Lesson 6: Incentives, Innovations, and Roles of Institutions

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

Mini Activity

  • Risk-Reward Currency Auction


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

National Content Standards Addressed

Standard 4: Incentives Matter

People respond predictably to positive and negative incentives.

  • Acting as consumers, producers, workers, savers, investors, and citizens, people respond to incentives in order to allocate their scarce resources in ways that provide the highest possible returns to them.

Standard 9: Role of Competition

Competition among sellers lowers costs and prices, and encourages producers to produce more of what consumers are willing and able to buy. Competition among buyers increases prices and allocates goods and services to those people who are willing and able to pay the most for them.

  • The introduction of new products and production methods by entrepreneurs is an important form of competition, and is a source of technological progress and economic growth.

Standard 10: Institutions

Institutions evolve in market economies to help individuals and groups accomplish their goals. Banks, labor unions, corporations, legal systems, and not-for-profit organizations are examples of important institutions. A different kind of institution, clearly defined and well enforced property rights, is essential to a market economy.

  • Property rights, contract enforcement, standards for weights and measures, and liability rules affect incentives for people to produce and exchange goods and services.

Standard 13: Income and Productivity

Income for most people is determined by the market value of the productive resources they sell. What workers earn depends, primarily, on the market value of what they produce and how productive they are.

  • To earn income, people sell productive resources. These include their labor, capital, natural resources, and entrepreneurial talents.

Standard 14: Profit and the Entrepreneur

Entrepreneurs are people who take the risks of organizing productive resources to make goods and services. Profit is an important incentive that leads entrepreneurs to accept the risks of business failure.

  • Entrepreneurs are individuals what are willing to take risks in order to develop new products and start new businesses. They recognize opportunities, enjoy working for themselves, and accept challenges.
  • Innovation is the introduction of an invention into a use that has economic value.
  • Entrepreneurs compare the expected benefits of entering a new enterprise with the expected costs.
  • Entrepreneurs accept the risks in organizing resources to produce goods and services, and they hope to earn profits.
  • Entrepreneurial decisions affect job opportunities for other workers.
  • Entrepreneurial decisions are influenced by government tax and regulatory policies.

Standard 15: Investment

Investment in factories, machinery, new technology, and in the health, education, and training of people can raise future standards of living.

  • Increases in productivity result from advances in technology and other sources.
  • Economic growth is a sustained rise in a nation’s production of goods and services. It results from investments in human and physical capital, research and development, technological change, and improved institutional arrangements and incentives.
  • Historically, economic growth has been the primary vehicle for alleviating poverty and raising standards of living around the world.
  • Economic growth creates new employment and profit opportunities in some industries, but growth reduces opportunities in others.
  • Investments in physical and human capital can increase productivity, but such investments entail opportunity costs and economic risks.
  • Investing in new physical or human capital involves a trade-off of lower current consumption in anticipation of greater future production and consumption.
  • The rate of productivity increase in an economy is strongly affected by the incentives that reward successful innovation and investments (in research and development, and in physical and human capital).

Key Ideas

Download full lesson guide for procedures and teaching tips.

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.

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