must overcome if it wishes to develop a National Innovation System (NIS)<sup>3</sup> that can be an instrument for creating wealth, raising standards of living, and increasing global competitiveness.

These documents acknowledge the importance of upgrading the technological base and global competitiveness of traditional Latvian industrial sectors.<sup>4</sup> But the recommendations emphasize (i) the production and commercialization of domestic R&D and (ii) the development of new high tech industries. They tend to downplay or ignore policies and programs that would (i) help to upgrade the technological capability and productivity of those traditional economic sectors that account for the largest share of Latvian employment and exports and (ii) help Latvia develop an efficient system to absorb and diffuse knowledge produced elsewhere.

This is not surprising. Latvia is struggling with two related challenges. The first is reforming the NIS so that it becomes a tool for converting the country’s considerable scientific capacity and human capital into an asset for economic growth, competitiveness, and rising standards of living. The second is enhancing competitiveness and productivity in non-high tech sectors. In confronting these twin challenges, Latvian policy makers need to address several policy dilemmas. Specifically:

- **<u>Dilemma #1:  Basic Research vs. Innovation and Technology Upgrading.</u>** Basic research and innovation are not synonymous concepts, especially in countries like Latvia where most enterprises operate far below the technological frontier.  As we will show in more detail below, very few Latvian enterprises innovate and most of these firms innovate by importing capital equipment rather than by either conducting basic research themselves or purchasing research services from Latvian or foreign research institutes.  For better or worse, in other words, innovation and basic research in Latvia are separate, distinct, and discrete activities.  Policy makers may be missing an important opportunity to increase employment, wages, and overall standards of living if they focus on basic research to the exclusion of the more “mundane” tasks of technology upgrading -- design and engineering, the ability to acquire technology developed outside the country, and the managerial, organizational and technical capacity simply to

- 3 The NIS can be defined as the way in which the private sector, universities, R&D institutes, and government policies interact to generate inventions and innovations that can be converted into new products or production processes that enhance the competitive advantage of firms in that country.

- 4 For example, Chapter 1 of the National Innovation Program for 2003-2006 states, “Restructuring of the Latvian economy must be carried by stimulating the transformation of the traditional economic sectors on a productive technical and technological basis as well as creating for the first time in Latvia new branches based upon new knowledge and up-to-date technologies.”  Similarly, the Innovation Survey (Chapter 3, page 18, declares, “GDP growth can be ensured only by increasing the value added of the manufactured goods and services. This can be achieved by increasing the material input and labor capital involved in the production process.  Due to the limited possibilities to increase input the main way how to ensure GDP growth is to boost the amount of the intellectual capital in business.”

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