More efficient innovation may be critical to staying competitive

One of the reasons we started Commodore was concern about a decline in Total Factor Productivity (TFP) in many major economies (e.g., US, China, Euro area). TFP is, put simply, the portion of economic growth that occurs from using either labor or capital more efficiently—in some ways it’s a measure of innovation within an economy. (A certain Commodore founder, who shall remain nameless, has been a bit of an economics geek ever since he watched Mr Hyslop furiously describe price elasticity of demand on a dusty chalkboard in Fifth Form Economics.)

Economists have been noting a decline in TFP in recent years. There’s still some debate, but if the decline is real, it could have a worrying negative impact on future economic growth since productivity gains, rather than growth in labor and capital, have been expected to be the dominant source of economic growth in the coming decades.

There is a multitude of things that could be done to help address TFP, from adjusting monetary policy to reforming education. But one of those things is to ensure companies are innovating efficiently. We all know there’s no shortage of appetite for innovation within firms, so (for this and a number of other reasons) Commodore’s focus is on helping with the “efficiently” part.

So, it was with some alarm that we recently came across an National Bureau of Economic Research working paper (did we mention the economics geek thing already?) which, at least at first glance, appears to suggest we have our work cut out for us: productivity of innovation efforts is declining. The researchers explain their findings using the example of the number of researchers required to maintain “Moore’s Law”:

The number of researchers required today to achieve the famous doubling every two years of the density of computer chips is more than 18 times larger than the number required in the early 1970s.

The researchers found similar evidence in other sectors (e.g. agriculture, medicine). They also found evidence of declining research productivity in a large set of publicly traded companies. The numbers are staggering. Research productivity is declining in 85% of companies in the sample. The rate of research productivity decline observed was 10% per year.

This trend should concern forward-looking business leaders because it could impact their ability to remain competitive*.

Declining research productivity means the cost of innovation is increasing—the next big breakthrough in your industry will be considerable more expensive than the last. But those higher costs will not necessarily impact all firms evenly—especially if labor is a significant component of innovation costs in your industry. Firms with access to lower cost R&D labor (e.g., in China, India) will have an advantage (assuming similar levels of productivity). Firms without such access may struggle to cost effectively keep pace with innovation in their industry. The current rise of economic nationalism globally further complicates matters; for example, increasing trade barriers may limit companies’ ability to access lower cost R&D labor.

For firms facing this problem, continuing to globalize R&D/innovation and fighting against economic nationalism are potential options. So too is investing in building a more efficient innovation system within your company—and the risk adjusted return of this option is arguably the more attractive.

*Taken to the extreme this trend in declining research productivity could lead to an existential crisis for “innovation.” As research productivity declines, the cost of a company achieving the ultimate objective of profitable revenue growth through innovation will increase. At some point firms will increasingly favor investment in alternative sources of growth, and reduce their investment in innovation.