The innovation fallacy

It is the dirty little secret of innovation economics and policy that we do not know if it works. Here I propose that the tenuous link between innovation policies and innovative outputs are at least partly due to what I call the ‘innovation fallacy’. I argue that innovation policy is only solving half of the problem that it seeks to ameliorate.

The conventional economic ‘innovation problem’ is what supposedly provides the rationale for innovation policy. The story is that in a free market there are fewer resources dedicated to innovative activities than what is deemed to be some optimal ‘socially desirable’ level. That is, we do not have enough research and development (R&D) and that research and development is good.

The familiar diagnosis given here is one of ‘market failure‘. As we well know the faint allure of market failure is swiftly followed by calls for some state-based cure. ‘Market failure’ and ‘the need for state intervention’ are not inextricably coupled; rather they are very separate claims (this is a story for a separate post).

What I wish to clarify here is the underlying innovation problem that innovation policy is trying to solve has two parts. The first part takes the form of a technical or scientific problem. This is where investments in new technology are important and is usually the task of engineers, scientists, or hackers. This is also where innovation policy focuses.

But there is also another part of the problem that is often ignored. This is is problem the entrepreneur faces in acquiring and applying information about the catalytic economy to a new technology. This is an extremely uncertain task.

Entrepreneurs need information about: who wants the technology; how they will use it; what price points; under what conditions; in which jurisdictions; under what regulatory regime; complementary investment possibilities; what constellation of comparative advantages; potential economic externalities and so on and so on.

This entrepreneurial information about market opportunities is costly, distributed and shrouded in uncertainty.

Thus innovation is not simply about creating new things. Innovation — and the entrepreneurial process — is about creating new things that the market wants to buy. This is the distinction between an invention and an innovation. We may have as many inventions as we wish, but if they do not seek the demand of the market then that invention fails to provide the the very societal transformations we care about.

Innovation policy seems to rest on this innovation fallacy: that the innovation problem is solved once the technical phase is completed. This is tantamount to claiming that the recognition of market opportunities and the adoption and diffusion of innovation — the second phase — just occurs in some costless and frictionless process. This is clearly not the case. The bits of information I describe above are costly to produce, are generally learnt only through experience, and are largely contextual about a particular technology.

If the innovation fallacy is understood, where does the state sit in this process? This is an ambiguous and open question. I am not suggesting that an understanding of the innovation fallacy will somehow fix innovation policy. However it certainly will not break it. What is important for policy makers to understand is that more innovation policy does not necessarily generate more innovation because the underlying assumptions suffer from a fallacy.

This post is partly based on an upcoming conference paper which I will place up on SSRN soon. It outlines my PhD and presents a potential solution to the innovation problem that emerged from civil society institutions, not from state coercion: The Innovation Commons. See:

Allen, D. and Potts, J. 2015. ‘The innovation commons — why it exists, what it does, who it benefits, and how.’ A paper to be presented at the International Association for the Study of the Commons biannual global conference.

The innovation fallacy

Does occupational licensing ignore the creative destruction on skills?

Occupational licenses can be thought of as the fixed costs of entering a profession, with the intention of paying those costs off over a career. This argument is strong when a life-long career was a serious possibility. However, there is clearly increasing movement between occupations due to faster technological change.  Does this weaken the government-imposed education-licensing-approval problem? Is there an argument against occupational licensing citing the increased creative destruction on skills?

When Joseph Schumpeter introduced the concept of creative destruction he had a particular vision in mind. He told a story. That story was that the economy began in some state of rest, and entrepreneurs came along and disrupted this rest.

Entrepreneurs did this by introducing new combinations, technologies, businesses and so forth. What this did was destruct the incumbent businesses by taking their profits and customers. What was understood–at least to some economists and policy-makers–after this was that we should let the market process play out because the entrepreneur is a central determinant of change, thus engendering societal change, economic growth, prosperity, and so forth.

