The economics of innovation

One of the services we provide is innovation support. We help companies of all sizes when they need help with the concrete parts of developing new digital products or services for their business, or making significant changes to their existing products.

A few weeks ago the Royal Swedish Academy of Sciences awarded the Nobel Prize for Economics to Oliver Hart and Bengt Holmström for their work in contract theory. This prompted me to look at some of his previous work (for my sins I find economics fascinating), and I came across his 1998 paper Agency Costs and Innovation. This is so relevant to some of my recent experiences I wanted to share it.

Imagine you have a firm or a business unit and you have decided that you need to innovate.

This is a pretty common situation – you know strategically that your existing product is starting to lose traction. Maybe you can see commoditisation approaching in your sector. Or perhaps, as is often the case, you can see the Internet juggernaut bearing down on your traditional business and you know you need to change things up to survive.

What do you do about it?  If you’ve been in this situation the following will probably resonate:

agency2

This describes the principal-agent problem, which is a classic in economics. This describes how a principal (who wants something) can incentivise an agent to do what they want. The agent and “contracting” being discussed here could be any kind of contracting including full time staff.

A good example of the principal-agent problem is how you pay a surgeon. You want to reward their work, but you can’t observe everything they do. The outcome of surgery depends on team effort, not just an individual. They have other things they need to do other than just surgery – developing standards, mentoring junior staff and so forth. Finally the activity itself is very high risk inherently – which means surgeons will make mistakes, no matter how competent. This means their salary would be at risk, which means you need to pay huge bonuses to encourage them to undertake the work at all.

In fact commonly firms will try and innovate using their existing teams, who are delivering the existing product. These teams understand their market. They know the capabilities and constraints of existing systems. They have domain expertise and would seem to be the ideal place to go.

However, these teams have a whole range of tasks available to them (just as with our surgeon above), and choices in how they allocate their time. This is the “multitasking effect”. This is particularly problematic for innovative tasks.

My personal experience of this is that, when people have choices between R&D type work and “normal work”, they will choose to do the normal work (all the while complaining that their work isn’t interesting enough, of course):

variance

This leads large firms to have separate R&D divisions – this allows R&D investment decisions to take place between options that have some homogeneity of risk, which means incentives are more balanced.

However, large firms have a problem with bureaucratisation. This is a particular problem when you wish to innovate:

monitoring

Together this leads to a problem we’ve come across a number of times, where large firms have strong market incentives to spend on innovation – but find their own internal incentive systems make this extremely challenging.

If you are experiencing these sorts of problems please do give us a call and see how we can help.

I am indebted to Kevin Bryan’s excellent A Fine Theorem blog for introducing me to Holmström’s work.