth occurs when a nation’s institutions provide incentives for entrepreneurship.

4. Profit, the reward for successful entrepreneurship, helps to allocate resources, including entrepreneurial talents, to their most highly-valued uses.

• Economists distinguish between labor and entrepreneurship. Entrepreneurs are investors, risking their resources in the present with the expectation of future profits. They organize the activities of others, including laborers, in productive endeavors.
  • Laborers, who do not bear the risks of production or the promise of future rewards, trade their time and talents for wages.
• Because entrepreneurs are responsible for the ultimate outcome of investments, they are also known as “residual claimants.”
  • As risk-takers, they claim the “residual” – what remains after all the costs of production have been paid. This residual is called “profit.”
    • Successful investment leaves a positive “residual” – or profit.
    • Profit acts as a magnet, drawing in other resources, including competing entrepreneurs.
    • Unsuccessful investment leaves the entrepreneur with bills to pay; the “residual” he claims is a loss.
      • Losses discourage further investment, freeing up resources, including entrepreneurial talents, for more highly valued uses.
• Innovative entrepreneurs must be willing to bear the risks of production, gaining from profits and learning from losses.
  • Profitable innovations attract resources, but also attract competitors.
  • Increased competition reduces profits and encourages an on-going search for improved products and lower-cost methods of production.
  • Unprofitable innovations create information about what is valuable in a market or economy – and what is not valuable!
  • Note that the innovative process is a classic example of the famous economic dictum: Profit is the motivator, competition is the regulator.

5. Innovation creates a dynamic economy.

• Entrepreneurs who successfully innovate create wealth. They also pose challenges to others affected by the innovations.
  • Existing products and services can become obsolete or inefficient in the face of more innovative products or services.
  • Owners of existing products or services are provided incentives to innovate in the presence of other innovative competitors; otherwise, their wealth will be adversely affected as their resources lose value.
  • The on-going market challenge presented by new innovations is known as “creative destruction”.

6. Innovation requires investment in both human and physical capital.

• Investment is the willingness to forego consumption now in anticipation of greater rewards in the future.
• Investment is risky, so the “future rewards” must be sizable enough to compensate for the risks.
• Investment decisions are made by comparing the risks and the potential rewards: the greater the risk, the greater the potential reward necessary to convince the entrepreneur to act.

7. Nations with institutions that encourage entrepreneurship also encourage the innovation that leads to economic growth and rising standards of living.

• Entrepreneurial innovation leads to improvements in product quality at generally lower costs and market prices.
• Governmental institutions may encourage or discourage growth-producing innovation:
  • Stable property rights and well-enforced rule of law attract entrepreneurship.
  • Particularly important in reducing risk for entrepreneurs is the government’s record of enforcement of multi-period contracts.
  • Business taxes, regulations, and poorly-protected property rights discourage entrepreneurship by reducing return on or increasing the risk of investment – or both.

Ideas To Take Away From This Lesson

• New ideas, products and processes that pass the test of the market are considered innovations.
• Innovation is the key to increased productivity and economic growth.
• Institutions that reward entrepreneurship create incentives for more innovation.
• The economic changes that result from ongoing innovation impose costs and create benefits. Historical evidence, in the form of the increasing wealth of nations that support entrepreneurship, supports the contention that the benefits greatly outweigh the costs.