I want to suggest here that we may also envision creative destruction on skills, not on businesses. It is true–both by anecdote and data–that gone are the days of a life-long career. Individuals are moving between careers at a fast pace. As businesses evolve they require different skills of their employees. And in the same vein as creative destruction on businesses, these changing skills are fantastic for society. We want to encourage labour to be mobile between different occupations. Nevertheless–at least in the US–we’re seeing a huge number of licenses required to work. For example, see the recent work on opticians licensing in the US by Timmons and Mills at Mercatus:

What we have is an institutional system that requires many individuals to undertake specific, costly, and lengthy processes of education before entering a profession. Note that while I focus on occupational licensing here, it is clear this also includes the various degrees, and apprenticeships and so forth that are required to enter a profession. I focus on occupational licensing because it is the government-granted restriction. These can be seen as the fixed cost, or barrier to entry, through which you must pass to enter a profession. These are of course advocated in the ‘public interest’ (namely safety). But there must be a corresponding argument for the ‘public interest’ of innovation and the societal change it engenders.

We often ignore that increasing the barriers to entry to particular occupations creates friction in the movement of labour. This friction in labour is the equivalent of friction on industry and business structure (something that is more widely understood). Moreover, continually increasing occupational licensing requirements ignores the clear fact that individuals have a shorter time to pay off those fixed costs because of their movement between occupations.

Does occupational licensing ignore the creative destruction on skills?

Architects and planners: the perfect storm for rent seeking

On the weekend I attended an event at the Australian Institute of Architects (AIA). I walked out concerned about the future of our cities. Disclaimer: I am not an architect or a town planner; I am an economist. However the points in this article are general in nature and stem from literature around regulatory capturepublic choice theory and rent-seeking. The fact that these theories rarely enter the town-planning discussion is precisely my motivation.

The two broad points I make below are connected. First, that the institutional structure of our architecture and town planning industries have generated a perfect storm of rent-seeking. By rent-seeking I mean private agents using the tools of the political process to gain additional profit (rent).

And second, that the debates over planning and zoning regulations make the fundamental mistake that our the decision is between either central planning or no planning. This is not a debate over whether to plan, or not to plan. The question is who should do the planning: should it be individuals or should it be regulators?

Be warned, this is a fairly long post. So if you read no further, then just remember this:

‘True art is always spontaneous and can never adapt itself to the dictates of a public works commission.’ – Elisee Reclus in Anarchy, Geography and Modernity

Architects and planners have a love-hate relationship. On one hand architects have a distaste for planners because they make their jobs harder–rejecting plans, constant changing and ambiguous enforcement of rules, achieving impossible sustainability stars, and so on. But on the other hand, town planners don’t like architects because they constantly break their prescriptive rules and yell at them in public.

But telling this as a hate story misses the point. They also love each other. This is a symbiotic relationship because of the unique institutional characteristics of the industry. Let me muse over a few of these interesting aspects:

Architect is a protected title: It is against the law to refer to yourself as an ‘architect’ where you have not passed a certain level of requirements. These requirements are overseen by various jurisdictional boards (in Victoria, for example, there is the Architects Registration Board of Victoria [ARBV]). These boards are constantly lobbied to increase the entry requirements.  This is a problem because protected titles mean barriers to entry. Restricting the use of the label ‘architect’ decreases the supply of architects. This increases the average wage in the industry. Yes, this is economics 101. 

Of course, there are some possible arguments for registering professions. But these must be weighed up against the tendency for the barriers to rise higher and higher in the name of the ‘public interest’. Currently, Architects in Australia must endure an excessively lengthy and costly process: an approved degree; 3300 hours of architectural practice experience; a national examination paper; and an examination interview.  Following this arduous process–extending over approximately 7 years–architects are rewarded with compulsory registration fees for the remainder of their career. Why would architects want it to be so expensive? It may at first seem surprising that these weighty tasks are placed onto architects by lobbying architects. But there is an obvious reason; once you pass the registration you are granted the right to use the title.  You have jumped the barriers to entry and now you are inside them. A small fee is not your friend; preventing those pesky grads from stealing your work. This whole process makes the architecture pie bigger, it also splits it between fewer people (‘registered’ architects).

