A Stylized Model of Innovation: The Dynamics of Capitalism

Nicola Tesla

There has been a debate in economics on whether innovation is exogenous (outside the economy) or endogenous (inside the economy).  This is another one of those dichotomies that obscures explanations of economic processes.

This is a stylized narrative of the path of economic innovation, the dynamics of the modern, industrial economic system. The resulting economic structure is mostly oligopoly, the domination of markets by large corporations.

Innovation begins with public knowledge, often scientific or mathematical discoveries that sometimes do not seem to have any practical value.  Imaginary numbers, general equations of electromagnetism, the Second Law of Thermodynamics, Brownian motion, E=mc**2, the structure of DNA, the conductivity of solids, quantum superposition, etc.  Some scientists and inventors begin to see possible applications of this scientific knowledge.  In the 20^th century, they are often funded by governments that see possible military applications.  Almost all of the hardware and software we use today as part of information technology was originally developed with government funds. Most of the basic research in biotechnology is still directly or indirectly funded by the government.  Then entrepreneurs begin to see possible commercial (profitable) development of the technology. Because of the uncertainty of how the technology will meet potential wants and whether it will be profitable, usually many companies try to develop different versions of the technology. Only a few will succeed and become the large, dominant companies. This is the stage where partial analogies to Darwinian selection, and their modern models, are suggestive. 

Much of the work is in engineering, production, design, distribution and marketing (creating demand). Further economic development occurs as companies create new products and services from combinations of new and existing technology. Often much of the innovation includes exploiting existing “network” technologies, such as railroads, electrical grids, mass media, telecommunications, or the Internet.  

Most of the early companies go bankrupt; about 500 auto companies were started in the early 20th century in the U.S.  A few companies successfully develop different niches of the potential market based on variations of the new technology. In the past, higher transportation and information costs might limit the geographical reach of any one company, allowing local and regional companies to succeed.  As distribution and information costs come down and new production technology leads to economies of development, a few of the innovative companies take over a larger percent of wider, growing market.

The surviving companies often exhibit two other traits. They are able to attract outside capital at critical inflection points in their growth. Growth is accelerated beyond that possible if they relied solely on internal cash flow. Also, they are able to acquire large competitors or small companies with technology or products that make them potential competitors. 

Typically, no one version of the technology gives the best benefit/cost ratio to all customers or consumers. Differentiated products or services aimed at developing different segments of the market lead to an oligopolistic structure of the market or industry. Total demand increases. Each company attempts to develop and protect proprietary information, be it better engineering, more efficient production, brand names, patents, packaging, etc., as the basis for growth in market share and economic profit. 

But with time, patents expire, engineers and managers leave existing companies to start their own company, and "industrial espionage" diffuses knowledge. Proprietary information leaks out to other companies and, with standardized products and slowing innovation, economic (above average) profit begins to disappear.  Products become commodities, meaning customers or consumers choose mostly on the basis of price. Market structure tends to stabilize.  New companies might enter to better serve a specialized niche of the market.  Some are acquired by large companies with declining internal investment opportunities; some replace existing companies as one of the dominant companies.  The overall market structure remained oligopolistic, often with the distribution of company size represented by a relatively stable exponential power law.

Another source of diffusion of knowledge and structural stability is that companies providing inputs, often large capital goods or information technology companies, offer standardized machinery, production systems or information technology and software packages to all existing corporate customers. Capital goods companies are crucial to continuing innovation since this is how they compete.  But now inputs embodying innovation are available to all. Company customers, however, often customize the input technology to make it more "firm-specific," to make it part of their proprietary knowledge.

This is part of a more general process where technology and information become widely known.  Much of the change in an industry is in cost reduction, relatively minor product changes and marketing.  Rates of return on new investments approach the company’s cost of capital.

Often, a new round of basic innovation begins.  Typically, it is driven by new companies, often outside the industry that innovated in the past.  Large companies have large investments in existing technology and much of the firm-specific knowledge supports this technology, existing distribution channels, a large customer base and existing marketing strategies. One should also not underestimate internal resistance to major change in any large organization, especially if the company has a long history of profitability and market dominance.

So the cycle begins again.  No company, no matter how big and how profitable, is immune from attack.  Think of General Motors, AT&T, IBM, Intel, Sears, U. S. Steel, Eastman Kodak, Xerox, Polaroid, Nokia, and many others.  New companies based on new technology appear.  Old industries are transformed and new industries created. But the dominant industry structure remains oligopolistic because of the internal dynamic of innovation (economic development).

There is an important lesson here. The basis of competition in most, if not all, industries and markets, is innovation, not price.

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For an excellent example of an entrepreneur at the beginning of the Industrial Revolution in England, see

Josiah Wedgwood, the Wedgwood Pottery Company, and the Beginning of the Industrial Revolution.

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