Architects earn commission based on build cost: While this is worth noting, it is not dissimilar to other industries (more on that with the next point). I am not suggesting that this is a problem in itself. But what commission-based work means is a classic principal-agent problem. That is, an architect is engaged in a project where their job is to serve the interests of their client, but their private incentive is to blow out the budget. It must be clear I am not suggesting that architects are bad people (I know many quite well). I am simply stating that people have been known respond to incentives; and the incentive on a commission-based project is increase the cost on which the commission is based.¹ There are a number of ways to ameliorate this problem. For example, by agreeing to some fiduciary duty when registering. However it is of course hard to prove that an architect has broken this duty in such a value-subjective profession (by picking a more expensive facade, for example). It is even harder to prove when they achieve that increase in build cost not through their direct actions but through lobbying and indirectly molding the regulatory environment.

Build cost is a function of regulatory prescriptions: It is not controversial to suggest that the building cost is some positive function of the regulatory prescriptions on the building process. Regulations do not make processes cheaper; regulations make projects more expensive. Prescriptions on buildings–including sustainability stars, window facings, minimum sizes and so forth–make those buildings more expensive. Higher costs means higher commissions for architects. Note that there is also the second aspect that making the process more complicated may mean that there is higher demand for architects simply due to the complexity of the process.

The story looks something like this:

  • Architects are protected by occupational licensing barriers to entry;
  • These barriers decrease the supply of architects, raising their wages;
  • Regulators make rules because that what they are taught to do–they are trained to intervene–and the more they intervene the more town planners are justifiably funded through the public purse;
  • These prescriptive rules increase build costs by complicating the process; and
  • Architects make money off commissions based on those build costs.

This is a particularly poignant example of the theory of economic regulation coming from Stigler 1961 and Peltzman 1976. The crux of these two papers is that there exists both a demand and a supply of regulation. A mutually beneficial exchange can occur between the regulators and the regulated. What I am suggesting here is that the architecture and town planning professions have created an elaborate exchange. The architects need rules and barriers to keep their profession exclusive; planners need to regulate to keep their jobs. Let me provide a few examples (it is clearly easier to provide examples of the demand side of this equation because those are easily observable through lobbying).

Earlier this month a new ruling in NSW increased the minimum size of apartments. The ruling cited NSW’s State Environmental Planning Policy 65 (SEPP 65). These guidelines were introduced as the brainchild of former Senator Bob Carr. The ruling increased the minimum apartment size guidelines (by . This even went above and beyond the apparent industry ‘rule of thumb'; enforcing the minimum apartments sizes to the stricter level set out in the guidelines. There is almost no need for me to explain the pitfalls of this plan. The result will be higher house prices and a lull in the innovative use of space. This comes at a time when Australia faces a housing affordability crisis. See the telling graph below by a colleague of mine at the Institute of Public Affairs, Mikayla Novak, on the number of years on the average wage needed to purchase a median-price capital city house:


But this most recent ruling is on the more modest end of recommendations of the Australian Institute of Architects. The national president of the AIA recently called for the ‘mandatory use of architects for the design of certain types of buildings.’ That’s right, not only do they want to limit the number of architects, but they want to be the intermediary on all transactions. This is like protecting the title of financial planners and then saying every time you make a credit card transaction over $1000 you have to engage with them. Moreover, there are also calls in SEPP65 for mandatory ‘expert’ peer review panels. This is absolutely ludicrous rent-seeking at its finest. Nevertheless, as would be expected, the rhetoric is not about rent-seeking. Rather, there is a elaborate facade of optimism. Sustainability. Family. Community. The list goes on. While it is not obvious at first, the grounding of these arguments are deeply pessimistic. It is pessimistic because the implicit assumption is that individuals cannot be responsible for their own decisions. Mandating the design of building–such as the number of windows or minimum floor size–is suggesting that individuals cannot plan for themselves. It’s saying people do not know what is best for them.

But this simple mistake has terrible ramifications. The problem is that the planning problem is given as a dichotomy between central town planning or no planning. But this is not the case at all. This is not a debate about whether we should plan or not. It is a question of who should do the planning and through what institutions. F. A. Hayek spoke of this question in 1945:

“[the] question which arises here, that of who is to do the planning. It is about this question that all the dispute about “economic planning” centers. This is not a dispute about whether planning is to be done or not. It is a dispute as to whether planning is to be done centrally, by one authority for the whole economic system, or is to be divided among many individuals. Planning in the specific sense in which the term is used in contemporary controversy necessarily means central planning-direction of the whole economic system according to one unified plan. Competition, on the other hand, means decentralized planning by many separate persons.” Hayek (p520, 1945)

The rhetoric around planning plays out as if the city would decompose into some chaotic anarchy without specific zoning and planning laws. That for some reason if we don’t dictate the minimum size of apartments then people will start living in homes that are too small for them. And that the government explicitly knows what house is too small.

But this chaotic outcome simply has no evidence. In fact, there is some significant evidence to the contrary. The US, in some sense, has provided us with a huge range of data from effective natural experiments in planning and zoning laws between the states. Zoning is controlled by the states and we have many years of data of house prices and such that can be compared against each other. What comes out of the data is that the more lenient (or absent) zoning laws–remember, individual planning rather than central planning–have produced more affordable housing and more innovative and growth friendly environments (see this on Cato).

The most popular example of this spontaneous order in town planning is of course Houston, Texas. What has happened in Texas is a natural and organic form of order. It works because cafes want to be near cafes. Factories want to be near factories. And so forth. Of course there have been some blunders. However what must be remembered–although can never be measured–is the huge savings from having no regulations. Also, don’t forget about the burgeoning phenomenon of private cities such as Guragon, India, where planning is entirely privatised (see a chapter by Rajagopalan and Tabarrok, or an econtalk podcast here). The lesson–time and time again–is that planning decisions are between the individual and the state, and that individuals outperform states.

Disclaimer: the event had $4 drinks subsided by the annual fees. I may go back for more next month.

¹ Note that the alternative is to increase your commission per cent; an approach the AIA did attempt by colluding fees across the industry. While these were never compulsory–taking the form of recommended fees provided to those looking to be entered into the profession–there was a significant case for price fixing and were later removed.

Architects and planners: the perfect storm for rent seeking

The innovation commons as a solution to the entrepreneurial problem

Here’s a work in progress abstract that I am currently writing up:

The entrepreneurial problem is one of knowledge coordination under uncertainty. This process consists of search, discovery, and action. The goal of the entrepreneur is to determine the viability of a particular innovation and thus reduce private uncertainty about the opportunity they imagine. The innovation resources to solve this problem, particularly at the beginning of a trajectory, exhibit some peculiar properties: they are dispersed about the economy in individual minds; they are uniquely of the ‘you don’t know it until you see it’ kind; and are likely to exhibit diminishing returns the more minds possess it. Combining institutional and evolutionary economics, as well as the commons literature, we are led to a new solution to the entrepreneurial problem: the ‘innovation commons’. Unlike conventional economic solutions, this is a collective action solution rather than an allocative one. We propose that the innovation commons exist where entrepreneurs pool their technology and knowledge resources, and govern as a common pool resource. This ties in with existing commons literature of how individuals deal with uncertainty (in rainwater falls, for example, the commons presents an institutional solution as a form of social insurance). Finally, we present a number of theories over what may be occurring here and what the innovation commons look like: they are temporary in nature (if they are successful they will disappear); they are likely to emerge more readily as transaction costs fall (hence the emergence of the innovation commons only now); and they may have a defensive function against alternate institutions.

The innovation commons as a solution to the entrepreneurial problem

Links to some of my writing in the last few months

Here’s some some cross-links to reports, articles and media that were up in December/January.

‘The sharing economy: how over-regulation could destroy an economic revolution’ (co-author was Chris Berg). This report can be downloaded here. It was featuredin The Australian here. I was interviewed on SBS radio about this here and I wrote a guest post for the OECD on the topic here.

Freedom to teach: a research report on the work and conditions of teachers in Australia’ (co-author was Vicki Stanley). This report can be downloaded here. It was featured on the front page of The Australian here and was the topic of The Australian editorial the following day.

Journal Articles:

Moilanen J, Daly A, Lobato R, and Allen D, (2015) ‘Cultures of sharing in 3D printing: what can we learn from the licence choices of Thingiverse users?’ Journal of Peer Production 6. Available here.

Links to some of my writing in the last few months

Libertarians and the Commons are Friends

It is no secret that libertarians profess freedom, rule of law, and property rights. Unfortunately, the latter tends to be an immediate reaction to the commons. As the story goes – disputes over shared property are solved by strong application of property rights and binding contracts. I’m not convinced.

We’re missing two things: (1) the commons have their foundation in voluntary collective-action governance; and (2) the commons can be conceived as a market. If you were to take ‘commons’ out of the last two sentences, then most libertarians would be happy. If you put it back in, there are calls for strong property rights to solve self-interested individuals from themselves.

Let’s talk about this for a minute.

Collective-action, by definition, is voluntary cooperation between private agents in civil society. Yes, voluntary. Sounds nice, doesn’t it? These institutions are complex environments characterised by implicit norms, tacit rules, and operational level decisions. They are not a free-for-all. Nor are they a form of re-distribution.

If you disagree with the commons as a voluntary system of institutional rules to share resources, then you’re going to have to disagree with firms, too. That’s what firms are – they coordinate and share resources under rules.

Collective-action governance is one of the purest forms of freedom. Contracts are often unwritten and implicit. Punishment mechanisms are set up by the agents themselves. Rules are specifically tailored to the social dilemma at hand. There’s little need for state protection of property rights through the courts. A well developed and evolved commons institution is an island of rules near absent from state pressures.

Sounds pretty free to me.

Further, the commons can be conceived as a form of market. Viewing the commons as a market seems counter-intuitive, yet it is not entirely crazy. They just look different; we’re not very good at understanding different institutions. The lines between market and non-market transactions are blurred.

This is best demonstrated through example: the innovation commons. The innovation commons are an emergent institution mixing technology and local Hayekian market knowledge through shared collective-action governance rules.

We have to remember that shared property is property, too. It’s not private individual property, like your home – but it is still property. There’s still a bundle of rights. There’s still exchanging of these bundles. There’s still a cost of entering and participating in the commons (often prior tacit knowledge or reputation). Sounds pretty market-like to me; and libertarians love markets.

Let’s take a more specific example – hackerspaces. Hackerspaces are collective-action institutions where private agents share local market knowledge, coalescing around certain technologies. The cost to enter the commons is the value of prior tacit knowledge. What’s exchanged is knowledge and technology. The exchange just isn’t in dollars, it’s through your contribution and cooperation (see a recent paper by Kealey and Ricketts 2014, on contribution goods).

The commons are not a free-for-all utopian commune. They’re an institution that appears effective at coordinating knowledge. You see, the commons and libertarians should be friends. We just need to take a step back before we (once again) label the commons as a remorseless tragedy and privatise them. Some failures should not render them obsolete. Rather, this should signal the complexity involved. From what we’ve learnt from economics over the past two decades – institutions matter and complexity matters. The commons encompass the two.

I am not suggesting the commons are economy-wide phenomena. Nor are they infallible (actually, they’re highly subject to failure). All I’m suggesting is that the next time you think about the commons, do not think of property first. Think of institutional governance – that is the challenge.

Ostrom suggested that institutional diversity may be as important as biological diversity. The commons are important to our institutional diversity, and should not be lost over an obsession with property rights. Property rights are the easy answer (because we understand them). This does not make an answer correct.

Libertarians and the Commons are Friends